I REALLY WISH THERE was a topic to discuss today other than the grotesque war being perpetrated against Ukraine. But unfortunately, there isn’t. This situation has prompted numerous questions from investors. Below are the three questions I’ve heard most over the past week.
1. What’s the financial impact of these events? Since Russia invaded Ukraine, global stock markets have bounced around with no discernable pattern (other than the Russian market, which has—not surprisingly—been a disaster). This reflects several realities. The first is that the economic impact is still very much an open question. Because no one knows when or how this crisis will be resolved, it’s difficult right now to estimate the net impact on the world economy.
In the meantime, though, the market is doing its best—however imperfectly—to gauge the impact. So far, investors have, on average, concluded that the impact may be minimal. According to FactSet, companies in the S&P 500 derive just 1% of their revenue from Russia and Ukraine. Circulating online last week was a video of a Russian man angrily smashing his iPad—a proxy, I assume, for his anger at Apple for suspending sales in Russia. That made for good theater.
But the economic reality is that Russia, while large geographically, has a surprisingly small economy. It’s less than one-tenth the size of the U.S. economy. It’s largely irrelevant as an export market for American companies. That’s one key reason the U.S. stock market has barely registered these events. Sometimes, the market overreacts—as it did in the early days of the pandemic—but sometimes it does react proportionally, and that’s what we’re seeing in this case.
A second reality, as some have grimly noted: War isn’t necessarily bad for the economy. Companies like Apple might lose sales, but others will gain. Unfortunately, defense contractors will probably have a good year. Energy companies, which were already having a good year, will likely see profits improve further due to rising oil prices. According to Bank of America, commodity prices have already risen at a faster rate this year than in any year since 1915. The bottom line: As things stand now, the financial impact of Russia’s war is unclear, but the best estimate is that, on balance, it may be insignificant.
Another reason why the market reaction, so far, has been muted: Markets are politically agnostic. What’s going on in Ukraine is a humanitarian crisis and an assault on democracy. It’s terrible. But it isn’t currently an economic crisis. In some ways, the market’s reaction to this crisis mirrors what we saw in 2021: Despite an ongoing health crisis, the market rallied to new highs. Many found that puzzling and perhaps troubling. Similarly, when a country is being senselessly leveled, it seems like markets ought to react. But for better or worse, the market is sometimes quite unemotional.
2. Even if the financial impact today is muted, could there be an economic impact over the long term? This question is harder to answer because we don’t know what the resolution of this conflict will look like. Still, it’s worth exploring the potential impact and the range of possibilities.
The clearest risk is to consumer prices. Before this started, inflation was already a problem, and it could get worse. That’s because Russia and Ukraine produce several key commodities. Ukraine produces significant amounts of wheat and corn, while Russia is a major oil producer. If Ukraine is in ruin and Russia is isolated economically, prices for these commodities could see further increases.
Russia only accounts for a small portion—less than 10%—of U.S. oil imports. But it’s a much more important source of energy for western Europe. Because commodities are fungible, a supply constraint in one market tends to drive up prices everywhere as consumers scratch around for other sources.
While commodity prices pose the clearest risk, inflation could spread more broadly throughout the economy if Russia chose to escalate and expand its aggression. That’s because global supply chains are already snarled, and a broader international conflict could make transportation that much more difficult. Depending on which way things go, it could also cause a recession.
China is another piece of the puzzle. In recent years, under Xi Jinping, China’s posture toward the world—and the West, in particular—has become increasingly hostile. An especially troubling example: There was news this week that Putin had consulted with Xi about his plans for Ukraine, and that Xi—rather than trying to dissuade a madman from embarking on an unprovoked war—had instead simply requested that he wait until the Olympics in China had concluded. If true, that tells us a lot about Xi and significantly raises the overall risk to the U.S. economy. It’s rare that we see a product stamped “Made in Russia,” so it’s fairly painless to isolate Russia economically. It would be far harder to isolate China in the same way. If Xi chose to borrow from the Putin playbook, we’d have a far bigger economic problem.
3. Going forward, should I do anything differently? The most important thing for investors to do today is the same thing that’s always been most important: to diversify. As the pandemic and this crisis both illustrate, risks can come out of nowhere and at any time. Diversification means that you’ll rarely have the top-performing portfolio among investors, but it also means you’ll rarely have the worst performance.
What else can you do? In recent years, there’s been growing interest in socially responsible investing—that is, structuring portfolios to reflect an investor’s values. A common acronym is ESG—short for environmental, social and governance, which are three important criteria for scoring public companies’ conduct. Some people choose to structure their portfolios in line with their values purely because that’s what’s important to them. Others believe that investing in good companies will actually produce better investment returns—because companies that are run in a principled way will tend to have happier, more productive workers and will also get into less trouble.
Usually, ESG is applied on a stock-by-stock or industry-by-industry basis. But as you look at the geographical distribution of your portfolio, you might apply a similar lens. Is Vladimir Putin someone you would want to do business with? How about Xi Jinping? If not, then it may be worth asking whether you want any of your investment dollars in their domains.
In the portfolios that I manage, I typically allocate only 5% of stocks to emerging markets. Of that 5%, China accounts for about 30%, while Russia accounts for just 2% or 3%. In the past, I’ve felt that’s a reasonable risk level. But in light of recent events, this is something to reconsider. By some measures, Russian stocks are down 90% or more. It’s tough to say right now because its market has been closed, and it’s being kicked out of the primary emerging markets index.
Is now the right time to exit emerging markets? In general, I don’t like investing based on the rearview mirror. That’s called performance chasing, and it’s a good way to suffer whiplash. That’s why I generally recommend setting an asset allocation and maintaining it through thick and thin. But that doesn’t mean change is never warranted.
When British economist John Maynard Keynes was criticized for changing his mind on a public policy question, he is said to have responded, “When the facts change, I change my mind.” Unfortunately, when it comes to Russia—and the risk posed by emerging markets in general—it’s hard to argue that the facts haven’t changed.