THE WAR IN UKRAINE AND THE ROAD AHEAD FOR MARKETS / BARRON´S MAGAZINE

The War in Ukraine and the Road Ahead for Markets

By David Sterman

Unless there's a rapid drop in energy prices, inflationary pressures could remain a key headwind for the stock market./ ANDREW COWIE/AFP/Getty Images

These are the moments when advisors truly earn their keep. 

Helping clients understand and react to changing market conditions is a core part of the job. 

Advisors who fail to stay in front of clients during stressful times can see clients take their business elsewhere.

And when it comes to the rapidly unfolding events in Ukraine, your clients may be more confused than ever. 

They’ve likely seen their portfolios lose 10% or more of their value in just a few months. 

Advisors need to help determine whether it’s best to ride out market struggles—or cut their losses in the face of still worse days to come.

The instinct to sharply reduce client exposure to equities is surely tempting. 

After all, the S&P 500 has fallen by double digits on a percentage basis in a short time, and the tech-heavy Nasdaq Composite index is already pinned down by a growling bear market. 

Consider that the seven largest companies in the U.S. (by market value) have collectively shed $3 trillion in value from their peaks, according to the Irrelevant Investor. 

Those companies, which include the likes of Apple , Google, Tesla , and Microsoft , are precisely the stocks that sharply boosted client portfolios in recent years. 

And it’s not just megacap tech stocks that are taking it on the chin. 

Consumer Discretionary Stocks, as one example, are now in bear market territory as well. 

Small-cap stocks (as measured by the Vanguard Small Cap Index Admiral fund (VSMAX)) are now back at levels seen at the start of 2021. 

For clients who own Russian equities and bonds, either directly or through investment funds, navigating the road ahead may prove to be especially tricky. 

The Russian stock market remains closed, and when it reopens, stock and bond prices could open sharply lower. 

Even then, it may make sense to cut losses and avoid the temptation to wait for a rebound. 

Russia’s military actions likely have caused a long-lasting rift with the West, which is likely to lead to economic isolation and perhaps a deep economic recession in Russia. 

(High oil prices, and Russia’s ability to continue selling its oil, might mitigate against an economic catastrophe). 

Investments in Russian stocks and bonds may ultimately provide their greatest value as tax-loss harvesting candidates later this year. 

Then again, an alternative outcome may play out. 

Russian oligarchs are starting to feel the pain of various economic sanctions and may look to steer President Putin toward some sort of exit strategy. 

And if sanctions are lifted and the Russian economy avoids a deep recession, then Russian stock and bonds will come to appear as deep bargains at current prices. 

Crude’s complex calculus. 

Of course, not all sectors and markets are in a funk. 

Surging energy prices have delivered impressive gains for oil and gas producers. 

Yet as Barron’s Jacob Sonenshine notes, a surge in the price of a commodity becomes self-correcting, as production rises and demand wanes. 

As he concludes, “Oil stocks may be able to keep gaining, but there is lots of room for them to fall.”

That kind of logic can be confounding for advisors and clients these days. 

It remains unclear whether the segments of the market that have been mostly deeply affected by the unfolding war in the Ukraine might stage a sharp reversal if markets conclude that various concerns about the global economy have been overblown. 

Selling at a market bottom—if one is approaching—always looks unwise in hindsight.

Connecting the dots. 

To be sure, the sharp spike in oil prices, to levels not seen since 2008, has set off alarm bells. 

If oil prices fail to cool in coming weeks and months, then a range of inflation gauges may move yet higher. 

First-quarter earnings season is about a month away, and if oil prices have not backed off by then, earnings guidance from manufacturers and transportation firms is likely to be weak. 

Firms that rely on industrial metals are also struggling to source reasonably priced production inputs. 

Nickel prices, for example, have soared in recent days and now trade at multidecade highs.  

At the moment, energy markets are reacting to the Biden administration’s ban on Russian oil and a U.K. decision to phase out the import of Russian oil by year-end. 

The U.S. likely will see higher oil prices in the near term, with hopes of a subsequent cooldown in oil markets as domestic production increases along with output from nations like Saudi Arabia. 

