Ukraine: Is A Russian Conflict Discounted In To Global Stock and Bond Markets?

Is A Russian-Ukraine Conflict Discounted In To Markets?

After a brief flight from risk and run for cover, equity markets and bond markets are adjusting to the idea of conflict on the Crimean peninsula. But are these markets accurately accounting for the rise of a real conflict between Russia and its former territory? Given the growing hostilities between the two nations, and US equity indices heading back toward record levels, it is hard to accept that a real conflict is priced in to markets.

As of this writing, Russia is amassing troops and running exercises near Crimea and the Ukraine has "eliminated" some "terrorists" that had set up road blocks. These are, so far, relatively minor incidents. However, wars have been started for less, especially, if one party is motivated by hostilities. Through referendum, Crimea has voted for its secession from Ukraine, which Russia acknowledges but the European Union and the United States do not. The US accuses Russia of inciting unrest in the region which Russia strongly denied. Over half of the Crimean population is of Russian ethnicity, accounting for why a referendum would be successful. So why the hostilities, why now? Russia, and Putin, its leader, could well be motivated by both economic and military interests. The ports in Crimea represent access points that represent maritime routes to the Mediterranean and to key Russian military bases in Crimea. As Ukraine distances itself from Russia, Russia may fear losing access to these strategic routes and its military bases. The area also has significant energy reserves in the form of gas. Is this incentive enough to start a potential military conflict with a heavily nuclear-armed opponent? It could be if Putin's ego is large enough, and the recent winter Olympics reflect at least that much.

Why Do Markets Care?

Markets dislike uncertainty. It could be its most detestable concern. Markets can handle most any issue that arises and discount it in, or price it in, accordingly. What markets struggle with mightily, is the unknown. How do you price in something you cannot evaluate or measure? That's what markets struggle with the most and why political and military hostilities pose such a threat to markets, both equity and fixed income. Typically, uncertainty is reflected in markets by a flight to quality, which is reflected in a sale of risk assets and the purchase of US treasuries, seen as a safe haven. The implications are immense. The importance to money managers is return performance, and to consumers is interest rates. A flight to quality can lower mortgage rates which benefit homeowners and homebuyers.

Is the Possibility of a Conflict Priced In to Markets?

The point of the article is to explore whether or not the possibility of conflict is accurately reflected in both equity and fixed income markets. Given elevated equity levels near all time highs and relatively high interest rates, as of now, it seems markets are not truly reflecting a real conflict is on the horizon. Where should equities and interest rates be? It's hard to say what would reflect a proper accounting for this possibility but some risk premium should be evident in both markets to account for possible hostilities. Equity indices should reflect some spread below where they could be absent any conflict whatsoever, and fixed income assets should show some spread above where they should be. The inherent problem with this logic is that, since the economic recession and extreme Federal intervention to stabilize markets, it's difficult to ascertain whether markets again expect Federal intervention in markets if a real conflict emerges and therefore is not discounted in properly.

Conclusion: The Fed Saves the Day...Again.

After a nearly unstoppable five year run, the bull market continues its stampede with the Fed tailwind behind it, and no conflict is insurmountable from the markets perspective. The possible Russian-Ukraine conflict will prove this again. Investors will cavalierly place their bets that any hiccup caused by geopolitics will be swept away by more liquidity and more artificial stimulus. This observation is not cynical but based on the past five year history of how markets are behaving in the current environment. What is unknown, and the market should despise is, what will be the cumulative effect of looking past all of these market hurdles, that the Fed has offered a soft landing, when it steps back?

Corporate Earnings Are Coming: Is Weather A Built-In Excuse?

George R.R. Martin has given life to the phrase "Winter is coming" in his expansive fantasy series

Game of Thrones. However, this phrase seems to have caught on with corporate America as it is being used as a scapegoat for weaker than expected earnings

Alcoa kicked off earnings season after the market close yesterday, the first of many earnings to come out over what seems like an endless parade, blurring the end of one earnings season and the beginning of another. After what has been a stellar period of earnings, corporations are challenged to maintain robust earnings growth. One challenge has been difficult comparisons. Earlier earnings easily hurdled prior weak earnings. But as earnings rose and after implementing financial engineering (read: stock repurchases via low cost borrowing) to continue the strong results, corporations are running out of growth and strategic options to paint a strong picture, all in an effort to justify and add to historic equity levels. Enter the excuse parade, and what better after a difficult winter than to trot out the weather excuse? Is weather a reasonable excuse for poor earnings? If the weather were mild would sales have been more robust? Did this winter more adversely affect U.S. businesses than past winters? Is there a typical winter effect?

The Growth Challenge: Revenue, the Bottom Line

The stock market gets its juice from discounting higher future earnings growth. Without it, earnings are simply an annuity with a value attached to them, the only variable changing is some chosen discount factor. Otherwise, the math is pretty straight forward. For the value of a company to go up, and therefore its stock to rise, earnings forecasts must constantly rise. This is the challenge corporate America faces today. Revenue growth is stagnant, so, corporations elected to reduce the number of outstanding shares to reduce the denominator in the earnings/share ratio to make earnings look better. Once corporations run out of either stock to buy back or cheap money to do it with (what we will be seeing more of as interest rates rise) earnings growth will have to come from somewhere else. This is where we will see if the economy is healing or if the stock market has gotten ahead of itself. To sustain a rising equity market, investors will look to earnings and forecasts to make investment decisions on whether to remain bullish or become more cautious.

Enter the Blame Game

The most convenient excuse for earnings disappointments is bad weather. The problem with this excuse is that when earnings surprise to the upside weather is never trumpeted by CEOs as the reason. At least if this were the case sometimes, investors could buy the excuse for poor earnings. When corporate earnings for companies located in moderate weather climates disappoint it also flies in the face of using the weather excuse. What weather excuse do Californian or Arizonan companies use? Rain? There is currently a drought in California. Floods? There are floods in Arizona every year. This winter the east coast has suffered through a severe winter, to be sure, and weather will be used as a legitimate excuse in some cases. But as winter becomes a distant memory and we move further in to spring those excuses will ring hollow. And what of bad weather every winter? Retail sales dip each year when the weather turns cold and stormy. Is each year identical from a weather stand point? No, they are not. Therefore, companies will continue to use the blame game as it is impossible to compare one year to the next. It would prove extremely difficult to accurately show how much weather affects results from year to year. No baseline exists to look at.

Conclusion: Investor Tolerance

Ultimately, it is up to investors, that put up their hard earned dollars, to decide whether disappointing earnings are an anomaly and are not a cause for concern of a larger problem. Investors will look around and decide if an entire industry has been affected by some common factor and allocate their dollars accordingly. If investors find that certain corporations have been disingenuous about the reason behind disappointing earnings, they will penalize those corporations with their investment decisions.