Sleeping With the Enemy

The U.S. and Europe are now beginning to pay the price for their inability, or unwillingness, to recognize the growing dependence of Western economies on political adversaries.
The economic connections between Russia and the U.S. and EU have complicated the situation and have skewed sanctions to the weakside thus far. Sanctions would be most effective on the Russian oil and gas industry, which is the main driver of the Russian economy, but the EU is also highly dependent on Russian oil and gas exports. Thus, sanctions on Russian oil could be just as painful in Europe as they are in Russia. The EU is unlikely to agree to such sanctions.
Weakened U.S. resolve, or at least the appearance of weakened resolve, has likely emboldened enemies to confront the West with more aggressive tactics and rely on the economic interdependence to hold the West at bay. Ukraine may be the first example, but it is unlikely to be the last.
The Russians are expected to physically take Ukraine quickly. How the West responds will likely dictate the direction of history from this point forward. A military response does not appear to be on the table. A strong economic response is handcuffed by the economic ties. A weak economic response invites additional trouble with China and Iran.

Unlike the 1980’s, when ‘Japan, Inc.’ appeared to be taking over the world (recall when Mitsubishi purchased a controlling stake in Rockefeller Center in 1989), Russia and China are not only economic competitors, they are also political adversaries. When the Soviet Union failed, it was hoped that democracy would grow. When China opened up to the world, the hope was that they also would embrace democracy. Those hopes have long been extinguished, but the extent of our economic ties has only become more intense – particularly Europe with Russia and the U.S. with China.

U.K. Prime Minister, Boris Johnson, responded to the Russian military actions in Ukraine by saying “In concert with our allies, we will agree a massive package of economic sanctions designed, in time, to hobble the Russian economy and to that end we must also collectively cease the dependence on Russian oil and gas that for too long has given Putin his grip on Western politics.” This is the first instance in our memory of a Western leader willing to address the core problem here – dependence on political adversaries emboldens them to more aggressive acts. We can reverse that dependence over time, but we cannot change it quickly. Until then, the West remains at increased risk.

How Does This Affect Your Portfolios?

Sudden events can trigger fear, and sometimes euphoria. Markets have a way of punishing those that respond to those emotions. It is best to ignore them and be in a balanced portfolio. It is impossible to time these events, no less predict precisely how markets will respond to them. The stock market initially nose-dived by about 2% and then rallied right back again. No one was predicting that! This is precisely why we attempt to balance portfolio risk on a continuing basis. That makes it much easier to remove emotion from our process and allow diversification to work.