Managing Risk Amid Geopolitical Uncertainty
Given the war in the Ukraine, I thought it would be helpful to provide insights for advisors and investors to think about risk and what if any actions should be considered. I begin by noting that the historical evidence demonstrates that geopolitical risks affecting markets are a fairly frequent occurrence.
There’s an old curse that goes, “May you live in interesting times.” Like it or not, we are now living in interesting times – times of danger and uncertainty. There is no downplaying the frightening news from Ukraine over the last week. Compounding the problem is that investors already had much to worry about: equity valuations at historically high levels (the Shiller CAPE 10 ratio began the year at 37.5, a level only exceeded once when we approached the end of the tech bubble); the S&P 500 “correction” of almost 12% between January 3 and February 23, 2022; interest rates on bonds at historically low levels, with real rates on safe bonds at significantly negative levels; inflation increasing at a much faster pace than most (including the Federal Reserve) expected and showing signs that it’s not transitory; and concerns over the massive increase in the federal debt, causing the debt-to-GDP ratio to rise above 100% (and the implications of that for future economic growth).
The increased uncertainty of both geopolitical and economic risks results in a significant widening of the potential dispersion of potential outcomes (with the tail risk increasing both in width and depth). As one example of how the potential dispersion of risks has increased, in his Marginal Revolution analysis on the Ukraine situation, Tyler Cowen stated: “Russia has to win fairly quickly, or these and other forces will increasingly work against it. Ukraine thus can fight for a military stalemate, but Russia cannot. The Russian forces must take increasing levels of risk, even if those risks have what decision theorists call ‘negative expected value’ – that is, they serve as desperate gambles and on average worsen the Russian situation. Of course, that makes the war increasingly dangerous, and not just for the Ukrainians. If Putin is afraid the forces in the field won’t always carry out his orders, for example, he may order the launch of 10 tactical nukes rather than just one.”
Thanks to the research team at J.P. Morgan, we can examine the impact on markets of the last 12 major geopolitical events that led to volatility, going back to the Arab-Israeli War/oil embargo of 1973. That was one major event about every four years on average. Thus, investors should consider that such “black swan” events are normal and should be built into plans (we just don’t know when they will occur or what will be the cause). With that said, the evidence suggests that these events have led to short-lived volatility, with the average market sell-off caused by geopolitical events of only about 6.5% and just 12 days duration, and the average time to recovery of about 137 days. The longest duration was just 27 days (the 1973 Arab-Israeli War/oil embargo) and caused a sell-off of 17.1%.
History doesn’t always repeat, and people can drown in a stream with a depth of just a few inches. In other words, this time might be different, with the duration longer and the sell-off steeper. Investors should be prepared for that possibility – especially given the high level of valuations of some U.S. stocks (particularly growth stocks).
Not even good forecasters can tell us what is going to happen in the markets. The best we can do is make sure our plans anticipate negative shocks appearing regularly and that they address the risks we are most concerned about, reducing them to an acceptable level. We can also learn from the lessons history has provided.
While events can be shocking, investors around the world adjust their expectations as the events unfold and new information arrives. Geopolitical events are widely followed by investors quickly incorporating new information into prices. And as the situation evolves, markets continue to digest this information. Thus, unless we can forecast more accurately than the collective wisdom of the market, it is already too late to act on new information – trying to time your allocation to risk assets has been proven to be a loser’s game. With that said, we will provide insights into the outlook for the economy, the markets, inflation and interest rates.
Impact of the Ukrainian situation
While Russia’s economy is the 11th largest in the world, its GDP is less than 2% of world GDP. However, because Russia is a major player in several key markets, the impact of the war, and the sanctions imposed on it, can be much greater. Not only is Russia a major oil and gas producer (and the main supplier of gas to several European countries), it and Ukraine are two of the world’s largest exporters of wheat, accounting for almost 30% of global exports. And the two countries play a dominant role in world sunflower oil supplies, shipping about 80% of exports. This explains the dramatic increase in the prices of these commodities, which will cause inflation in food prices around the globe, disproportionally affecting poorer nations and those with low incomes because such increases act like a tax. In addition, the sanctions on travel and restrictions on banking will cause further disruptions to global supply chains. For example, Ukraine exports parts used in German car manufacturing, and the conflict has caused German car manufacturers to shut production. In addition, global supply chains rely on components and little-known commodities from Russia such as neon gas and palladium, important ingredients to make semiconductors, which has negative implications for many products.
