Resilience in Times of Adversity

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This week’s invasion of Ukraine by Russia has thrown major new complexities and uncertainties into the geo-political and macro-economic outlook.  Markets had already been pricing in the possibility of escalating conflict given the build-up of troops on the Russia/ Ukraine border and the continuous and vocal communication about the likelihood of military action by the US and other countries.  However, since the reality of the invasion markets have entered a new phase of risk and volatility.

It is clear that the Covid pandemic, which we finally seem to be overcoming as Omicron remains much more infectious but less severe than previous variants, and as countries across the world are discontinuing the physical distancing measures they have put in place, has accelerated much of the change and disruption we have seen over the past decade.  The most obvious is the transition from offline to online and the importance of the digital economy for businesses and consumers.  However, another less obvious change and disruption is the disruption of global supply chains, exposing the fragility of off-shored production and just in time delivery.  The resulting re-shoring is already happening and will have a significant impact on places that are closer to major end markets. 

It seems to us that Russia’s invasion of Ukraine will lead to a similar acceleration of change and disruption in the geo-political framework and the transition from a post-war period of hegemony by the US and its allies to a multipolar world in which the US, China and Europe, along with other countries, will have to find ways to co-exist peacefully and to deliver prosperity to their people.

In the same way as we are not epidemiologists, we are not political scientists.  It is our responsibility to assess the available information and make judgments about how they will affect our investments. 

Russia is one of those ‘other’ countries with a long history of empire and collapse, a resource-driven economy that provides much of Europe and the world’s oil and gas, wheat, fertilizer and non-ferrous metals, a political system that appears increasingly autocratic and and a military, and in particular nuclear, capacity that means it has an outsized global role that is greater than its population or economy would imply.  Whether the Russian government’s actions are in the long-term interest of the peace and prosperity of their people is not for us to judge. 

It is impossible to say how long Russia’s current first move will take or what its outcome will be.  Russia appears to be looking for an annexation of at least part of Ukraine by Russia and a regime change in Ukraine, even if the short-term economic cost to Russia through sanctions is meaningful. The political will in Russia to achieve this goal appears to be much greater than the ability of Ukraine to resist it or the resolve of Western powers to block it.

The key questions for us as investors are how the invasion will play out, how far the Russian incursion will go, and what response the Ukrainian government, military and most importantly population will have.  The outcome and timing will have an impact on how sharp the short-term reaction will be in terms of energy and other commodity prices, what impact this reaction will have in turn on inflation and policy responses by the central banks, and how great the risk is of a significant further escalation or a prolonged period of great uncertainty which could materially undermine the current expectation of global economic recovery and strong GDP growth in 2022-23.

We should have a first indication of some of these outcomes in a matter of days or weeks.  A scenario could be that annexation/some regime change will occur in Ukraine within two months or so. Russia would effectively take control of the Eastern part of the country including further valuable access to ports on the Black Sea. If active hostilities calmed down during this period, markets would increasingly view it as a regional conflict with limited impact on global growth. The immediate mood of heightened risk in markets would dissipate and the focus would return to the economic costs, increased inflation and likelihood that energy prices would steadily fall back as market conditions normalise, supply increases and supply chains realign.  In this scenario we would expect markets to remain volatile but to avoid a prolonged downturn, as in many industries and countries the impact will be manageable. Countries with lower levels of self-sufficiency in energy and companies with high input costs in energy, minerals and agri-commodities would be squeezed the most. Other companies, in particular of the type we invest in, would see limited impact on their operating environment or profitability.

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