Before the White House’s announcement on the oil ban, strategists at JPMorgan Chase predicted that a barrel of Brent crude oil could rise to $185 if Russia trimmed supplies or the U.S. blocked Russian oil imports. 

Inflation hawks are watching this space closely. 

Expectations of future price increases are already being contemplated by consumers, and that could lead to a retrenchment in consumer spending.

At this point, the Fed remains on track to start increasing benchmark interest rates at next week’s Federal Reserve Open Market Committee meeting. 

If the economy starts to materially slow in coming months, then policy makers may approve fewer rate hikes than expected. 

The CME ’s FedWatch tool currently anticipates a 64% chance that the federal funds rate will be between 1.5% and 2.0% by December. 

Havens from the storm. During tumultuous times, investors seek out safe haven assets that are noncorrelated with equity markets. 

Gold, for example, has shined in recent weeks, with an ounce recently selling for more than $2,000.

Cryptocurrencies had been expected to emerge as another stable asset for unstable times, yet Bitcoin, the largest digital coin by market cap, has moved lower in recent sessions. 

Its 40% drop from all-time highs may be leading some crypto investors to reconsider the role that Bitcoin and other cryptos play as a portfolio hedge. 

Advisors need to also start closely scrutinizing individual stock positions as well, determining which holdings may be impacted by a protracted economic battle with Russia. 

As one example, tobacco giant Philip Morris derives nearly a quarter of its sales from Russia and Ukraine. 

Well-known U.S. food and beverage brands including McDonald’s , Coca-Cola, and Starbucks  have suspended Russian operations. 

Their moves followed earlier exits by companies as diverse as Netflix , Mastercard , and FedEx . 

For a company like McDonald’s, the revenue exposure is material, although less than 5%. 

The company just quantified the impact of suspending Russian operations at $50 million per month or about 5 cents to 6 cents a share. 

To be clear, for many firms outside fast food and tobacco, Russian subsidiaries only contribute a small portion to company-wide sales, so clients shouldn’t overreact to such news.  

Where to from here. In the early weeks of the Russian attack on Ukraine, it has become clear that the conflict will further deepen before it eases as President Putin doubles down on demands that Ukraine and the West may be unwilling to consider. 

Russia is demanding that Ukraine refrain from joining the EU and NATO, which may or may not be negotiable. 

It is Russia’s insistence that a pair of regions in Eastern Ukraine (Donetsk and Luhansk) become Russian territory that is likely a key stumbling block to any imminent cooling of tensions. 

If anything, military attacks and casualties may grow more dire in coming weeks, especially if the West follows through with plans to provide greater hardware and logistics support to the Ukrainian army. 

And that creates the core challenge for advisors right now. 

Equity markets have slumped, energy and commodity prices have surged, and clients with long-term time horizons should have a willingness to endure further market weakness in coming days. 

(For clients with extreme risk aversion, this is likely a good time to sharply slash equity exposure, as long as you clearly explain the possibility that they would be “selling near the bottom”).

This may also be a wise time to trot out the old Warren Buffett maxim, “widespread fear is your friend as an investor because it serves up bargain purchases.” 

And bargains surely abound in that market. 

Take growth stocks as an example. 

The Vanguard Growth Index Fund ETF (VUG) has shed nearly 20% of its value in just the first 11 weeks of 2022, erasing the impressive gains of 2021. 

Indeed, a “buy the dip” remains in place for many, as we saw with a sharp market rally on March 9. 

However, if “dip buyers” continually get punished with their optimism with sharp subsequent pullbacks, then they may also move to the sidelines, creating a capitulation across markets.  

As a result, patience is likely a virtue here. 

Unless we get a rapid drop in energy prices, inflationary pressures may remain a key headwind, which we’ll hear more about during the upcoming earnings season. 

At that time, reduced forward guidance may push some stocks and sectors even deeper into the red. 

For long-term bargain hunters, that may prove to be a solid point of entry ahead of an eventual market rebound.

David Sterman is a journalist and Registered Investment Advisor.  He runs Huguenot Financial Planning, a New Paltz, N.Y.-based fee-only financial planning firm.