When goldilocks markets meet a Russian bear

Not every investment has an equal distribution of upside and downside. Humans, as a rule, tend to deal with asymmetric risk badly. Lotteries are a good example: a very low probability of a big gain is hard to calculate. So hard that governments regulate lotteries heavily. They understand how bad humans are at maths. Insurance has the opposite distribution: a low probability of a significant loss. The market value of insurers, who profit from those hedging these risks, is in the trillions of dollars.

The Ukraine is offering asymmetric risks at the moment.

The downside risks are significant but with lower probability. 

For one, there is a reasonable chance of a financial crisis type event. Will it be an overleveraged hedge fund betting that it would all be OK? A bank that runs into counterparty risk via a Russian counterpart? Or simply unforeseen circumstances when a major economy’s central bank is locked out. Or it could all be fine. 

The odds are also non-zero of a recession. Booming energy prices crimp demand. Central banks are caught in the headlights of high inflation, unable to move. Government stimulus is on the wane after years of pandemic support. Recession ensues. 

Supply chain issues could (will?) rear again. Bans on Russian imports/exports combine with war-damaged Ukrainian exports to further gum up global deliveries. This keeps inflation high, adding to the problems above.

And those are just the more likely outcomes. The real left-field events see the war expand. Or Putin starts cyber attacks on western financial targets. Nuclear involvement is probably only the slimmest of options, but it is non-zero.  

Any of these present a significant downside to stock markets that are still pricing a benign outlook.  

Is it all about the Fed? 

US markets finished last week at the same place they were at the start of the week. i.e. before the war began. Some of the positive support was undoubtedly due to the initial round of sanctions being less than the market expected. Some of it may have been relief that a broader war didn’t begin. And then the robots probably also got involved – buying the dip.

My guess is the most significant effect was the market’s assessment that the US central bank would be more accommodative during a war. 

The upside seems limited. 

We are starting from a point where earning growth is petering out. Worldwide, central banks have decided they can no longer wait for supply chains to reign in inflation. Instead, central banks are keen to reduce demand down to the level of current supply. And governments are withdrawing pandemic stimulus. And valuations are still high.

The best upside case for stocks? The 11th largest economy attacks the 57th largest, and the US is not directly involved, but the US central bank puts rate rises on hold anyway. This is where we get caught in reflexivity:

  • If markets rise, the US central bank is more likely to raise rates, judging that inflation is the bigger threat.
  • If markets fall, the US central bank is more likely to hold off on rate rises, judging financial instability as the bigger threat.

Which caps the upside. A rising stock market will lead to the Fed being more hawkish, which will push the stock market back down.  

Investment Effect of the Ukraine invasion

As hard as it may be to believe, we aren’t always bearish! Our growth fund finished 2nd vs other growth superannuation funds for 2021, so we were no stranger to holding risk assets during 2021. However, that is no longer the case. We steadily wound back our stock exposure into the end of the year, and are now holding significant cash looking for a re-entry point. But not yet. 

Our sector weights are tilted towards quality defensives and away from value stocks. Value stocks traditionally do well in an expanding economy – not in a supply-constrained one with central banks leaning on demand.  

The sensible geopolitical outcome is that all parties take a step back and negotiate something better than financial and physical destruction. But geopolitics doesn’t always work out that way. 

The upside/downside calculation is not yet attractive. But, volatile markets do throw out opportunities. Now is the time to have your shopping list of high-quality stocks that you want to own. And the price that you are willing to pay. Then wait. 

A lot has gone right for markets over the past two years. Markets are still pricing in a relatively ‘Goldilocks’ scenario of not too hot and not too cold. The danger is that a Russian bear may crash the party. 


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