In recent months, media attention has centered on geopolitical pressures like the conflict on the Russo-Ukrainian border. This conflict is extremely troubling as any human-manufactured event that could lead to a loss of life is truly a tragedy. Needless to say, hopefully, a diplomatic solution will be presented and the world can avoid military conflict.
Beyond these real human concerns, investors have asked us how a potential Russian invasion of Ukraine would impact our investment strategy. After all, the timing of this conflict exasperates the existing volatility surrounding inflation, supply chain delays, and commodity prices. Markets never like uncertainty so it is understandable that the stock indexes have contracted. However, any investor who knows us has heard us say many times that geopolitical conflicts historically do not impact the long-term trajectory of the market. In this instance, we also think the damage to markets will be short-lived.
Impact of PE Multiples
2022 P/E multiples have already contracted considerably to start the year, beginning at around 20.5X and falling to 17.5X. Although the majority of this contraction can be attributed to concerns around inflation and interest rates, we posit that the markets have already priced in a lot of negativity. Moreover, the impact that Russia has on US companies is arguably very low. During the Russia/Crimea Invasion in 2014, Citibank published a list of international companies that have at least 2% of their sales exposed to Russia. Only three US companies made that list including Philip Morris (10%), PepsiCo (7%), and Avon Products (5%). Notably, there were no Canadian companies on that list. Hence, earnings impact will be limited and North American stock market multiples should not contract meaningfully or permanently due to this conflict. Rather, most of the impact would likely occur in regional zones such as Eastern Europe. Should there be any further damage to market multiples, it would more likely be due to investor emotions rather than long term fundamental reasons. Hence, these pullbacks should be taken as more transitory in nature.
“Sell the Build Up, Buy the Invasion”
Fundstrat Research published a very interesting piece last week, where they highlighted that in the last 5 instances of war, equity corrections generally bottomed when the "invasion started." See charts below. The phrase “sell the build up, buy the invasion” implies that markets experience the most damage due to the uncertain timing and potential of an invasion. However, in some sense, once an invasion occurs the market can gradually find a bottom as it begins to look forward and corporations can begin to adjust their businesses to preserve growth. This is not to say that markets should cheer for an invasion, but rather to recognize that the tension and buildup to the event is the main perpetrator of downside pressure.
Geopolitical Events & Stock Market Reactions
Time and time again, we have discouraged investors from making drastic changes to their asset mix and portfolios due to geopolitical events alone. The reason for this is that history has displayed that this risk to portfolios is short-lived. The chart below from LPL Financial Research highlights events from terrorism to full-scale wars. Regardless of the event’s nature, much of this is consistent with the view that only periods of short-term volatility will follow these events, with S&P 500 drawdowns averaging -5.0% and the number of days to recover averaging 47 days.
Irrespective of the geopolitical event, from what history tells us, instances of “geopolitical stress,” have tended to trigger more short-term volatility rather than any long-term trend reversal. This ultimately suggests that the global economy is resilient to these types of events and the prevailing fundamentals remain the drivers of global markets. Therefore, key equity drivers such as corporate profit growth and macro-economic trends should continue to be the factors that drive your multi-asset portfolio strategy.