B R E T T O N W OODS R E S E A R C H, L L C

Transcription

1 War in Europe: A Market Perspective May 1, 2014 Executive Summary: Amid the unrest in Ukraine and growing tensions between Russia and the West, BWR reviews numerous episodes of geopolitical turbulence since the onset of World War II to contextualize near-term equity risks. Based on the history, we conclude that the downside risk to the S&P 500 is not significant. Ukraine splinters more and more every day, and the rhetoric between Russia and the West intensifies. Acting Ukrainian President Oleksandr Turchynov conceded today that his government has lost control of eastern towns occupied by pro-russian militants. All the while both sides are arresting or expelling suspected spies. Eight military inspectors have been detained by pro-russian gunmen in Slavyansk, accused of falsely operating under the guise of the OSCE to gather intelligence on separatists, and Moscow s naval attaché in Kiev has been expelled for espionage. Outside Ukraine, the West continues to apply more costly sanctions on Russian interests, with President Obama now threatening to implement sanctions on Russian industrial sectors entirely, as opposed to specific companies and individuals. President Putin, for his part, is now threatening his own economic retaliations. Certainly, fears of an escalating conflict or even war are reasonable. How much risk does the Ukraine variable pose to equity markets? Today we examine the reactions of the S&P 500 to previous, major geopolitical flare-ups, such as those leading up to World War II and when the Soviet Union invaded Afghanistan. These previous episodes are, of course, not perfectly parallel to the current crisis in Ukraine, but they provide some useful context. 1

2 : The Onset of World War II As one can see in the above chart, Pearl Harbor, the German invasion of Czechoslovakia, the annexation of Austria and blitzkrieg on France, Belgium and Holland caused the S&P 500 to quickly sell off between 10% and 26%. On the whole, between Kristallnacht and the worst point in the S&P 500 following the bombing of Pearl Harbor, the S&P 500 sold off roughly 46%. Cold War Examples Afghanistan & Others After the Soviets invaded Afghanistan in late 1979, the S&P 500 quickly sold off 2.5%. However, in real terms (i.e. in gold-adjusted terms, which allows for a proper comparison to pre-1971 market levels) the S&P 500 sold off nearly 43% at its worst point during the following month. 2

3 Other Cold War examples that caused significant losses in the S&P 500 are: 1) the Berlin Blockade between June 1948 and May 1949, causing a 7% selloff within the first three weeks; 2) the Berlin Wall Crisis in August 1961, causing a 3.3% selloff within the first month; and 3) the Cuban Missile Crisis, causing a 6% selloff between October 15 & October 23, Ukraine 2014 This year, we mark the beginning of Ukraine variable as February 18, the date when protesters were first shot and killed in Maidan Square. This incident quickly led to the toppling of President Yanukovych s government and the present crisis. One month following February 18, the S&P 500 was up approximately 1% in nominal terms. It traded down only 4.2% in real terms (adjusted for gold) at its worst point. Notably, the nominal S&P 500 hardly traded down after the murders in Maidan Square triggered today s crisis. Implications There are four major deductions to be gleaned from this market history: 1) Conventional World War Equates to 45+% Downside Risk, in Real Terms: The stock market action during World War II implies that in a worst case scenario, the onset of another conventional world war, the S&P 500 could decline 45-50%, similar to the decline in the S&P 500 between Kristallnacht and the Spring of Some could argue that a war between Russia and the United States would pull stocks even lower given the existence of nuclear weapons. But, perhaps, mutually assured destruction would prevent all-out thermonuclear war, and thus the near-term downside would be less than 45-50% in a situation where Russia & its allies face off in limited, relatively isolated engagements against conventional NATO forces. 3

