The biggest threat to your portfolio in wartime isn’t a special-forces operative or an explosives expert. It’s the guy who is convinced he knows what is going to happen next.
Consider the notion that Russia’s bloody assault on Ukraine would turn into a great buying opportunity. This was a staple of market commentary in recent days. It relied on historical evidence showing that stocks usually tumble by double-digit amounts when bullets start flying, then rebound strongly in subsequent months.
Or consider the equally compelling notion that war in Ukraine could turn into boom times for commodities such as oil and gold. This seemed to make sense if you assumed Russian energy exports would be curtailed by sanctions and that panicked investors would rush into havens such as bullion.
Neither view has held up particularly well. Investors who still want to place bets on the next step in this conflict should consider three observations.
It could already be over: The S&P 500 index, the benchmark for large U.S. stocks, decided on Thursday that the war in Ukraine was effectively done, at least as a threat to corporate bottom lines on this side of the Atlantic. This was perhaps because of the less-than-sweeping sanctions that were announced or perhaps it was because of a belief that the war would encourage the Federal Reserve and other key central banks to throttle back on their plans to raise interest rates. For whatever reason, the index bounced higher and continued to surge upward on Friday.
The rebound seems callous – and it is – but also justified on a strict dollars-and-cents basis. As horrifying as Vladimir Putin’s conduct has been, neither Russia nor Ukraine loom large in the global economy. Europe’s addiction to Russian gas and oil give Mr. Putin’s country some serious regional clout. However, so long as Russian fossil fuels keep flowing in some fashion – and the patchy sanctions unveiled so far indicate they will – the global impact of any curtailment will probably be limited.
Reports on Friday that Russia is open to sitting down with Ukrainian leaders suggest that Moscow may want to cow the invaded country into submission but avoid a long war. Investors who were rushing into havens are already unwinding their bets. Oil and gold have both retreated from their peaks on Thursday. The panic trade may resurface, but for now, it is fading.
High inflation ends in recessions – usually
U.S. consumer price index, percentage change
from year ago
15.0%
U.S.
recessions
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
1950
1960
1970
1980
1990
2000
2010
2020
the globe and mail, source: federal reserve
bank of st. louis
High inflation ends in recessions – usually
U.S. consumer price index, percentage change from year ago
15.0%
U.S.
recessions
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
1950
1960
1970
1980
1990
2000
2010
2020
the globe and mail, source: federal reserve
bank of st. louis
High inflation ends in recessions – usually
U.S. consumer price index, percentage change from year ago
15.0%
U.S.
recessions
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
1950
1960
1970
1980
1990
2000
2010
2020
the globe and mail, source: federal reserve bank of st. louis
Watch Powell, not Putin: Stocks did well after past shooting wars because central bankers rushed to the aid of their wartime economies with interest-rate cuts. But that doesn’t seem likely this time around. Bond yields have remained stubbornly high.
For Jerome Powell, chair of the U.S. Federal Reserve, and governor Tiff Macklem at the Bank of Canada, the biggest imminent threat isn’t Mr. Putin. It’s inflation. Prices in both the U.S. and Canada are climbing at their highest rates in decades. If the futures market is to be trusted, Mr. Powell and Mr. Macklem will hike rates, and keep on hiking them in months to come, as they attempt to slow their economies and cool off red-hot inflation.
Hiking cycles are bad news for both stocks. Over the past several decades, U.S. stocks produced modest real returns of only 3 per cent a year when the Fed was raising rates. In comparison, they produced real returns of 9.7 per cent a year when the Fed was cutting rates, according to the latest edition of the Credit Suisse Investment Returns Yearbook, published this week.
The historical evidence suggests investors should keep their hopes for the remainder of this year in check. At best, returns seem likely to be muted. At worst, more losses could be in store.
As researchers at DataTrek noted this week, previous episodes of high inflation in the United States typically ended with a recession. This isn’t an iron law (inflation declined in the 1990s without a slowdown) but it does hold true an uncomfortable amount of the time. Especially when U.S. inflation is running above 5 per cent, as it is now, the track record is ominous. Consider yourself warned.
Know what you don’t know: The torrent of commentary in recent days has demonstrated that nobody shines at seeing the future. Markets move in surprising ways, especially when it comes to something as inherently chaotic as war.
A good example of this unpredictability is the relative performance of the iShares Europe Exchange Traded Fund (IEV) versus the SPDR S&P 500 Exchange Traded Fund (SPY). Both have lost ground this year, but the iShares Europe fund, which tracks a wider range of European stocks, has lost less than the S&P 500 index fund, with its focus on U.S. stocks.
Who would have predicted that European stocks would outperform their U.S. counterparts despite a shooting war on the continent? If nothing else, the surprising resilience of European stocks suggests you shouldn’t run to reposition your portfolio based on the latest reports from the front. Wide diversification remains the best insurance against the high probability that things won’t turn out quite the way you think they will. In times of war, that insurance is particularly valuable.
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