We welcome you to this week’s Coffee & Cash on a more somber note. Yesterday, Russia began its attacks on the Ukraine from multiple fronts. While the human cost of this war is heartbreaking, in today’s video, we will spend some time discussing how war and past conflicts have historically impacted the stock market and the different ways that investors can manage risks in the current environment.

As a starting point, it is important that we acknowledge that no one on earth knows for sure how this all resolves and plays out in the coming days, weeks, and months. The range of possible outcomes is enormous.

A helpful starting point, however, is to look at how stock markets have reacted during past wars and periods of geopolitical turmoil. While there is no perfect comparison, here are a few conflicts highlighted in an LPL Financial research report that we can look to glean some historical context from:

An important caveat is that geopolitical events take place against the backdrop of the economic environment at the time. In today’s context, US stock markets were already under pressure as they adapt to a shift from a very accommodating economic environment (low interest rate, high stimulus) to a less accommodating economic environment (higher interest rate, less stimulus). In addition, the global recovery from the pandemic is still underway and central banks around the world have been grappling with the difficult challenge of managing inflation while not choking off economic growth. This is a tricky tight rope to walk, even without wars breaking out.

Although the United States imports very little Russian oil, Russia is a major supplier of oil and natural gas to Europe and other countries. In fact, The EU is Russia’s largest trading partner and receives a third of its energy from Russia, as well as a significant supply of commodities like wheat. This is significant, as interruptions in supply of oil and natural gas could certainly put a damper on economic growth and could make inflationary pressures even worse if Russian supply of oil and food suddenly stops.

So, what options do investors have to manage a risk like the current war?

1. Predict & gamble. In this approach, you try to predict the outcome of the conflict and guess the ultimate investment winners & losers. While this sounds like an attractive option, it is incredibly difficult to predict the outcome of a situation as fluid and with as many variables as this one. Even if you can correctly predict the outcome, identifying and timing your entry into the investment winners is highly unlikely. While early days in this conflict, it has been fascinating to see that the stock market ended significantly up both on the day that the invasion started, as well as the day after. This just goes to show how difficult it is to accurately predict market moves in reaction to different geopolitical events.

2. Protection First. In other words, ‘sit it out’ until things calm down. This also sounds great. Who wouldn’t choose to avoid all market pain and just get in when times are good? The issue is that, as long-term investors, there are never periods of time when there is no risk. Look at this chart with all the crazy economic and geopolitical events that have occurred throughout the last 13 years:

If investors sat on the sidelines every time a scary event occurred, they would not be invested for very long. This isn’t to say that there aren’t some economic & geopolitical events that warrant increased caution, but it does illustrate that a ‘sit it out’ strategy is not very productive.

3. Hold Tight. This is the old buy and hold strategy, and if done with discipline, has generally resulted in better outcomes for investors than the first 2 options. While generally a better option than the first two, merely being apathetic and never making any adjustments or trying to better position your investments for changing economic environments isn’t necessarily the best strategy either, which is why we typically adjust our models 3-4 times per year. While you will never see us go 100% to cash due to the difficulty of timing the market effectively, we are open to the idea of shifting more aggressive or defensive depending on the environment, as well as making certain moves like adding commodities into our models during periods of inflation hedges, for example.

4. Look for opportunities. Events like the current conflict tend to create dislocations where certain investments get hit harder than they likely should, based on fundamentals. For this reason, investors might be able to take advantage of a market over or under reaction to increase or decrease their exposure to certain parts of the market.

The outcome of a conflict like this is very uncertain, but fundamentally, what always matters most to stock markets is how the situation in question impacts corporate profits and earnings. In short, tending to avoid knee-jerk reactions except to take advantage of potential opportunities remains our core approach.

It is important to note that when we repositioned portfolios at the end of last year, we did so in a more conservative manner, not because we saw the Russia/Ukraine situation playing out as it has, but because stocks prices were expensive and we believed that it was very likely that we were going to be entering a period of economic transition from an environment with low interest rates to a period of rising rates. Remember that we don’t believe in diversification because of what we know, we diversify because of what we don’t know. Reducing risk and losses in bad times is critical to a successful long-term strategy.

We will be looking to do our March rebalancing trades in the coming week, after which, we will give you an update of any shifts made. If you have any questions about your portfolio, please feel free to give us a call, or book a time to connect.

How does war impact your investments?