Investors should head for the bunkers

MoneyWeek cover illustrationTensions are rising between the West and Russia, and this will impact the economy. Prepare to protect your investments, says John Stepek.

Two countries with a McDonald’s have never gone to war with one another. That theory – posited by New York Times columnist Thomas Friedman in the mid-1990s – has become one of the clichés of the globalisation era.

When political scientist Francis Fukuyama talked theoretically about “the end of history” in 1989, the ‘McDonald’s theory of war’ was what it meant in practice. The Golden Arches, and everything they stood for – middle-class consumerism, prosperity and integration with a global community – represented the dawning of a new era.

Capitalism had trumped communism. Democracy for all seemed only a matter of time. In short, how could two countries that were economically and politically evolved enough to host an international burger franchise like McDonald’s ever be stupid enough to waste lives and resources on going to war with one another?

Like most economic theories, the McDonald’s take on global warfare assumed a lot more rationality on the part of the human beings involved than was realistic. The theory finally bit the dust in 2008. While the financial crisis was shaking faith in global capitalism, Russia (where McDonald’s first opened in 1990) invaded Georgia (which got its first Big Mac outlet in 1999).

And now the burger chain could be among the first Western business casualties of the current turmoil in Ukraine. In response to sanctions from the US and Europe, Russia’s consumer protection regulator has suddenly decided that McDonald’s products aren’t healthy enough for its citizens.

As Courtney Weaver puts it, in the Financial Times, “Russia has finessed the art of adopting ultra-stringent health and safety standards just when geopolitical tensions are reaching their peak.”

It’s fitting that McDonald’s – the ultimate symbol of post-Cold War globalisation – should now be under fire. Because what the invasion of Ukraine – and the destruction of Malaysian Airlines flight MH17 in particular – have made clear, is that the West’s view of the world hasn’t prevailed at all. In fact, it now looks as though we could be heading for Cold War mark II.

Do geopolitics matter?

Like natural disasters, war and revolution have a horrendous human cost. But from an investment perspective – like natural disasters – their impact can often seem to be minimal.

Most geopolitical upheaval in recent years has proved nothing more than an opportunity to ‘buy the dips’. And there have been many instances where war, or the prospect of war, has had little or no effect on stock markets.

Since 1950, notes Michael Cembalest of JP Morgan Asset Management, “with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium-term impact on US equity markets”.

For example, “markets were not adversely affected by the Falklands War, martial law in Poland, the Soviet war in Afghanistan, or US invasions of Grenada or Panama”.

However, this seems a rather narrow view of geopolitics and markets. Cembalest excludes the Vietnam War (“since it’s hard to pinpoint when it began”). Yet, Vietnam helped transform the entire monetary system, by putting the final nail in the coffin of the gold standard. The high cost of the war forced President Richard Nixon to stop backing US dollars with gold in 1971.

You could argue the inflationary nature of the 1970s was at least partly down to this move, not just the oil shocks of that decade. Meanwhile, the 1989 collapse of the Berlin Wall, and the apparent triumph of democracy it represented, had a huge and lasting impact.

It helped to open up a whole new world of cheap labour and brand new markets, creating a dis-inflationary wave that enabled Western central banks to keep interest rates unusually low for long periods of time without driving inflation higher.

This backdrop is what made former Federal Reserve chief Alan Greenspan’s ‘Great Moderation’ possible. So while the argument that political upheaval isn’t important, because markets don’t always react instantly, might be comforting, it’s too simplistic.

The new Cold War

And this latest spat matters. Because it’s not a one-off – the West’s relationship with Russia has been deteriorating for some time. The invasion of Georgia in 2008 barely made the headlines, given the economic panic everywhere else in the world. Russia’s support for the Assad regime in Syria has also gone largely unchallenged.

And, up until now, it looked as though Russia would get away with annexing Crimea and destabilising the rest of Ukraine too, with Europe too concerned about energy security to risk serious retaliation. But the shooting down of flight MH17 makes the whole situation harder to ignore.