The longer the conflict lasts, the greater the impact on global supply chains and economies. And while it is possible the conflict will end quickly, it is also possible it will go on for a long time, creating a drag on global growth and increasing inflation risk at the same time (creating the risk of stagflation).
Finally, geopolitical risks are typically associated with flights to quality and liquidity. The result is an increased risk in the short term that the dollar (foreign currencies other than the yen and Swiss franc) will rise and Treasury yields will fall as cash flows to safe havens. When the crisis is resolved, these flows tend to reverse quickly.
Outlook for the U.S. economy
Prior to the invasion of Ukraine, the outlook was constructive, with relatively strong growth forecasted. In 2021 real GDP increased 5.7%, and 6.9% in the fourth quarter. While growth was expected to slow somewhat in 2022 (due to reduced fiscal stimulus and an expected tightening of monetary policy), it was still expected to be strong. For example, the first quarter 2022 Philadelphia Federal Reserve’s survey of professional forecasters predicted 2022 economic growth of 3.7%.
Growth has been helped by strong improvements in productivity. For example, thanks to new technology and businesses adapting to the work environment created by the COVID crisis, nonfarm business sector labor productivity increased 6.6% in the fourth quarter of 2021 and 1.9% for the full year.
The economy should also be well supported by consumer spending, as consumer balance sheets have improved dramatically since the COVID crisis began – net financial assets increased 35% from 2020 through third quarter 2021, while liabilities actually fell slightly. Spending should benefit from both the wealth effect (rising value of financial assets) and pent-up demand for services. And if for no other reason than inventories must be rebuilt, business spending should improve. In addition, with the dramatic increase in wages and the shortage of labor, we can expect investment in plants and equipment to increase. Consumer spending should also be supported by the strong and very tight labor market. Unemployment has already fallen to 4% and is expected to end the year at 3.7%. In addition, we now have about 1.5 job openings for every unemployed person – there are about 11 million job openings and less than 7 million unemployed. The tight labor market has allowed wages to increase – wages in the United States increased 9.16% in December 2021 over the same month the previous year.
On the negative side, the dramatic increases in food and energy costs act as a tax on consumers and could negatively impact spending. And for better or worse, the present administration is constraining U.S. energy supplies, which increases the risk of higher prices caused by lost supply from geopolitical issues and increases the geopolitical risks at the same time. The good news for the U.S. is that it is not a net energy importer, unlike the developed economies of Europe and Asia. Thus, relatively speaking, it is better positioned than they are to absorb the increased costs.
Finally, history demonstrates that recessions are caused by one of two reasons: an exogenous shock (such as a geopolitical event or a financial crisis like in 2008 and 1929) or the Federal Reserve driving real interest rates to sufficiently high levels to choke demand and thereby reduce inflation risk. While it is certainly possible that geopolitical events could lead to a recession (such as the Ukrainian situation dragging on for a long time), it is highly unlikely that the Federal Reserve will drive real interest rates to a level that would strangle demand (say, 2 or 3% higher than inflation). In fact, the greater risk might be that because of the uncertainty created by the Ukrainian situation, the Fed might slow down its efforts to fight inflation, resulting in less quantitative tightening (letting their balance sheet run down, which would drive up interest rates) and fewer rate hikes, and a slower pace of them.
We turn now to the outlook for corporate profits.
