Russia and Ukraine in Perspective
We all awakened this morning, February 22nd, 2022, to what was assumed as inevitable – Russia would invade at least part, if not all, of Ukraine. Sure enough, the Russian military has moved into the eastern part of Ukraine. The inevitability of that move aside, few commentators offered thoughts on what the Russia and Ukraine situation means for the economy, and we would like to address that here.
We’ll start by offering our sympathies for those who live in Ukraine and are dealing with this as a very real tragedy for them personally and for their fledgling independent country. Words cannot express the sorrow felt by someone who has lost their country, and we mourn that loss with them.
Having said that, we must note that economic consequences are often much different than political or personal consequences, and such is the case here. Russia’s invasion of Ukraine is unlikely to change this year’s or even the long-term economic outlook. As we write, equities have already dropped a bit and may well drop more before the week is out. But even if that drop is indeed significant (10% or more), we steadfastly believe it will represent a buying signal, not a selling signal.
It appears as though the Biden administration and much of Western Europe will impose economic sanctions on Russia, some of which may have a minor negative impact on the U.S. and the west. Russia’s economy is already quite small in relation to the rest of the world, and it will most likely be buttressed by support from China. In a sense, we may be returning to a situation reminiscent of the Cold War, only with Russia and China more supportive of one another this time around. It is important to remember that the economies in the rest of the world were able to grow and prosper even during the Cold War. We see this playing out again.
The negative effects on the U.S. and Europe will be limited. The supply of oil will no doubt be restricted if sanctions include cutting off the Nord Stream pipeline. That will cause oil to spike if the market has not already anticipated this. But worldwide supply will adjust, and all that may be necessary is a resumption of U.S. fracking levels. As that happens, oil prices will resume “normal” levels, and the economy will adjust without much hesitation.
We cannot begin to predict what will happen in other political hotspots around the world, but that is, and always has been, an ever-present risk.
The market prices those considerations into its assessment of the value of future economic activity, and specifically into future profits. That is true today, and so we turn our attention there.
Looking at the profits that are already on the books of publicly traded companies, and adopting a reasonable discount rate (we have explained our methodology in detail in past posts, so will only reference it here), we still believe that equities are undervalued at today’s stock market levels. To be specific, we see a Dow in the 40,000 range by year-end as reasonable and fair given today’s reported profit levels. If future profits come in higher, the Dow could easily rise more.
The major influences on profits and the fair level for the Dow are inflation and interest rates. As we’ve written before, stocks will hold up against inflation in the long run. Companies adjust their pricing to reflect increased costs, and for most companies, profit margins will be maintained. There may be some short-term lags or adjustments in that process, and different sectors will adjust at different rates. In general, though, profits are up roughly 18% over the last year and are up 20% from the pre-Covid high. We believe these levels will be maintained and continue to grow.
Interest Rates and Inflation
Interest rates remain the wild card. The Fed will increase interest rates. That fact has already been priced by the market, and we have used that fact in our discounting calculations. Whether it takes 3, 4, or 5 hikes, we expect to see the 10-year Treasury rate rise to approximately 3% by the end of the year. That will be healthy, good for the economy, and support our assessments of fair value. Long-term, run-away inflation is bad for the economy because of how it distorts decision-making. Consumer prices are up 7% from a year ago, and this needs to come down. The Fed is finally recognizing this and taking action. The likelihood of long-term run-away inflation is diminished, and this is a positive signal for the future.
What could change this assessment? The Fed increasing rates by significantly less or significantly more than what they’ve signaled would be read as negative news and probably cause a market pullback. Too small an increase in rates would suggest the Fed sees economic weakness somewhere; too large an increase in rates would suggest the Fed sees higher levels of inflation. Either would be a surprise, and markets hate surprises.
Markets also hate bad news. If economic activity were to be compromised significantly, or if profits were to fall substantially, the markets would retrench; prices for stocks would drop accordingly. But that is not what we face today. As noted above, profit levels are strong and expected to actually grow. Corporate balance sheets are better than they’ve been in decades, and consumers remain in a healthy position.
We are saddened at the actions Russia is taking, and we mourn with Ukrainians at their loss. But in the interest of our clients, we do not recommend a change in strategy at this time. We will wait this out and make tactical moves as appropriate to either buying opportunities or to allocations to different sectors where companies can more easily absorb and pass on cost increases. Clearly, there will be more information to come, and we will keep you posted as events unfurl.