As Robert Legvold puts it, in Foreign Policy magazine: “The hard reality is that whatever the outcome of the crisis in Ukraine, Russia’s relations with the US and Europe won’t return to business as usual, as they did after the 2008 Russian-Georgian war.”

Initially, the most obvious economic casualty is Russia itself. Sanctions imposed by the US have already cut certain Russian companies off from Western funding. Roughly $160bn in foreign debt owed by Russian companies and banks is set to mature in the next 12 months.

Jacob Nell at Morgan Stanley notes that this is manageable, “given the relatively strong fundamentals of Russian corporates”, but it would start to become a problem if “sanctions continue to increase in degree and in duration”.

And that’s exactly what looks set to happen. Now Europe appears keen to put ‘tier three’ sanctions in place – banning European Union citizens and companies from investing in Russia’s financial sector.

Meanwhile, the Russian central bank has recently raised its main interest rate to 8%, partly to try to prop up the rouble and stop capital flight. None of this will help Russia’s already struggling economy.

And in the longer run, as Legvold says, Russia depends on “an inflow of Western capital and technology” to try to diversify away from its reliance on resources.

If this option is lost, then “Moscow will be forced to become vastly more dependent on either its relationship with Beijing – in which it is a distinctly junior partner – or on scattered partnerships with countries that do not offer anything resembling the resources of the US and Europe”.

As Neil Shearing of Capital Economics puts it, “the pick-up in investment needed to revive Russia’s ailing economy is starting to look ever more unlikely”. And just like the US, says Legvold, Russia has plenty of other security issues it needs to worry about – including “violence in the northern Caucasus and instability in central Asia”. So it can ill-afford to overstretch its military in fresh Cold War-related conflicts.

But the freezing up of relations with Russia will have consequences in the West too. Russian gas accounts for 5%-10% of consumption in “most Western continental European countries” and 30%-40% of those in eastern Europe, according to Richard Batley of Lombard Street Research.

Although Russia would suffer the most from any shutdown, as its revenues from energy sales plunged, some of these countries will have to find alternative power generation methods.

Germany, Europe’s growth engine, could suffer a painful economic hit too. Wolfgang Munchau notes in the FT that around 350,000 German jobs are thought to depend directly on German-Russian trade: “My guess is that the cumulative global effect of the sanctions will be much stronger than estimated.”

In the longer run, as Charles Dumas at Lombard Street points out, if sanctions push Russia closer to China, “this holds out the prospect of a new polarisation of world politics, in effect a renaissance of the Cold War”.

For example, the Brics nations (Brazil, Russia, India, China and South Africa) this month established the ‘New Development Bank’ as an alternative to the World Bank, which will help developing nations to fund infrastructure. They also funded the ‘Contingent Reserve Arrangement’, which will serve to ‘bail out’ troubled countries – International Monetary Fund-style – if necessary.

The question of whether or not these institutions will be particularly helpful doesn’t really matter. What it does reveal is that emerging nations are no longer prepared to sit back and wait for the West to offer them more influence on the global stage.

Instead, they are prepared to set up rival organisations and financial systems to get that influence. America’s dominance of the global economy is partly down to the fact that the US dollar is the world’s reserve currency. This could represent the first serious step towards a time when a significant challenger to the dollar, and the financial infrastructure that supports it, arises.

One thing is for sure – just as cooler relations with Russia will encourage Europe to find alternative sources of energy, Russia will also have a very strong impetus to find alternatives to a US-dominated financial system for trade and capital-raising.

All of this is happening at a time when central banks in the West are relying on being able to take their economies off the drip of low interest rates and printed money at a slow and steady pace. That’s a tricky job in the first place. And all of this might make it a lot trickier.

The things that made the era of near-omnipotent central banking possible – disinflation from cheap labour and imports from developing nations, and the globalisation of financial markets – are now threatening to go back into reverse.

Ultimately, however well deserved, sanctions have the same impact as protectionism. They make it harder for goods and services to move between countries, driving up costs in the process. And if we’re moving to a world where nations are each scrabbling to secure their own supplies of vital resources because they can’t trust their former trading partners, then we can also expect resource scarcity to become more of a problem.

