02 Apr War and Portfolio Diversification – 2022 Q2 Commentary

We had hoped that we were moving on from global calamities – at least for a brief respite. However, despite our first quarter newsletter proving fairly accurate in terms of the Omicron Covid-19 variant, in March the world watched as Russia invaded Ukraine. Not only did we not enjoy a respite from the pressures applied to the worldwide economy by Omicron, but the onset of war ratcheted up those pressures.

We offer our thoughts and prayers to the people of Ukraine and to those in Russia, who wanted no part of an armed invasion. At the time of writing, there seems to be movement toward a peaceful settlement, but with nothing imminent. Viewing this war through an economic and market lens, we identify many current and potential negatives. Russia supplies Europe with a large percentage of its oil and gas. The Ukraine supplies the world with a large percentage of wheat. See Graph 1, for the effect of the hostilities on exasperating inflationary effects around the world. Basic needs from protein to gasoline have significantly ramped in price over the last 12 months due to both demand and supply imbalances. That filters through the world economy as inflation saps money for savings and growth. In other words, inflation guides the misallocation of resources that results in a recessionary environment.

In addition to inflation and other issues stemming from the Russian invasion of Ukraine, we identify the largest potential issue as declining support for the US dollar as the world’s reserve currency. By easily confiscating Russian financial assets, the world witnessed one form of US advantage from controlling the reserve currency. If the world becomes less reliant and supportive of the US dollar for things such as trade, the willingness of sovereign nations to hold US dollar debt may decline. That would put upward pressure on US interest rates and make it more difficult for the US to service its debt without devaluing the currency. Therefore, we highlight geopolitical issues like Saudi Arabia considering accepting Chinese Yuan for oil and Russia asking for payment for oil in Rubles as a potential beginning to the decline in the US dollar as the world’s reserve currency. We will monitor these developments and attempt to adjust the portfolio accordingly.

As we have noted in recent newsletters and discussions with clients, we have become more cautious toward the stock market in general. Part of the related defensiveness has been expressed in the form of holding precious metals miners. One might reasonably ask that if we were already cautious and a war had broken out, why would you not be invested in more defensive companies or industries?

As we write, the war may be escalating, the Federal Reserve seems to be growing more hawkish, and growth in certain sectors of the economy may be slowing. However, the broad S&P 500 has actually increased in value over the last few weeks. So the primary answer to our question above is that over time diversification improves performance. If one invested a portfolio in all precious metals miners, then that person is running a mining portfolio and one day that portfolio would not work – sometimes spectacularly. For example, for someone that levered a portfolio to the “work from home” stocks of the Covid-19 time period, that portfolio would have worked really well until it did not. Graph 2, below, illustrates that an assortment of the “work from home” stocks are individually down greater than 50% over the last year. That does not include how much they are down from the peaks of last summer. If one held just that basket of stocks, he or she would have done the opposite of protecting and growing his or her wealth.

We strive to build a balanced portfolio that not only benefits from some of the investment themes (like those named above) of the moment, but also will benefit as the investment environment changes in the future. We say and write about protecting and growing your assets because executing only one aspect of that almost by definition negates the other piece. Our portfolio may have benefited when the precious miners performed but it also benefited when those stocks did not perform. That diversification benefits you over time. We may not receive the super charged returns of being 100% invested in a given theme while it works, but we will also avoid the meltdown of that sort of portfolio when interest in the theme wanes.

Our investment management allows clients to invest in one portfolio – ours – and sleep well at night knowing that we pursue industry diversification, but look to take advantage of overweighting some industries or themes at a given time. For example, we invested in some Covid-19 “work from home” companies before the investment media dubbed them “work from home.” Similarly, we invested in inflation beneficiaries while the Federal Reserve insisted on calling inflation “transitory” – it has since changed its framework for inflation. We also became more defensive at a time last fall before the stocks in Graph 2 started performing poorly. The cumulative results of the above decision making will hopefully add up to protecting and growing your assets over time.

Finally, at times it may seem difficult to imagine that the last 24 months have included a global pandemic and the beginning of a war. Times of stress may remind you that a well thought out personal financial plan and cash flow management system may not be necessary all the time but acts as an indispensable guidepost when the world becomes less clear. Please remember that we can do that work for you and you may call, email, or come by to discuss these things at any time.