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A War on Everyone’s Doorstep

Russia’s invasion of Ukraine on February 24th marks one of those rare times in history where the world order appears upended. We would say overnight, but the conflict has been brewing since Russia invaded Crimea in 2014.

The battle lines were drawn

At the risk of oversimplifying, the battle for Ukraine encapsulates two competing approaches to international relations: the first based on mutual interest, co-operation and international law; the second based on projecting national power among neighbors and allies.

While Western powers are guilty of using both approaches, Mr. Putin is firmly planted in the second school of thought and its realpolitik. The Russian president was a young KGB agent in East Germany when the Berlin Wall came down in 1989 and it seems he has been trying to rebuild Russia’s influence ever since.

More damage to globalization

Events in Ukraine have shattered the belief, mostly held in the West, that open dialogue and economic integration naturally lead to mutual prosperity and peaceful co-existence. It has also raised doubts about whether the world’s major powers – notably Russia and China – are particularly committed to keeping the current global order intact.

Stability and rule of law favor growth and prosperity

Growing multilateralism since the 1980s has been very good for markets and wealth creation, certainly much better than the armed conflicts and government posturing that characterized the Cold War.

To illustrate how regional conflicts have long-term consequences, consider the following:

Based on World Bank data, In the seven years after Russia invaded Crimea, net foreign direct investment (FDI) into Russia dropped by close to two thirds, down US$245 billion versus the prior seven years to US$140 billion.
Similar to Russia, those former soviet states not in NATO saw a 62% drop in FDI in the seven years after Russia moved into Crimea, down 62% to US$145 billion.
In contrast, those former Soviet states that were able to join NATO saw a 23% increase in FDI in the seven years after Crimea, totalling US$573 billion.

Being in NATO appears to be very good for business, while the uncertainty of being out of NATO has a real cost.

Russian stocks were doing well. Now they’re not

Despite the drop in FDI, the largest corporations in Russia (and their oligarchs) did very well post-2014. In the eight years ended December 2021, the Russian stock index (MOEX) was up four-fold, versus three-fold for the S&P 500. The sanctions brought on by Russia’s latest attacks on Ukraine look set to reverse much of those gains, however; the Russian MOEX was down 34% in 2022 before Russia’s stock exchange closed on the last day of February. It has yet to reopen, marking a record stretch of closure for Russia’s exchange.

The consequences of war

The near-term prospects for a peaceful resolution in Ukraine look grim. Russia will either fight to occupy major portions of the country or continue to degrade Ukraine’s infrastructure and economy to reduce its ability to fight back. Ukraine is well armed and unlikely to back down, setting up the prospects of a long conflict.

Europe will need to re-orient its energy supply away from Russia, raising the prospects of much higher input costs and, potentially, a major economic slowdown. The products that each country exports will be curtailed – Ukraine because of damaged and occupied supply routes; Russia because of sanctions. Commodities such as grains, fertilizers, oil & gas, nickel, gold etc. will see major advances as Ukrainian and Russian exports are affected. Russia will further re-align its interests and trade towards China.

In the near-term we expect:

A sustained bull market in commodities, triggering further inflation and weaker corporate margins.
Increased defense spending with further fiscal pressures pushing up sovereign yields
An ongoing flattening of the yield curve with widening spreads on high yield instruments
Rising risks of a recession, with the slowdown, if and when it comes, triggering a correction in commodity prices.

Our funds are well aligned with these trends, with significant exposure to Canadian energy producers and overweight positions in defensive sectors such as REITs, Staples and Utilities. Our Absolute Return Fund also stands to benefit from potential volatility, given its ability to go both long and short, as well as use options.

As markets renew their emphasis on fundamentals and quality of earnings, we continue to benefit from the detailed research and accounting work provided by Veritas Investment Research. As always, their research helps our funds identify high quality names and manage our exposures to reduce risk.

Through the end of February 2022, the NASDAQ was down 12.7%, the S&P 500 was down 8.0% and the S&P/TSX was down 0.1%. Over the same period, our Canadian Equity Fund rose 1.2% and our Absolute Return Fund +1.3%. (Performance based on F series).

DISCLOSURES

The S&P/TSX Composite Total Return Index is a Canadian dollar denominated, capitalization-weighted index that includes the largest float-adjusted stocks trading on the Toronto Stock Exchange, subject to inclusion criteria. The index provides the broadest representation of market-weighted returns for large capitalization Canadian-listed stocks, including reinvested dividends, making it an appropriate index for diversified portfolios that invest primarily in Canadian stocks, such as the Veritas Absolute Return Fund and the Veritas Canadian Equity Fund. While our funds are benchmarked against the S&P/TSX Composite, we may reference returns for the S&P 500 and NASDAQ Composite, as well as yields on U.S. ten-year Treasury bonds, which we view as relevant investment benchmarks for investors in North American equities. The S&P 500 represents approximately 80% of the total market capitalization of U.S. stocks, and remains the most broad-based indicator of large-cap U.S. equity returns. In contrast, the NASDAQ has a greater proportion of technology and growth stocks, which we view as providing additional insight into investors’ risk appetite. The ten-year U.S. Treasury rate is referenced as a measure of the lowest-risk investment alternative to equities (‘the risk-free rate’). Contact Veritas Asset Management Inc. for more information regarding comparative indices.

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