Russian Bears, Ukrainian Beets, Battlestar Novorossiya
Two events are driving the global economy: the Russo-Ukrainian war and the collapse of oil. Both the EU and the Russian Federation want to maintain the global economic status quo at the expense of Ukrainian territorial loss. Portfolios should be robust to continued expansion as well as black swan events. Many of the naysayers of the new year 2015 are being proven wrong: there has been no significant market correction in U.S. equities – as Bill Gross of Janus Capital and others had foreseen for 2015 – and Europe is showing signs of slow growth, despite numerous bears claiming the opposite. Timing is notoriously difficult and self-fulfilling with doomsday prophecies. I argue that there are two factors that any portfolio must be robust to, and each of these possesses its own positive or negative drag on the global economic environment: Russia and oil. Vladimir Putin of Russia could start World War III within seconds if he so desired, but he knows the country’s economy simply isn’t ready. Russia’s activity in Eastern Ukraine and the Crimean peninsula has in one year established a new norm in geopolitics: an ebb and flow between Russian aggression and Western appeasement, both of which are understandable from each side’s perspective. President Putin will not accept a loss in Eastern Ukraine because it is antithetical to his ideology that Russia is both under attack from the West and simultaneously superior to it . In comparison, Francois Hollande of France and Angela Merkel of Germany know that any escalation of the Russo-Ukrainian conflict could trigger open war and disrupt the EU’s fledgling recovery – German GDP rose 0.7% in the 4th quarter , after growing 0.1% in the previous 3 months. There is little confidence on Wall Street that the Minsk II agreements signed on February 11th will lead to prolonged peace, as the DJIA surged 72 points after the Minsk Protocol in September 2014 and decreased by 3 points after Minsk II and the German GDP surprise. The other looming fundamental driver is the price of oil. The market seems to lag when oil falls and prosper when oil increases. After flirting with the technically significant price of $43 per barrel, oil markets rallied on substantial CapEx cuts in the industry. However, there is no surety that oil will not plunge into the $30s this year. As Tom Kloza of Oil Price Information iterates , oil prices will bottom in Q2 corresponding with “one of the expirations of the WTI contracts.” The International Energy Agency explained that “ample supplies will raise global inventories before investment cuts begin to significantly dent production.” Combined with the astronomical impact of low oil prices on Russia’s budget, there is reason to suspect that the US is saving oil manipulation as a last economic tactic against further Russian aggression. The question is, which black swan event will happen first – open war in Ukraine or a collapse in oil? U.S. bond and equity markets are rallying despite mediocre economic fundamentals, because the U.S. is the only place to invest globally. Not that the U.S. is a powerhouse of growth and prosperity – it is, relatively, the only space where investors can earn better-than-index returns with a reasonable amount of risk. US Treasury yields are at record lows, because the dollar is strong and the U.S. Treasury is the only entity in the world that investors still believe has zero default probability. U.S. equities continue to trade at unusually high levels for two reasons: first, capital has poured into U.S. equities in search of higher returns in the low interest rate environment, fueling a sustained rally in the stock market (barring the “correction that wasn’t” that took place in October 2014); second, U.S. companies are taking advantage of low interest rates to lever returns at debt ratios not seen since before the collapse in 2008. A collapse in oil could be the catalyst that brings the U.S. equity market down to earth, especially given the heavy interdependencies between Western and Russian corporations. As long as the status quo remains the same and a black swan event doesn’t occur, this bubble may actually last and transition into a normal economic growth cycle. But that’s the catch – can the status quo be maintained? Expect Russian aggression and a collapse in oil to be inevitably linked. If one happens, so will the other. In this scenario, a portfolio overweight with U.S. treasuries and municipal bonds is ideal, with significant cash on hand to buy U.S. equities in the oil space on the dip. The status quo survives if Eastern Ukraine turns into a frozen conflict on the likes of Transnistria and Abkhazia as the U.S. and eurozone transition out of recovery into expansion. In this case, a portfolio overweight in cyclicals is ideal. Each scenario seems equally likely, so a risk-parity portfolio robust to both cases might be the best option. Unfortunately, neither the Ukrainians nor the Russians appear willing to concede territory at any cost, so look here to history for the consequences of inaction. Appealing to the words of Winston Churchill, “An appeaser is one who feeds a crocodile, hoping it will eat him last.” Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
