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Market Update: Risks Plaguing the World

March 25, 2022

The geopolitical and economic risks plaguing the world have raised investors’ uncertainty about the market for the early months of 2022. Will this persist, or have we reached peak fear/uncertainty?

Like all things, only time will tell; however, my conclusion is the following:

Summary of my projections:

While present geopolitical tensions have a low probability of precipitating into global conflict, the abundance of events that could raddle US markets make it difficult to brandish a bullish outlook. Additionally, inflation has proven to be resilient, despite the Fed’s best intentions. The global issues have furthered this by putting more pressure on global supply chains. It is difficult to see any meaningful resolution to these factors in the near future.

That being said, markets often react more unfavorably to uncertainty than they do towards negative events. At a time when investors can make market projections with a semblance of certainty, I expect we will be back in a bull market.

For the time being, I can see US energy, US food and agriculture, consumer staples, companies with low earnings multiples or high pricing power to be a backbone for the market during this volatile period.

 

My basis for this projection is outlined in the following report:

 

Market Analysis 3/25

This report contains information on some of the current events and economic risks that are lingering. It is impossible to cover the entirety of the world’s issues; therefore, I have outlined what I believe are some of the more notable risks. I have structured this report to explain some key events by region. I follow by describing the likelihood of the risk, and the resulting market implications if it were to occur.

The first scenario I will be describing is the risk that the war in Ukraine escalates:

Ukraine & Russia

  • Poland Intervenes
    • Poland either breaks the ice under their feet or Russia does it for them…
      • The Russian command has sent airstrikes to Ukrainian cities neighboring Poland’s border. I do not believe these airstrikes were intended to spark a war with Poland, but it has been viewed as a threat by Putin to NATO. It seems as if Putin is implying that he is not afraid to act if NATO escalates their involvement in the war.
      • If an airstrike were to hit Poland, the US would be forced to declare war against Russia according to Article 5 of NATO. This reaction could quickly escalate the war between Ukraine and Russia, to a much more extensive war.
    • Likelihood: Very low
      • I see Putin escalating the war to involve NATO as highly unlikely unless China joins the fight. Russia is already struggling to take control of key cities in Ukraine. They certainly cannot afford to engage in combat with all of NATO. Putin knows this. I am assuming he only sent these airstrikes in order to deter western countries from further involvement.
    • Market Implication
      • If Russia did hit Poland, thereby declaring war on all of NATO, this would have tremendous implications for the market. Local energy, agriculture, consumer staples, and US defense companies would see a massive inflow of capital immediately. On the contrary, companies and sectors that rely on other countries, especially ones with a loose relationship to the US, would be at risk of collapse.
  • China Escalates the War
    • China could get involved in the following ways:
      • The first is that they provide military aid to Russia. They would do this in order to strengthen ties with Russia and other Eastern countries. This action would be in concert with their “No-Limits” pact with Russia, which was signed into effect on February 4th. In the pact, Russia and China committed to forming a stronger eastern alliance and restricting NATO’s expansion. China also expressed support of Russia in their territorial conflict with Ukraine. Russia made a similar claim, backing China in their issue with Taiwan.
      • This takes us directly to the second way that China could complicate the war: China uses the pressure on global supply chains and war in Ukraine as an opportunity to take control of Taiwan. China has stated many times that they intend to repossess the island within the near future. Since the beginning of 2022, they have substantially increased the number of warplanes sent to fly over Taiwan. While there has been no act of aggression thus far, they have continued to make both verbal and military threats towards Taiwan, and towards the US in the case of US intervention. If they were to take over Taiwan, the US would be forced to respond, given that about 90% of our advanced semiconductor chips are made in Taiwan. Semiconductors are directly related to technological manufacturing and innovation. The US cannot afford to lose such an important resource. I could see the US’ response be via economic sanctions or military actions.
    • Likelihood: Low
      • While China has condemned the US’ sanctions on Russia, they have repeatedly stated that they want to be seen as a “neutral” figure in this conflict. While it is very possible that China gets involved, contradicting everything the Chinese Government has pledged, I do not see it to be in their best interest to get involved at this time.
      • It is not in China’s interest because they are the world’s largest exporter of goods and rely heavily on western countries to keep this title. After seeing the unified response by western governments toward Russia, they will not be eager to have the same restrictions put on them. China’s main goal is to pass the US as the world’s leading superpower. In order to do so, they need to leverage their relationships with western countries. Seven out of the top 10 countries with the highest GDP are either members of NATO or an ally of the US…
    • Market Implication
      • If China sends Russia military aid, then the US may begin imposing harsh sanctions on China. This would have a substantial impact on both the US and Chinese economy, given that the United States is China’s number 1 export country. This would cause an immediate recession for both the US and China. Depending on the severity of the sanctions, it could take decades for supply chains to recover.
      • If China were to take over Taiwan, a similar situation would occur, and the US would be forced to impose sanctions on China. However, a big difference would be that the US would also need to look for new suppliers of semiconductor chips. This would move an enormous amount of capital from TSMC (the world’s largest semiconductor manufacturer which is based in Taiwan) into other chip manufacturers such as Samsung.
  • Energy, Food, and Fertilizer Shortages
    • Inflation worsens in key sectors.
      • According to a Reuters article, “Europe remains heavily dependent on Russian gas, which supplies around 40% of its needs, and is now worried that Russian President Vladimir Putin could use it to retaliate against sanctions.”
      • Supply chain shortages within the food and agriculture space were already an issue coming out of Covid-19 lockdowns. The sanctions imposed on Russia and their following counter sanctions have put a substantial amount of pressure on global supply chains in these industries.
      • Ukraine is obviously affected as well by the large amount of agricultural land that has been destroyed. It will take both countries years to recover from the war. To give perspective as to how bad this could be, a Financial Times article explains, “Ukraine and Russia account for about 30 percent of the world’s traded wheat and still have crops from last year to ship.”
    • Likelihood: Currently Occurring
      • I see this scenario as the biggest issue currently plaguing markets and the global economy. This is not a speculation in that it is already happening. The inflation coming from sectors such as Oil/Gas and Food/Agriculture is currently being realized. The risk is that it will continue to get worse.
    • Market Implication
      • As we have already seen, companies in the described sectors have seen an inflow of capital over the past few weeks. I suspect that as the war progresses, supply chain issues will get worse in these areas which will force companies around the world to begin sourcing their energy and agricultural products from other regions. For example, the US may put a higher emphasis on bringing back manufacturing and energy production into the US. If this were to happen, US energy and agricultural producers will continue to see an inflow of capital.