In short, a less secure world is a more inflationary world – and that could be very bad news for anyone who still expects interest rates to remain at these low levels for the forseeable future.

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How to protect your portfolio from shocks

On a ‘big picture’ scale, if inflation becomes a more serious issue, and central banks come under pressure to raise interest rates more rapidly than they would like, then debt has to be the most vulnerable asset class right now.

At the very risky end of the spectrum, investors are pricing in little chance of companies or nations defaulting. They are happily hoovering up junk bonds with few protections for lenders, and demand for bonds from countries which have regularly gone bust, or have no demonstrable track record of paying back debt, remains high.

As for ‘safe’ government bonds like US Treasuries or UK gilts, they could be hit particularly hard if rates rise faster than expected. In previous bond bear markets, investors have at least had high income yields to compensate them for capital losses. With yields so low at the moment, any losses would be a lot more painful for today’s investors.

As for stocks: at the start of the Ukraine crisis, we suggested Russian stocks represented a buying opportunity. They were cheap, and they still are. But with increasingly strict sanctions looking likely, Russian stocks could get a lot cheaper, as institutions sell first and ask questions later. We’d avoid investing any more money in the market for now.

As for what to buy – as regular contributor Jonathan Compton pointed out, in the context of geopolitical upheaval in Asia a few weeks ago, defence stocks are likely to do well in the case of heightened hostilities between Russia and the US. As Legvold puts it: “both sides will likely start developing new and potentially destabilising technologies, including advanced precision guided conventional weapons and cyberwarfare tools”.

BAE Systems share price chartJonathan’s tips included BAE Systems (LSE: BA) and Raytheon (NYSE: RTN). But if you’re looking specifically for a play on cybersecurity, then look at Symantec (Nasdaq: SYMC). It trades on a relatively modest 12 times forecast earnings for 2015, due to concerns that large companies are bringing their cybersecurity work in-house.

However, Symantec is aiming to stop this trend by upgrading the quality of its products. JP Morgan reckons that Symantec’s high margins mean that even a small boost to sales will deliver a significant boost to cash flow.

The newly frosty relationship with Russia will also have an impact on global energy resources. The Russians need Western technology to help them to develop new potential sources of energy such as in the Arctic. That’s not going to happen now – so at the margins at least, the outlook for new oil discoveries has deteriorated a little.

On the other hand, the drive to find alternative natural gas suppliers to Russia can only be good for the fracking industry in both Europe and the UK. As Charles Dumas of Lombard Street Research puts it: “Even German purists may be persuaded to accept fracking, given the downsides of alternatives.” My colleague David Stevenson writes about fracking regularly in the Fleet Street Letter – you can learn more about it here.

One of his favourite UK-based plays on fracking is iGas (LON: IGAS) which we’ve mentioned previously in MoneyWeek on a number of occasions. The company concluded a promising deal with French oil giant, Total, in February for two of its licences. Shares in iGas have drifted back a little recently, so now could be a good buying opportunity.

Physical gold is of course worth hanging on to. We’ve seen it as a good source of portfolio insurance (it usually goes up when most other things go down) for quite some time now, and we haven’t changed our minds yet. Keep about 5%-10% of your portfolio in the yellow metal.

Mining in general starts to look more attractive in a more protectionist world. Russia is a major producer of many metals, meaning that sanctions may put pressure on supplies. And a more inflationary world should be good news for commodities producers.

We’ve liked mining stocks for a while now, and this is one more reason to favour them. You could opt for a big general miner like BHP Billiton (LSE: BLT), or buy an investment trust such as Blackrock World Mining Trust (LSE: BRWM).

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  • John Morgan

    Why does MoneyWeek have a picture of a angry bear grabbing land on their front cover?

    Are you going to have an angry bulldog with its paws over the Falkland Islands and/or Gibraltar for your next issue?

    Why cant the West just accept that a majority of ethnic Russians, be it in the Crimea or the Donbass, don’t want to be ruled by Kiev and have voted accordingly – just like the good people of the Falklands and Gibraltar have!

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