Corporate profits The latest consensus forecast (February 24) for S&P 500 earnings in 2022 is $225, an increase of about 8% from 2021. That puts S&P trading at about 19 times expected 2022 earnings. As mentioned earlier, the improving profits have been helped by rising worker productivity and wages rising slower than inflation. While a P/E of 19 is higher than the historical average, it is not high relative to interest rates, nor is it high relative to the average P/E in recent years. For example, the last year that began with the P/E of the S&P 500 below 19 was 2014. And we have begun only six of the last 26 years with the P/E below that level. Thus, valuations do not seem excessively rich for the S&P 500. They are just relatively high, forecasting lower than historical future returns.
We have one more point to make on valuations. While the valuation of the overall U.S. market and the S&P 500 Index are at historically high levels, this is not the case for either developed international stocks or emerging market stocks. For example, using Vanguard’s total market fund, U.S. stocks have a current P/E (which has about as much explanatory power in terms of future returns as does the aforementioned CAPE 10) of 19.9 (earnings yield of 5.0%), while developed market stocks have a P/E of just 13.2 (earnings yield of 7.6%) and emerging market stocks have a P/E of 12.3 (earnings yield of 8.1%). The earnings yield is as good a predictor we have of future real returns. Thus, investors seeking higher returns could increase their allocation to international stocks. With that said, the higher earnings yield does not mean international stocks are better investments; it means the market believes they are riskier. Thus, they require a risk premium. One reason might be that the energy independence of the U.S. and the greater dependence on Russian energy makes international stocks riskier.
While the overall U.S. market is at relatively high valuations, this is not the case for value stocks, in particular small value stocks. For example, three of the U.S. small value funds we recommend, BOSVX, DFAT and AVUV, have current P/Es of just 8.7, 10.7 and 9.0, well below their averages for that asset class over the past 30 years.
We turn now to looking at the outlook for inflation.
Clearly, inflation has been a larger problem than many economists, including those of the Federal Reserve, forecasted. One reason is that loose fiscal and monetary policies as well as the Fed being an aggressive buyer of mortgage-backed securities, driving down mortgage rates, has led to a dramatic rise in home prices and rents. Home prices have risen about 20% in the past year (far more than inflation) and rents have increased by about 8%. Because of the way the government calculates the impact of housing prices on the CPI, the impact lag is about 12 to 18 months (as leases expire). And housing makes up about 30% of the CPI. That means housing will likely have a negative impact on the inflation rate for quite some time, which is among the factors that have caused inflation forecasts to rise. For example, the Philadelphia Federal Reserve’s first quarter 2022 survey of professional forecasters predicts 2022 inflation of 3.8%, up from its prior quarter forecast of 2.7%. As another indicator of expected inflation, the breakeven inflation rate between nominal 10-year Treasuries and 10-year Treasury Inflation Protected Securities (TIPS) was lower, at 2.65% (February 28).
However, as noted earlier, the invasion of Ukraine has increased the risk of even higher inflation, especially in energy and other commodity-related products. And unfortunately, the Ukrainian situation could act as a constraint on Federal Reserve inflation-fighting actions as they try to ensure the economic sanctions don’t create liquidity problems for the financial system and the hit to global economies doesn’t cause a recession. Thus, while there is little to no risk that inflation undershoots the expected rate, there is significant risk that it could be more of a problem than the Federal Reserve and other economists believe.
Another risk to higher inflation is that the recognition of the increased geopolitical risks to supply chains will lead to a reversal of the trend toward globalization of supply chains. Economists have argued that globalization has helped lower prices – as trade barriers fell, domestic companies were forced to compete with cheaper imports, and technology and trade liberalization encouraged businesses to outsource production to low-wage countries. This pattern seems likely to reverse as the combination of the COVID-19 pandemic and the invasion of Ukraine speeds up the retreat from globalization that has been under way for several years. While supply chain bottlenecks should eventually ease, other trends could persist – protectionist policies such as tariffs and “Buy American” procurement rules, and businesses moving production back to the U.S., where it will be less vulnerable to those policies. The bottom line is that the reorganization and shortening of supply chains could increase costs that will be passed down to consumers.
For investors who are either greatly concerned about the increased risk of inflation or whose financial plans would be more damaged by higher-than-expected inflation, there is an alternative to traditional safe bonds (like Treasury securities, CDs and high-quality municipals) that is worth considering.
