The Russian invasion of Ukraine is a massive external shock to financial markets, but more importantly to the real economy. In financial jargon, this is a black swan, i.e. a rare and highly unlikely event that can have enormous consequences in the short and long term.
The Russian president has taken a foolish gamble, the cost of which is already proving to be monstrous for his country.
For more than 30 years, we have surfed the wave of wealth creation resulting from the peace dividend. The world has globalised, allowing emerging countries to develop and the West to reach an unhoped-for level of prosperity. Only the distribution of this wealth and the environmental impact have been problematic.
Energy has been abundant and its supply secure. International specialisation has made it possible to concentrate on high-value-added tasks and processes, while outsourcing lower-margin, capital-intensive activities to emerging countries.
The outbreak of war in Europe was the first surprise for almost all investors. Paradoxically, the second, even bigger surprise was the reaction of Western governments.
In a context of fiscal orthodoxy, the Western world has enjoyed an abundance of supply. Central banks, struggling to achieve their ideal inflation target of around 2%, have only had to ensure that demand does not collapse when imbalances are abruptly corrected, as in 2000 (the internet crisis), 2008 (the housing and financial crisis), 2011/2012 (the eurozone crisis), and 2020 (the global pandemic).
The war in Ukraine and the Western response to Russia are now definitely plunging us into a new regime of supply-constrained economies where the state is omnipresent and hyper-interventionist.
Three surprises in a row
The outbreak of war in Europe was the first surprise for almost all investors. Paradoxically, the second, even bigger surprise was the reaction of Western governments, especially given Europe’s dependence on Russian energy sources.
Germany and Italy, in particular, have agreed to put their energy security at stake in order to exert joint pressure on Moscow.
Taking into account the fact that the objective of the sanctions imposed by Western governments on Russia is to economically ostracise it, one is forced to note the unintended consequence of these measures, which is that Western investors holding claims or stakes in Russian companies will suffer significant losses.
It took only a few days for major Western multinational companies to unleash a flood of announcements about boycotts or withdrawal plans from Russia.
The supervisory and compliance authorities of the participants in a financial system that is instrumentalised for economic warfare are forced to liquidate Russian assets (whose intrinsic value has not necessarily diminished) at knock-down prices – if they can be liquidated at all. For now, these Western sanctions will facilitate a huge transfer of wealth to Russian investors or to investors in jurisdictions not affected by the retaliatory measures.
The third surprise, however, is the one we find the most unexpected. It took only a few days for major Western multinational companies to unleash a flood of announcements about boycotts or withdrawal plans from Russia.
This is surprising because the situation on the ground in Ukraine remains highly uncertain, and the duration and potential outcomes of this tragic conflict may be dramatically divergent. This rush is probably a result of the importance currently placed on environmental, social, and corporate governance (ESG) factors in the West.
In this respect, the about-face on the financing of arms companies will be an interesting test for responsible investment standards and criteria.
Europe will pay the highest price
The European Union appears to be the big loser in this historic turning point. It has adopted policies that have made it dependent on the United States for its defence, on Russia for its energy supply, and on China for low-value-added manufactured goods.
From now on, EU countries will have to invest in energy independence, via renewables, and in their own defence, in particular. In order to finance these efforts, the Stability and Growth Pact and budgetary austerity, which were supposed to be revived after the interlude of the pandemic, will definitely have to be thrown out the window.
Europe is going to have to use fiscal levers and public spending to get out of its double impasse. We are thus facing a new macroeconomic policy context.
Supply-side inflation takes hold
As a result, supplies in many areas within the democratic countries of the West will be constrained by the need to invest more and faster in the energy transition, defence, and essential goods, such as agricultural products. This shift will have a cost in terms of living standards, as it will lead to structurally higher inflation.
In response, central banks will have to gradually normalise their monetary policy, which, in this new context, must no longer support demand so strongly. They will have to take their foot off of the accelerator, so to speak, without putting on the brakes.
From the peace dividend to the defence and independence tax
In light of the global pandemic and record inequalities in the West, we have been heralding the end of the neoliberal era and a shift to state-sponsored capitalism in our secular investment outlook for two years. The conflict in Ukraine is dramatically accelerating this transition.
We are moving from a peace-dividend regime, in which dependence on non-democratic countries is accepted in order to optimise capital allocation, to a regime of self-sufficiency in strategic goods and services, which inevitably implies a defence and independence tax. This tax can take several forms: inflation, taxation, and, especially, confiscation.
The potential consequences of the current war make historical averages misleading, as well as useless. An asset can never be cheap enough to protect its holder from confiscation.
From now on, the state will intervene in most areas, potentially changing the profitability of an industry overnight, if collective and strategic imperatives demand it. To these domestic risks, the additional dimension of domicile risks must now be added. Consequently, preference should be given to assets domiciled in democratic countries with a stable political and legal system.
All of this puts the usefulness of the usual valuation metrics that rely on mean reversion into perspective. The potential consequences of the current war make historical averages misleading, as well as useless. An asset can never be cheap enough to protect its holder from confiscation.
Finally, one must accept the volatility of risky assets and strategically favour real assets, such as equities, Asian real estate funds, and the producers of scarce commodities. Historically, these are the only assets with a purchasing power that is conflict-resistant.