Posted on April 8, 2014 by David Laidlaw

The turmoil within Ukraine and Russia’s opportunistic annexation of Crimea has dominated the headlines, but has hardly impacted the equity markets. Since February 22nd, the day Viktor Yanukovych, Ukraine’s democratically elected, but corrupt prime minister, fled his office, the S&P 500 has gained about 2%. The Russian Exchange Traded Fund (ETF) issued by iShares (symbol ERUS) is only down about 6% over the same period.

Russia’s Prime Minister, Vladimir Putin, appears to have calculated that annexing the Black Sea port and threatening further aggression against Ukraine advances Russia’s long-term interests. At the very least, Putin is stoking Russian nationalism to strengthen his political hand at home.  

Russia’s actions are particularly dangerous since it is a weakened power. Russia is no longer the old Soviet Union that controlled all of Eastern Europe and much of Eurasia. Russia is a faded economic power that receives 40% of its manufactured goods from Western Europe and is almost completely reliant on its energy exports. The country receives 50% of its net income and 75% of its tax revenues from this business. Compare this reliance to the United States, which produces more energy than Russia. In the US, energy companies represent about 10% of the market capitalization of the S&P 500 while energy companies are 54% of the Russian stock market. Russia cannot withstand a dip in hydrocarbon prices, let alone biting sanctions.

Since the fall of the Berlin Wall, Russia has become much more economically and politically integrated with the rest of the world than during the Cold War. For example, Russia trades over €260 billion ($356 billion) worth of goods and services to Europe. Oil and natural gas represent the bulk of this trade so that Europe receives over one-third of it hydrocarbons from Russia (see Chart).


Russia’s actions threaten to reverse this integration and introduce another Cold War. The country’s “19th Century” behavior marks a sharp break with the developed countries of the world. We do not believe the markets are accurately discounting this historic change.

Europe’s static economic growth could turn into a crippling depression if sanctions escalate to the point where Russia cuts off Europe’s supply of natural gas. The Europeans could not develop alternatives quickly enough to blunt the impact of this change. Norway and African suppliers could increase their output. However, it would take many years to build sufficient infrastructure to ship liquefied natural gas from North America to Europe.

Military budgets may also need to expand rapidly to counter Russia’s aggressive incursions. While extremely large in gross volume, the US spends about 4.5% of its GDP on defense which is the lowest amount during the post-WWII period except for a lull in spending which occurred in the late 1990s. Many European nations spend miniscule amounts on defense. For example, Germany and France spend 1.3% and 2.3% respectively of their GDPs. The diversion of these resources to defense may limit economic growth. The combined threats of an energy boycott and new “cold war” do not appear reflected in equity prices.

On the domestic front ….

Businesses, especially retailers, consistently blame the weather for lower revenues or slower growth. Oftentimes, the weather is used as a scapegoat for either poor management, or, more frequently, random fluctuations in demand for a good or service that have nothing to do with the weather.

This winter was different since the weather was so severe that it did impede economic activity. Washington, DC typically receives 15 inches in snowfall per winter. During the past season, the city received 32 inches and it was the 17th snowiest winter in the past 126 years. Chicago usually experiences 7 days where the temperature dips below 0 degrees Fahrenheit. This winter, temperatures fell below 0 on 23 separate days which is the most sub-zero days in 50 years and set a record of -16 degrees on January 6th.

During the 4th Quarter of 2013, the economy grew at a rate of 2.6%. Economists expect that this rate decelerated to 1.8% during the 1st Quarter. We expect that a major portion of the deceleration was weather related. For example, FedEx noted in its earnings release that it lost $125 million in operating income (almost 20%) due to adverse weather. FedEx and UPS are economic bellwethers since these companies are so integrated with the level of economic activity throughout the country.

Our view regarding stock valuations has not changed since our last commentary. We believe stocks are more expensive than they have been over the last few years and there are very few “screaming buys.” Some selling occurred earlier in the quarter, as investors took profits and slower economic growth from China threatened demand. However, participants poured back into the market at the end of the quarter. During the last 2 days of the quarter, the S&P 500 advanced 1.2% and very few stocks decreased in price. This suggests “window dressing” by managers who were buying at the end of the quarter to make their portfolios look more fully invested than earlier in the year.