“I need ammunition. Not a ride.”
History Lessons from War, Appeasement, and Markets
It’s useful to compare the events in Ukraine against history because we all have a stake in the outcome.
In 1938, Hitler annexed Austria; and demanded a portion of Czechoslovakia that was home to ethic Germans. The British and French agreed to the demand in exchange for a pledge to leave the rest of Czechoslovakia to its independence. Hitler reneged on that pledge and then invaded Poland in 1939. World War II was underway. Belgium, France, and the Netherlands were invaded in 1940; bombing began in Great Britain.
The parallels and potential spread of Russia’s invasion of Ukraine are eerily similar.
It’s worth remembering that tyranny invaded Ukraine for the sin of becoming a burgeoning democracy. Ukraine is fighting for its independence against the odds against the largest military in the region. The US war for independence against Great Britain was against the largest military in the world at the time. Absent French financial and military support, we could not have won.
The Western world thought that by integrating authoritarian regimes into global trade and commerce, they would eventually blossom into democracies. Post-World War II, this worked with Germany, Japan, South Korea and several other countries. This has not happened with China and Russia.
The big uncertainty is how will self-interested policy makers across the globe deal with Russia and China. China does not object to Russia’s aggression and is likely helping them circumvent economic sanctions. Both are authoritarian regimes with similar world views that seek to expand or strengthen their spheres of influence. Both have not played by the rules or norms because they have not been held to any standards of reform. Both have benefitted from global trade and commerce: China is now the 2nd largest economy in the world; Russia is a large supplier of energy resources (Europe imports 35% of energy needs from Russia; Germany is closer to 50%).
The democratic world’s economic appeasement over the past 30 years has strengthened their positions. The fear is that a Cold War 2.0 would be much harder to contain as China is now a global economic powerhouse. As a result, the world is facing complex calculations with serious political, economic, and humanitarian consequences.
The Economy, Inflation, and Interest Rates
The inflation genie was out before the war. Markets have seen war and inflation before. The spike in interest rates in 2022 created the worst bond market in 50 years. Some analysts believe markets may have overreacted to the prospect for Federal Reserve rate increases and rates could pull back. Still, rents and home prices continue rising faster than wages. Inflation is running over 8% on the year; unemployment is at 3.6%. If the economy stays strong, rates could go higher.
A Bloomberg analyst noted that we have never had a period when unemployment was less than 4% and inflation was over 4%, that did not lead to a recession. We also briefly saw an “inverted yield curve” which often is a recession indicator. Inverted is when long-term interest rates are lower than short-term rates. Normally long-term rates are higher than short-term rates. This is necessary for credit markets to work well. Banks borrow short-term money and lend long-term money and make a profit on the difference. If rates are upside down, banks don’t make money, credit doesn’t flow, and the economy slows.
If the economy weakens, rates usually decline, which helps re-stimulate the economy. However, if inflation persists even with economic weakness (aka stagflation) rates could rise further. That would make for a challenging investment climate. Supply disruptions such as we are seeing due to the war could mean higher prices. Additionally, in the wake of COVID and the geopolitical turmoil, companies are re-thinking “just-in-time” lowest cost supply chains and adopting “just-in-case” higher cost models.
Asset Class Review
United States: stock markets were down. They rallied off the lows but inflation, the specter or rising rates, and war offset strong economic data. Technology was hit hard. Consumer Staples and Utilities held up well. Energy was especially strong as the supply shock of Russia’s invasion drove oil higher.
The Eurozone: reliance on Russian energy supplies lead to a decline in equities. Only the energy sector fared well. Germany suspended the Nord Stream 2 pipeline from Russia. The region gets 30%-35% of its energy supply from Russia and is hastening efforts to diversify gas and oil sources and move toward renewables. Inflation ran over 7% in the quarter.
Asia-Pacific: Aside from the war, China’s COVID lockdown in Shanghai weighed on sentiment and lower demand forecasts. Chinese shares were off significantly. Other countries fared better, as some were in positive territory.
Emerging Markets: the benchmark was down lead by China. Russian exchanges were suspended. Commodity producing countries in LATAM were strong as were net commodity exporters in other regions.
US REITs: typically sell off when rates rise thought the underlying assets are a hedge against inflation. Ultimately the property rents should rise with inflation.
Commodities: were led higher by oil and wheat prices due primarily the invasion of Ukraine. Ukraine and Russian exports represent over 35% and 20% of the world’s wheat and corn, respectively. Rising food and energy costs can damage consumer spending and limit economic growth.
Bonds: yields across the developed economies spiked as central banks announced policies to mitigate inflationary pressures. In aggregate, we are off to the worst bond market performance in 50 years.
Jerry Matecun – Founder, President
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