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The crisis in Ukraine adds a further dose of uncertainty to markets

The writer is editor-in-chief of MoneyWeek

You don’t often lose all your money in an equity market. Every year Credit Suisse publishes its Global Investment Returns Yearbook, and in doing so remind us just how well things usually go.

Credit Suisse’s database covers the returns on stocks and bonds for 35 countries. The results are mostly cheering. For example, since 1900 the US equity market has given an annualised real return of 6.7 per cent and the rest of the world has returned a perfectly acceptable 4.5 per cent.

In two cases, though, they aren’t particularly cheering. In Russia in 1917 and China in 1949 investors suffered “total losses” after communist revolutions. Both markets reopened in the 1990s. There were no refunds.

This week, with the Russian invasion of Ukraine, has not been quite on the same scale — but the 33 per cent fall in the Moex index on Thursday was a sharp reminder of the risk that investing comes with. It should also be a reminder of the extent to which uncertainty drives equity prices.

There is endless guff talked about equity valuation, but at its heart it is very simple. A share is worth your forecast of what the total income from it will be over time, discounted for inflation and then discounted again for the extent to which you might be wrong. The number you are prepared to pay should be nothing more than the sum of the dividends you expect to receive adjusted for uncertainty. The more confusing the future looks for any particular stock or market, the less you should pay. Every complicated model you see that looks like it is about something else is actually nothing more than an attempt to get a handle on the likely scale and timing of the income you can expect. That’s it.

So what about Russian equities? They are now, by any measure, cheap. Prices are moving around too fast to be precise, but think a price-to-earnings ratio of three to four times and a dividend yield of 10 per cent. But they also come with absolute uncertainty — we have no idea quite what the various sanctions currently being announced around the world will end up doing to the earnings bit of the price/earnings equation. For now, that means buying them is not an investment but a speculation. 

However, it isn’t just the Russian market that should be worth less as a result of the invasion of Ukraine — pretty much all stock markets now have a new overlay of intense uncertainty. The big fund management PR machine has been pretty active over the past few days, telling us to buy on the sound of cannon and noting that markets have easily brushed off many of the nasty global events of the past few years.

Take the withdrawal from Afghanistan, the North Korean missile crisis and the 2017 bombing of Syria, said one manager: in all cases the market reaction was “surprisingly mild”. Buying the dip was the right thing to do.

It probably won’t be this time because of inflation and the extreme levels of uncertainty it introduces into future income calculations. Ukraine is the world’s biggest exporter of sunflower oil, the second-largest producer of barley and the fourth-largest producer of potatoes. It is also rich in metals and minerals. Add in Russia’s dominance over key strategic metals and you can see the potential for a nasty inflation shock.

This is all terrible for equities. The Credit Suisse yearbook gives us a few hints as to just how bad it could be. From 1914 to 2021 you can divide markets into periods in which interest rates were mostly rising and those in which they were mostly falling. During the former periods, when inflation was also on average 2 percentage points higher than otherwise, US equities offered a fairly meagre average real return of 3 per cent. In the falling rate periods that number was 9.7 per cent.

Data for the UK tells the same story — 1.2 per cent in tightening cycles and 8.5 per cent in easing cycles. This doesn’t necessarily mean that markets should fall, but this round of inflation comes with unusual levels of uncertainty. Will central banks decide to tolerate more inflation than they might have otherwise, given the situation in Ukraine? Will there come a point when they have no choice but to push up rates first? Perhaps inflation at 8 per cent is worse than crashing equity markets?

Then there is the question of who takes the inflation hit. Is it workers (who could see real wage declines), consumers (who could face higher prices) or shareholders (companies absorb the price rises and profit margins, and so potential dividend payouts fall)? Or indeed all three? And at what point will inflation become self-fuelling? Historically higher prices tend to start begetting still higher prices at about 7 per cent as consumer behaviour changes.

It’s usually worth going with the optimists when it comes to stock markets. But with valuations still high, an inflation crisis, a supply chain crisis and a geopolitical crisis on the go, maybe not this time. The good news (sort of) is that there is one clear path ahead for investors. The crisis in Ukraine brings us back to basics and to a focus on energy security, food security and actual security. It might seem a little 1970s, but these are the places where there is some certainty — and where you should be invested.

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