4 2) Ukrainian Variable Mostly Priced In: The decline in the real S&P 500 in reaction to the Ukraine variable (approximately 4.2%) is proportional and logical when compared to the flashpoints leading up to World War II (with a number of 10% to 26% declines) and the Soviet invasion of Afghanistan (43%), as well as other Cold War crises, which created between 3.5% to 7% downside. We believe the current discounting reflects an assumption that Russian troops will not engage Ukrainian or NATO member forces, and Crimea remains part of the Russian Federation. 3) Nominal Equity Prices Insulated From Geopolitical Turbulence: Nominal equity prices holdup much better in the floating dollar era (post August 16, 1971) during geopolitical flare-ups. 4) Strong Potential for Rebounds in Real Asset Prices after Initial Discounting: Financial markets tend to discount worst case scenarios very quickly and then drift higher, as they did after every major geopolitical event between 1938 and 1942, during the 1960s, and in late 1979, early Gaming Out Ukraine s Future We do not believe that the Ukrainian variable will spiral out of control toward a major military conflagration, nor does the market. Arguably, President Obama removing such a possibility is providing support to real and nominal equity prices. We believe that the S&P 500 has already discounted a worst case scenario of Ukraine devolving into civil war, given its nearly 5% selloff in real terms during the month after February 18. The 7+% recovery in the real S&P 500 since mid-april is consistent with the diplomatic evolution achieved between Kiev and Moscow. We believe the rebound beginning on April 14 was catalyzed by President Turchynov reversing course and opening the door for greater autonomy for Ukraine s regional governments -- a long-sought position of Moscow. This compromise paved the way for the April 17 th Geneva Accords where for the first time highlevel Russian and Ukrainian leaders met face to face. Since then, the Kiev government has toned down its rhetoric, meeting Russia in the middle on the fate of pro-russian protestors, with Russia warning Kiev not to launch a violent crackdown on demonstrators and Kiev refraining from launching large scale strikes, thereby reducing the threat of civilian massacres. Turchynov s acknowledgment that large sections of the East have already been lost is likely another issue where Kiev and Moscow can reach common ground to forge ahead with a more politically stable Ukraine. By no means does this mean the diplomatic path is free of obstacles. Despite the May 25 national elections and current plans for constitutional reforms to give Ukraine s regional governments more autonomy, the May 11 referendums in several East Ukraine breakaway regions such as Donetsk, present a serious diplomatic challenge that will require finesse from Kiev, Moscow, Brussels and Washington. Additionally, the anti-growth demands of the IMF will almost certainly hamper Kiev s efforts to forge national unity. Note, on the same day that 4

5 Turchynov acknowledged losing portions of the East to pro-russian forces, his government raised gas prices on Ukrainian citizens by 40%, adhering to demands set by the IMF but rejected by Yanukovich. Why would breakaway regions aspire to join a government raising living costs and implementing poisonous economic prescriptions? The most plausible of worst case scenarios that we see in Ukraine is civil war (30% odds, in our opinion). But even here, holding all other variables constant, the real S&P should not trade below 1.34, which was its worst point in mid-march. A real S&P 500 of 1.34 equates to a nominal S&P of 1855, if gold trades at its March high of $1385. If gold trades at $1300 (it current level), this would equate to a 1742 S&P 500. In conclusion, while we expect the Ukraine variable to churn, which could lead to more stock market turbulence, we do not believe there is extraordinary risk to nominal equity prices today, even if the variable escalated to a civil war scenario. The market experience in the face of the Soviet invasion of Afghanistan shows how a dangerous geopolitical event in a post-bretton Woods world does not mean automatic and severe damage to the S&P Index in nominal terms. As long as the Ukrainian variable does not spillover into nearby countries, we expect the risks to equity markets to be limited. Bretton Woods Research 5

6 Bretton Woods Research, LLC. All rights reserved. No portion of this report may be reproduced in any form without prior written consent. The information has been compiled from sources we believe to be reliable but we do not hold ourselves responsible for its correctness. Opinions are presented without guarantee. Domestic Reports, Global Reports, and Supply-Side Portfolio (collectively referred to hereafter as "Bretton Woods Research"), is published as an investment newsletter for subscribers, and it includes opinions as to buying, selling and holding various securities. However, the publishers of Bretton Woods Research are not broker/dealers or investment advisers, and they do not provide investment advice or recommendations directed to any particular subscriber or in view of the particular circumstances of any particular person. The information provided by Bretton Woods Research is obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Subscribers to Bretton Woods Research or any other persons who buy, sell or hold securities should do so with caution and consult with a broker or investment adviser before doing so. Bretton Woods Research does NOT receive compensation from any of the companies featured in our newsletters. The publishers, owner, agents, and employees of Bretton Woods Research, LLC, may own, buy or sell the exchange traded funds and other securities or financial products discussed in Domestic Reports, Global Reports, and Supply-Side Portfolio ("Bretton Woods Research"). Bretton Woods Research and its publishers, owners and agents, are not liable for any losses or damages, monetary or otherwise, that result from the content of Bretton Woods Research. Disclosure: The publisher and owner of Bretton Woods Research, LLC, may own, buy or sell the exchange traded funds currently listed in Supply-Side Portfolio's current list of recommendations and may purchase or sell some of the shares of the companies held by these ETFs. Bretton Woods Research and its publishers, owners and agents, are not liable for any losses or damages, monetary or otherwise, that result from the content of Bretton Woods Research. Past results are not necessarily indicative of future performance. Performance figures are based on actual recommendations made by Bretton Woods Research. Due to the time critical nature of stock trading, brokerage fees, and the activity of other subscribers, Bretton Woods Research cannot guarantee that subscribers will mirror the performance stated on our track records or promotions. Performance numbers shown are based on trades subscribers could enter. The trade results posted for Bretton Woods Research are hypothetical but reflect changes and positions with the last available prices. Investors may receive greater or lesser returns based on their trading experience and market price fluctuations. 6