Four weeks ago, I suggested that investors buy to the sound of cannons. Now that the cannons have sounded, is that still a good idea?
Yes, but there’s a catch. A detailed list of past crises from Ed Clissold
of Ned Davis Research reveals that stock prices usually rebound strongly after sudden shocks such as war. On average, the DJIA is up 4.2% after a month and 15.3% a year later.
Here’s the catch. Consider the following: Jeremy Siegel observed that stocks return about 7% real per annum. Supposing your distant ancestors had invested $100 in equities or equivalent at the time of Augustus Caesar and held the investment for the last 2000 years. Your family would be so obscenely rich that it could have rescued the entire global financial system during the GFC with the proceeds of less than one day’s interest.
The key caveat to event studies such as the effects of war and historical analysis of long-term returns is they suffer from survivorship bias. A past study from Credit Suisse of cumulative real returns illustrates the risk from the permanent loss of capital from war and rebellion. Simply put, a lot of people died in very nasty ways and they never lived long enough to enjoy the use of their assets.
Exhibit A is Germany, which was extensively involved in both World Wars.
China and Russia are even more extreme examples of the permanent loss of capital. Had you been living in those countries, the last thing on your mind would have been the value of your investment portfolio. If you were lucky, you escaped with your life.
The inflation fallout
How do these studies apply to the current circumstances? As NATO has repeatedly asserted that it will not militarily intervene and send troops into Ukraine, the tail-risk of a global catastrophe is off the table. Investors can rely on the plain vanilla analysis of how markets reacted in past conflicts.
Nevertheless, there are several important fallouts from the current war. As the West rolls out sanctions on Russia, an article in the Economist
outlined Moscow’s possible retaliatory steps that could dent the global economic outlook.
Such tougher sanctions would have several drawbacks for the West. They might prompt economic retaliation from Russia, in the form of cyber-warfare or restrictions on the sale of gas to Europe. They would impose direct costs on Western economies. Russia remains the eu’s fifth-largest trading partner, for instance. European banks have $56bn-worth of claims on Russian residents. Cutting Russia off from swift could cause instability in the financial system. And energy bills in Europe would probably rise further. Furthermore, to be truly effective the West would also need to ensure that the sanctions are globally enforced: that means either persuading or coercing Asian countries, including China and India, to abide by them, perhaps by threatening secondary sanctions on them if they refuse. Without this any stronger sanctions regime would be a leaky bucket.
The most obvious problem for investors is soaring energy prices which puts upward pressure on inflation. As Russian troops crossed the line of control, Brent prices spiked to over $100, which will both raise inflation and dent economic growth.
Less noticed by the Street is the importance of Ukraine as the breadbasket of Europe. Ukraine is the top global producer of sunflower seed and a major producer of corn, barley, and wheat.
In short, the war will spark an inflation problem. How will the fiscal and monetary authorities respond?
Rally around the flag?
It depends on the jurisdiction. The EU had long been a collection of bickering countries, but its response has been remarkably united. The German decision to suspend approval of the Nordstream 2 pipeline was a demonstration that it was willing to bear substantial pain.
Count on a strong fiscal response where Berlin exempts military spending and energy diversification initiatives from eurozone deficit targets. While this is highly speculative, the war will accelerate Europe’s transition to green energy, which is a bullish factor for capital spending and investment in the region. The ECB should cooperate and decline to offset any fiscal expansion with monetary tightening. Peripheral country bond spreads will narrow. We saw this movie before in 2014.
The situation across the Atlantic is another matter. It is unclear how much of a rally around the flag effect the US will see in light of the divisions in the American electorate. While both Democrats and Republicans called for the government to support Ukraine, a division is appearing between the supporters of the two parties about the degree of support. A recent YouGov poll
sponsored by The Economist reveals an elevated level of opposition to different degrees of military aid and support to Ukraine and divisions between Democrats and Republicans about these issues.
These divisions in the electorate make a fiscal response, either to offset the inflationary effects of war or increased military spending, less likely. Any rally around the flag effect in America is likely to be far more muted than in Europe. The fiscal drag is projected to be negative and the war is unlikely to move the needle significantly.
As for the Fed, it continues to be worried about inflationary pressures. Fed Governors Michelle Bowman and Christopher Waller recently suggested a half-point rate hike could be on the table at the March FOMC meeting. The market continues to discount seven quarter-point rate hikes this year.
In the meantime, the 2s10s yield curve continues to flatten, indicating expectations of a growth slowdown.
In conclusion, buy the war dip is the order of the day in the absence of risk of a total loss of capital from war and rebellion. Take note, however, that macro conditions still dominate in the long run. The Afghanistan War began in 2001 shortly after 9/11, which was in the middle of a recession. While stock prices rebounded, they continued to decline after an initial rebound as economic conditions deteriorated.
The S&P 500 forward P/E has declined to a more reasonable 18.5, which slightly below the 5-year average of 18.6 but above the 10-year average of 16.7.
I continue to favor large-cap high-quality growth stocks in the NASDAQ 100, which have become extremely oversold on a normalized historical basis. As economic growth becomes scarce, expect investors to bid up the prices of cash generative growth stocks.
While the primary focus of my analysis is on regions, countries, sectors, and factors, investors may wish to consider the top half of the RRG chart
for FANG+ stocks for inclusion in their portfolios.
I expect the market will recover from the war scare in a short time, but I reiterate my views from my recent publication (A 2022 inflation tantrum investing roadmap
). The Fed is undergoing a tightening cycle. Stock prices will not bottom until the inflation outlook improves and the Fed stops removing monetary accommodation.
Buy the market panic for a tactical rebound, but don’t overstay your welcome.
Disclosure: Long TQQQ