While there are no free lunches in investing, for investors who do not need liquidity for at least some of their portfolio (which is likely true for almost all investors), a way to reduce the risk of inflation while also increasing expected returns significantly is to shift some of their allocation to the safest bonds to interval funds of private debt, such as Cliffwater’s Corporate Lending Fund (CCLFX)*. The fund is an interval fund and invests in the senior secured floating rate private debt of middle market companies, the vast majority of which are backed by private equity firms.
Middle market loans are generally not rated, are considered non-investment grade, and are not publicly traded. However, that doesn’t necessarily make them riskier from a credit perspective. For example, the average recovery rate for U.S. middle-market senior loans between 1989 and 2018 was 75% – far higher than the 56% for senior secured bonds. As another example, while private debt default rates never rose above 2% in 2020 (during the COVID crisis), leveraged loan and high-yield bond default rates were around 4% and 10%, respectively.
Because direct private loans are not liquid investments, they do carry an illiquidity premium, resulting in yields that are generally significantly higher than similarly risky (from a credit perspective) traditional broadly syndicated bank loans and publicly traded high-yield bonds. For example, consider the Cliffwater Direct Lending Index (CDLI), which seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans as represented by the asset-weighted performance of the underlying assets of business development companies (BDCs), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. As of the end of the third quarter 2021, the index was yielding 8.58%, 4.53 percentage points higher than the 4.05% yield of the Bloomberg High Yield Bond Index.
The high yields along with the relatively low default losses (in its 2021 Q3 Report on U.S. Direct Lending, Cliffwater reported that realized losses since inception in 2004 were just 1.1%) combined with the elimination of term (duration) risk – all loans are based on floating rates – have attracted investors. The fund, whose inception was June 2019, already has about $5 billion of assets under management. See here for information about historical returns, volatility and Sharpe ratios.
The attraction for investors concerned about inflation risk is that by shifting some portion of their allocation to safe bonds from, for example, five-year Treasury securities with a yield of about 1.7%, to CCLFX with a current yield of about 7.3%, they can dramatically reduce their risk of inflation while also earning a risk premium of 5.6%. The trade-off is that they do accept some economic cycle risk and give up the daily liquidity offered by Treasury securities. As an interval fund, CCLFX is required to provide a minimum of 5% liquidity per quarter but typically not more than 25% and repurchase offers may be suspended or postponed in accordance with regulatory requirements (depending on demand for redemptions, it is theoretically possible an investor could redeem all their assets).*
The following is another example of why investors might consider CCLFX. At the end of January 2022, CCLFX was yielding 7.3%. Compare that to the 3.9% yield of the Vanguard High-Yield Corporate Fund (VWEHX), which has similar credit risk. CCLFX had a 3.4 percentage points higher yield while it also minimized term risk because its loans are all floating, whereas VWEHX has an effective duration of about 4.5 years. As of this writing (February 24, 2022), in the Treasury market that difference in maturity (one month versus 4.5 years) would require an incremental yield of about 1.75%. Despite investors demanding a term premium, CCLFX yielded 3.4 percentage points more. The trade-off of that significantly higher yield and minimization of term risk is that investors sacrifice the daily liquidity available in VWEHX.
For investors who don’t need liquidity for at least some portion of their portfolio, this could be a worthwhile trade – while not exactly a free lunch, it is at least a free stop at the dessert tray. For example, consider the retiree who is taking no more than their required minimum distribution (RMD) from their IRA account. Even at age 90, the RMD is not even 10%, while some interval funds are required to meet liquidity demands of at least 5% every quarter (but typically not more than 25% and repurchase offers may be suspended or postponed in accordance with regulatory requirements). For such an investor, the illiquidity premium is as close to a free lunch as one can find in investing.
