With one unilateral decision, Russia has taken an already uneasy global economy and flipped it completely on its head. Before Russia invaded Ukraine, most experts in geopolitics didn’t expect the Kremlin to invade despite Putin’s posturing to the contrary. The minute the decision was made for Russian troops to break Ukraine’s sovereignty, the world’s focus turned its attention squarely on the conflict, both humanitarian and economic. As a result, Russia has had the combined economic force of many of the globe’s largest countries, and public companies come down upon it to enact some of the most significant and punishing sanctions on a country since World War II, many of which are unprecedented in the modern era. In this newsletter, we’ll focus on what has happened economically since the beginning of the invasion and why this conflict halfway across the world has the potential to impact the US economy directly.
I’m writing this as of March 16, 2022, in what is still an incredibly fluid situation. The humanitarian cost alone has been extensive as more than 2.4 million Ukrainians have been displaced from their homes and fled the country since the beginning of the assault. While we acknowledge this tragedy and its cost at a human level, our scope for our views will be focused on the economics of the situation.
From this perspective, Russia has effectively been cast out to a desert island. The country is now the most sanctioned country in the world, well ahead of Iran and Syria in total sanctions. They have been disconnected from the SWIFT banking communications system, which effectively cuts off Russia’s ability to use credit cards and withdraw money outside of the country. Public companies such as Apple, Microsoft, Visa, Netflix, Starbucks, McDonald’s, and many others have committed to withdrawing their businesses from the country. This is in addition to many energy companies and countries committing to halting or significantly decreasing their purchases of Russian energy and commodity exports. Add on top of this the fact that Russia’s currency, the ruble, has fallen almost 20% versus the US dollar (at one point, it was down over 40%), and the country’s stock market is set to remain closed until at least March 18.
Any of these actions alone would be devastating for a country the size of Russia. Certainly, the country’s citizens will feel these impacts on their daily lives. The reason we outline what has happened to Russia economically is to set the table for how these actions have downstream effects for the United States. By cutting off imports of energy and commodities like oil, natural gas, and nickel from Russia to Europe and the US, we’re intentionally creating a supply shortage of these goods. In what has already been a tight supply chain disrupted by COVID, we’re now seeing inflation forecasts increase into the end of 2022 and beyond due to these sanctions. Additionally, wheat prices are increasing as production out of Ukraine is effectively shut down. According to the USDA, Ukraine accounts for approximately 12% of global wheat exports and 17% of corn exports.
What does this mean for the US economy? The assumption is we’ll see modestly higher inflation for longer, which has potential knock-on effects that we’ll explain later. Even if Russia were to withdraw its troops today, it’s doubtful many of these sanctions would be rolled back in a short period of time. Therefore, the US is likely to act as if these disruptions will persist for long enough to justify taking more permanent steps to reduce inflation and adjust our supply chains.
As for the knock-on effects, we believe the Fed will continue to be data-dependent on how they adjust monetary policy to combat inflation. The first 0.25% hike on March 16 was the first step in this direction, with six more 0.25% rate hikes projected for the remainder of 2022. This would put the federal funds rate to 1.75-2%. If these projections come to fruition, we’ll all be watching the state of the yield curve closely for any signs of yield curve inversion. This is because when the yield curve inverts, meaning longer-term rates (like the 10-year Treasury bond yield) are lower than short-term rates (like the 2-year treasury bond yield), it signals the increased likelihood of the economy falling into a recession.
Our base case assumes the economy will remain resilient as consumers continue to spend despite pressures of inflation lasting longer than anticipated. A ceasefire to the war in Ukraine would go a long way towards removing uncertainty from the market and redirecting our focus to corporate and economic fundamentals. We continue to believe the first half of the year will remain volatile as we digest the ongoing messaging from the Fed and the impact rate hikes and balance sheet runoffs have on inflation.
As a firm, we continue to believe maintaining a bias towards value stocks will provide relative portfolio stability compared to growth stocks. This is a position we solidified in early 2021 and have maintained up through this period. Fixed income remains volatile in the face of rising interest rates and inflation. To that point, we maintain our bias towards bonds that are less sensitive to interest rate fluctuations. We also continue to hold a position in TIPS as a primary inflation hedge. We will continue to monitor the market for opportunities to adjust our positioning as we observe material changes in our longer-term convictions.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted. All investing involves risk including loss of principal. No strategy assures success or protects against loss.