The next area I will be discussing is the Iranian Nuclear Agreement:

Iran

  • Iranian Nuclear Agreement failure
    • Iranian Nuclear Agreement is Poorly Negotiated or falls through completely.
      • As the Iranian Nuclear Deal comes down to a few final issues, there is concern that the coming Nuclear Agreement will be poorly negotiated and put Iran’s enemies and some US allies at risk. There is also the risk of not reaching a nuclear agreement at all.
      • If either scenario occurs, we can expect Israel to respond in some fashion. Iran has stated many times that they would like to effectively wipe Israel off the face of the earth. For this reason, Israel faces an existential threat in letting the Iranians get a nuclear weapon. If fighting were to break out, it could quickly escalate to involve more of Israel’s and Iran’s enemies.
      • A poorly negotiated deal would also undermine the U.S.’s international relationships and may damage alliances/trade partnerships, such as with Israel and Saudi Arabia.
    • Likelihood: Deal does not go through – Unlikely; Deal is Poorly negotiated – Moderate
      • As mentioned, the Iranian Nuclear Agreement has come down to some of the final issues. The current point of conflict is Iran wanting the US to delist the Islamic Revolutionary Guard Corps (IRGC) as a terrorist organization. This section of Iran’s Armed Forces is responsible for the taking of hundreds of American lives. Eyes are on the US to see if the US will submit to Iran’s demand to delist the IRGC. Doing so would certainly risk our relationships with Saudi Arabia, Israel, and other countries.
    • Market Implication
      • If there was a war between Israel and Iran, the market will likely sell-off quickly for fear of a widespread war. The market may favor companies that supply energy and defense to Israel and the US.
      • If tensions only increase but war is averted, Saudi Arabia will continue to distance themselves from the U.S. and limit our energy imports. This would worsen inflation in the US energy market, but perhaps cause a market shift towards higher US energy production.

The final area of discussion will be the trajectory of the United States if none of the other geopolitical risks occur:

United States

  • US Inflation
    • Inflation spiraling out of control.
      • Global supply chains were already under pressure from Covid-19 lockdowns. Now, they have seen increasing pressure from global tensions. The Consumer-Price-Index is currently showing inflation to be at about 7.9% annualized. On March 16th, The Federal Reserve raised the Federal Funds Rate by 0.25% to slow inflation down. They also released their plan for 6 more 0.25% rate hikes during 2022. On Monday, Federal Reserve Chairman, Jerome Powell, came out and stated, “Inflation is much too high.” He noted that this could force the Fed to raise rates by 0.5% instead of 0.25%.
      • The current risk is that the Fed will not be successful in slowing down inflation, thus pressuring them to aggressively raise rates at future FOMC meetings.
    • Likelihood: Very Probable
      • I expect it is very likely that we see inflation run higher than expected for some time unless there is a recession. In the past, the development of global supply chains has been one of our strongest strategies to reduce costs and inflation. Today, these supply chains are under an enormous amount of pressure. The world is scrambling to find nations that can supply energy and raw materials at the prices and quantities needed. This is only worsening the bottleneck and pushing prices higher.
    • Market Implication
      • The market has already priced in 0.25% rate hikes. If inflation continues at the current rate, or worsens, the Fed’s change to 0.5% rate hikes could have a substantial impact on borrowing by consumers and businesses: especially highly leveraged sectors such as tech and real estate. If this occurs, companies with low debt, high pricing power, or a low price-book value multiples will see an inflow of capital.

 

Final Thoughts

While many of these risks are unlikely to occur, there are simply too many of them that could have a substantial impact on the US, to feel comfortable returning to a “bullish” position. Does this mean I am giving up some upside potential if I am wrong? Yes, but during such a volatile period, I feel it is prudent to have more of a hedge towards the downside. JWM’s current allocation reflects these realities with the intention of protecting our investors from unprecedented turmoil in global markets.

 

*Statements of future expectations are based on current market conditions, and involve uncertainties that could cause actual results to substantially differ from those expressed. This commentary is for informational purposes only and should not be construed as specific advice. The views and opinions expressed are based on current economic and market conditions and are subject to change.