Broker Check

Could This Ignite World War III?

February 25, 2022

As if investors don’t have enough on their plates right now, Russia injected fresh volatility this week as they officially began military operations in Ukraine. But before investors panic too much, let’s address three questions to determine the ramifications for the U.S. economy and the long-term direction of stock prices.

The table below shows the impact of geopolitical events on the S&P 500 has been both temporary and trivial. Since Pearl Harbor, the average drawdown was 4.6%, and the average recovery took a mere 43 days. The median recovery, which removes the effect of extreme outliers, was 18 days. Hence, the first question to ask is:

“Is this time different?”

Before answering, let’s provide some context to the current crisis. Russia has been fighting in the region for well over a decade. Putin began with Georgia in 2008, then annexed Crimea in 2014, and now this.

Furthermore, the question refers to how long the market will pay attention – not how long the conflict will last – and you don’t need to be an expert in geopolitics to answer this one.

Back in 2014, the conflict between Russia and Ukraine worsened to the point where a civilian passenger flight was shot down - killing 300 people1. Not even that was enough to keep traders focused, so for this current crisis to impact the stock market for more than a few weeks, the story is going to have to keep getting bigger and scarier.

Two ways the media is currently scratching this itch is by suggesting (1) any success by Putin will incentivize China to invade Taiwan, and/or (2) this will ignite another World War. Regarding the former, while Russia and Ukraine are mostly isolated from the U.S., Taiwan is critically important because they manufacture over 50% of the semiconductors that go into everything from cars to missiles2. This would almost certainly provoke a response that involves more than just economic sanctions.

Russia may be isolated from the rest of the world and have enough reserves to keep their country running for some time, but China is a different story. They rely far more on international markets, and the U.S. has more levers to pull against them that would make such a move a painful one. That being said, politicians aren’t always rational, so this risk is one we must watch closely.

In regard to the latter, the odds of another World War are infinitesimally small. Leaders talk to each other more often, alliances are stronger, technology has facilitated education and sped up communication, globalization has created economic interdependencies between nations (and enemies), and there hasn’t been a military force like the U.S. in the history of mankind.

Simply put, it’s hard to answer “yes” to this question given the short-term memory of the stock market and the lack of a clear catalyst for this crisis to metastasize.

Will it impact spending?

The chart below shows that almost 70% of U.S. economic activity comes from consumer spending. Meaning, when we go out to dinner, visit a carwash, or get a haircut, the economy is growing. Add in business spending, and these two represent 87% of the $22 trillion economy.

Recessions happen when spending slows dramatically, so the second question becomes:

“Will Putin convince Americans to spend a lot less money?”

Personally, I don’t see how we will dine out less and cancel our Amazon Prime memberships because two countries in Eastern Europe embroiled in an eight-year conflict start fighting more. Especially right now when unemployment is low, trillions in cash are sitting in our bank accounts, and mask and travel mandates are being lifted for the first time in almost two years.

There’s plenty of data to support my skepticism. For example, retail sales boomed in January. At 3.8%, it was the fastest gain since March 2021 and strong across the board3. Retail sales is 30% of the U.S. economy alone4, and as we continue to get back to normal, it’s likely that a lot of that cash sitting in bank accounts will get deployed into sectors like travel, entertainment, and other services that tend to dominate spending during times of economic expansion.

Is it worse than these?

The chart below examines the performance of a balanced strategy of 60% stocks and 40% bonds after each major crisis over the last thirty-five years. For example, after the bankruptcy of Lehman Brothers and the depths of the financial crisis, this portfolio increased 4% (blue bar) one year later, 12% (yellow bar) three years later, and 47% (green bar) five years later.

The average return after each crisis has been a respectable one-year 6.4%, three-year 24.4%, and a staggering five-year 58.6%. Said another way, the market’s response to a crisis has been quite favorable to investors who remained diversified and patient. The third question then becomes:

“Is the Russia/Ukraine crisis worse than anything on this chart?”

It’s hard to see how Russia could inflict as much damage as the financial crisis, test America’s resolve more than 9/11, or inject the same risk into the banking sector as when the Savings & Loan crisis almost took down some of the largest firms on Wall Street. That’s why my answer to this question is also “no.”

Lastly, it’s important to note why this balanced strategy weathered the turmoil. It had nothing to do with getting out of the market at the right time and then back in just as the madness subsided. The success came from preparation, not timing, by building a well-diversified portfolio designed to recover from turbulence and grow over time.

The bottom line

Since I’m unable to answer “yes” to any of the three questions above, here are five key conclusions that continue to drive our investment process:

  1. Stocks usually take geopolitical events in stride. It’s unclear how this time will be any different.
  2. Spending trends should remain intact. The American consumer is arguably in the best financial shape in history, and Putin will struggle to change that.
  3. Our exposure to Russia is small. Our strategies currently have no more than 0.35% allocated to Russia and virtually none to Ukraine.
  4. The real risk facing investors is inflation. Geopolitical concerns come and go, but inflation is a problem for those who don’t protect against it. That’s why we are focused more on companies with pricing power versus moving to cash and losing 7.5% annually to inflation5.
  5. We continue to adjust our portfolios based on fundamentals. It’s not just inflation but also a world with higher interest rates. We’ve been actively preparing for some time, and deviating from this strategy to try to avoid periodic volatility risks converting short-term pain into long-term misery (sell into panic and then miss the potential recovery).


Lastly, take a look at one more chart below to see the last time Russia made a move like this. Had I not circled it in red, it’s doubtful even Putin could find it. That’s because these events are scary in real time, but after a while, they become a barely noticeable blip on a chart that’s created incredible wealth over time.

The bottom line is that the economic impact to the U.S. is expected to be small, and therefore, the stock market should reflect this at some point. Our strategy remains far more focused on inflation and rising interest rates because we view these as real risks, if ignored, over the long run.

 

Sources

1 https://en.wikipedia.org/wiki/Malaysia_Airlines_Flight_17

2 https://www.cnbc.com/2021/03/16/2-charts-show-how-much-the-world-depends-on-taiwan-for-semiconductors.html

3 https://www.ftportfolios.com/Commentary/EconomicResearch/2022/2/16/retail-sales-rose-3.8percent-in-january

4 The Federal Reserve. As of 2/24/2022

5 https://www.bls.gov/cpi/

Disclosures

This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.