There is one final example of why investors should at least consider a private debt interval fund. Investors who seek to reduce inflation risk while accepting increased economic cycle risk (credit risk) could choose to invest in a daily liquid fund holding securities with similar credit risk, such as the Invesco Senior Loan Exchange-Traded Fund (BKLN), with assets under management of $5.5 billion. That fund has a current yield of about 3%, or 4.3 percentage points less than that of CCLFX. That difference mostly reflects the illiquidity premium in CCLFX. If you don’t need the liquidity, why sacrifice the yield differential? Note that Stone Ridge’s Alternative Lending Risk Premium Fund (LENDX), which makes loans to consumers, small businesses and students, offers similar benefits (yield similar to CCLFX and short maturity with duration of just over one year.)
We turn now to addressing the risks for interest rates.
As I have been discussing, the increasing risks to rising inflation have been exacerbated by the geopolitical situation. The geopolitical risks almost certainly will lead to central banks taking a more cautious position before raising interest rates to fight inflation. That creates the risk that interest rates will have to rise more in the future to combat inflation, which argues for at least considering reducing the maturity of bond portfolios. And with the yield curve flattening in recent months, the cost of shortening maturity in terms of yield sacrifice has decreased. For example, the difference in yield between a two-year and a 10-year Treasury is now only about 40 basis points, and the difference between a five-year and 10-year is only about 10 basis points.
As mentioned earlier, while there are no better forecasters of interest rates than the “collective wisdom of the market” (as implied by market yields), the risks are not symmetrical – the tail risk appears to be much higher on the right side (rising rates). Again, we can look to history to provide us some insights as to the possible risks.
Historically, the one-month Treasury bill has provided a real rate of return to investors of about 0.4%. And the term premium between the one-month and five-year Treasury has been about 1.7%. Conservatively, if we assume that inflation will run no hotter than the Federal Reserve’s long-term target of 2%, we can estimate that the one-month T-bill should rise from effectively zero to 2.4%, and the five-year Treasury should rise from about 1.7% to about 4.1%. That would lead to significant losses on bond positions. If inflation runs hotter than the 2% target, rates would likely rise accordingly. In addition, to stop inflation from running hot, the Fed has historically had to raise the real rate to several percentage points above the current inflation rate. As we have discussed, given the risk that inflation might run hotter than expected, the risks of owning longer-term bonds can be viewed as significant.
We now turn to examining the issue of the dramatic rise in our debt-to-GDP ratio.
The massive fiscal stimulus in response to the COVID-19 pandemic, producing the largest deficit as a percentage of GDP the U.S. has ever experienced during peacetime, has pushed the U.S. debt-to-GDP ratio to in excess of 100%. In addition, large deficits are projected for the foreseeable future, which will lead to further increases in that ratio. And that is even without considering the negative impact of a return to more historical levels of real interest rates. As we just discussed, even with inflation of just 2% and assuming historical real yields, with about $30 trillion of publicly held debt, that would lead to an increase in interest costs, increasing the budget deficit by about another $900 billion, or more than 3.5% of GDP. And the debt ratio would keep rising, as the economy is not likely to grow fast enough to reduce it. This simple math has led to concerns about not only the possibility of rising inflation (fueled by very stimulative monetary and fiscal policies) but also the potential negative effects on future economic growth.
Why would a large federal debt have negative effects on the economy?
Economists have noted several reasons why high levels of debt-to-GDP can adversely impact medium- and long-run economic growth:
- High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates and inflation, and by placing future restraints on countercyclical fiscal policies that will be needed to fight the next recession (which may lead to increased volatility and lower growth rates).
- Large increases in the debt-to-GDP ratio could lead to not only much higher taxes, and thus lower future incomes, but also intergenerational inequity.
- Increased government borrowing competes for funds in capital markets, crowding out private investment by raising interest rates. Higher rates, along with higher taxes, increase the cost of capital and thus stifle innovation and productivity, reducing economic growth.
- If the government’s debt trajectory spirals upward persistently, investors may start to question the government’s ability to repay debt and may therefore demand even higher interest rates.
- Growing interest payments consume an increasing portion of the federal budget, leaving lesser amounts of public investment for research and development, infrastructure and education.
With that understanding, we turn to a review of the literature on the concerns about the potential for negatively impacting economic growth once debt-to-GDP approaches the level we are now at in the U.S.
Veronique de Rugy and Jack Salmon reviewed the literature (24 studies) on the relationship between government debt and economic growth in their 2020 paper, “Debt and Growth: A Decade of Studies.” Their goal was to evaluate the claim that high government-debt-to-GDP ratios have negative or significant (or both) effects on the growth rate of an economy. They found that every study except two found a negative relationship between high levels of government debt and economic growth, and most studies found a threshold between 75 and 100% of GDP. This led them to conclude that the empirical evidence overwhelmingly supports the view that a large amount of government debt has a negative impact on economic growth potential, and in many cases that impact gets more pronounced as debt increases.
In 2021 the Cato Institute undertook a review of 40 studies published between 2010 and 2020: “The Impact of Public Debt on Economic Growth.” The authors found that “at low debt levels, increases in the debt ratio provide positive economic stimulus in line with conventional Keynesian multipliers.” However, “once the debt ratio reaches heightened levels (nonlinear threshold), further increases in the debt level as a percentage of GDP have a negative impact on economic growth.” In other words, “a nonlinear threshold could suggest that increased government borrowing competes for funds in the nation’s capital markets, which in turn raises interest rates and crowds out private investment, confirming the debt overhang theory.”
Whatever you know, the market knows, and that new information gets incorporated into prices incredibly fast. That makes timing the market a loser’s game. Instead, focus on identifying the risks that are most important to you and build a plan that addresses those risks through broad diversification and asset allocation – and then stay the course. The risk of unexpected inflation is no longer symmetrical. Thus, investors whose plans are exposed to inflation risk should consider options to address it.
Financial plans should consider that there might be a negative impact on economic growth caused by rising debt and that it could lead to lower equity returns. Lower potential economic growth along with the risk of increased inflation, when combined with historically high valuations of U.S. stocks as represented by the S&P 500 and historically low bond yields, should at least raise concerns. Prudent investors plan for these risks. For example, they adjust forecasts of future returns to reflect current valuations and yields (as opposed to relying on historical returns). They may also consider increasing allocations to fixed income assets that are less susceptible to inflation shocks (such as TIPS and floating rate debt). There are other alternative investments that also can be considered because they have don’t have exposure to inflation risk or to equity risk. Among these are reinsurance funds (such as XILSX, SRRIX (interval funds) and SHRIX.) and market neutral funds such as AQR’s Style Premia Funds (QSPRX and QRPRX).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party sources which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Mentions of specific securities are for informational and educational purposes only and should not be construed as a specific recommendation to purchase the specific security as the securities mentioned may or may not be contained within an individual portfolio based on an individual’s need, willingness and ability to take risk and these securities are components of be included as of a globally diversified portfolio. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this information.
*Interval funds are non-diversified, closed-end management investment companies and involve substantial risk, including lack of liquidity and restrictions on withdrawals. Individuals should carefully consider the fund’s risks and investment objectives, as an investment in the fund may not be appropriate for all investors and is not designed to be a complete investment program. An investment in the fund involves varying degrees of risk and an investor should refer to the applicable prospectus for complete information on risk factors and risk of loss. Shares are an illiquid investment and investors will not have access to the money invested for an indefinite period of time. Investment should be avoided if you have a short-term investing horizon and/or cannot bear the loss of some or all of the investment. An investment in the funds is not suitable for an investor if the investor has a foreseeable need to access the money invested. Because an investor will be unable to sell fund shares or have them repurchased immediately, investors will find it difficult to reduce the exposure on a timely basis during a market downturn. The funds are non-diversified management investment companies and may be more susceptible to any single economic or regulatory occurrence than a diversified investment company. Investors should not consider these funds as a supplement to an overall investment program and should invest only if they are willing to undertake the risks involved. Investors could lose some or all of their investment. There can be no assurance that the fund investment objective will be achieved or that the investment program will be successful. LSR-22-251