March 2022 - Passage Global Capital Management

With the devastating ongoing war in Ukraine, one concern among investors is how this may affect their investments. Since the end of 2020, investors have grappled with several headwinds in the markets, from historically high rates of inflation to supply chain disruptions. Now, this geopolitical conflict has instilled more uncertainty into the minds of investors and has contributed to an escalation of volatility from the start of this year. Although investing in such times as this can be daunting, to panic and sell because the stock market has dropped can be one of the most substantial mistakes an investor could make. Rather, volatility can provide long-term buying opportunities to invest in high quality stocks at attractive prices. Additionally, although past results are no guarantee of the future, historical events have shown that drops are often followed by steady gains. Trepidation is natural, but it may be comforting to be informed on how the markets have behaved in previous times of conflict and war. We will take a more in-depth assessment into the current situation, other factors that contribute to stock market volatility, and how the stock market has previously behaved in other wars.

Any declaration of war has global repercussions, but it is important to note that there are a variety of other factors that are responsible for stock market behavior. Currently, many areas of the market have already fallen into correction territory, with the Nasdaq 100 index hitting the bear market level. On the contrary, defensive and energy stocks have recently performed well. Many investors have begun putting their trust into precious metal investments, such as gold, which may add protection to a portfolio during times of uncertainty. Some investors believe that Bitcoin is comparative to digital gold. They believe it will act as a hedge against inflation and serve as a diversifier to stocks; however, in recent times, Bitcoin prices have been highly correlated with stock prices.

The United States and other nations have issued sanctions against Putin and Russia, in an aim to erode their economy as punishment for the invasion of Ukraine. Given that Russia is the world’s third-largest oil producer, these sanctions may elevate energy prices even higher while threatening the global oil supply if Russia shuts off pipelines or suffers infrastructure damage. Upon Russia’s invasion, many commodity prices, including oil and grains rose. Furthermore, the pandemic has already significantly affected the global supply chain and a full-scale conflict may further disrupt it, adding to the high prices. If the ports surrounding the Baltic and Black Seas are interrupted, the shipping crisis may further continue. The Biden Administration has enforced other penalties as well, including the blacklisting of major Russian banks to hamper their ability to globally operate, a travel ban and asset freeze on Putin, and export control on specific technology products to Russia. Other factors relating to a war that will affect stock market behavior include the nations involved, location of the conflict, when it is occurring, length of conflict, and the public support for a war. Typically, when a conflict lasts longer, the market will reflect less of its impact. The increased likelihood of an armed conflict tends to decrease stock prices, but it does this even more so if this conflict is unexpected and comes as a surprise.

Skeptical investors often panic and sell their investments in volatile times due to the fear that a war will have a long-term negative impact on their portfolio. However, this is a common misconception because generally, U.S. stocks will plunge at the outbreak of war and then they typically recover. To examine this, we can take a deeper look at previous periods of wars and how the stock market has behaved. This may act as a gauge to be better informed on what to expect in regards to the crisis in Ukraine. Although we can look at historical events, it is important to note that this does not guarantee the future, there are other factors influencing the stock market, and the global economy may have looked differently depending on the time period. With the beginning of World War I in Europe, investors became spooked which resulted in panic selling. The DJIA dropped 30%, so in order to maintain stability, the New York Stock Exchange was shut down for months. Eventually, the markets reopened and the DJIA increased by 88% before suffering from 1917 to 1918. In mid-1919, the markets underwent a tremendous recovery. World War II was the most expensive war to date which threatened the economy. However, at the end of the war in 1945, the DJIA was up by 50%, which is equivalent to about 7% annualized growth from 1939 to 1945. The Korean War, which came as a shock to many, resulted in the DJIA dropping by 4.7% on a single day after North Korea’s initial attack. Additionally, consumers had to deal with inflation near 11%. By the end of the war, the DJIA was up close to 60%, which is an annualized growth rate of 16%. The DJIA fell over 5% in the first few days of the Cuban Missile Crisis in October 1962 but gained nearly 17% from there to end of year. One of the most unpopular wars in U.S. history is the Vietnam War. In 1965, U.S. troops entered Vietnam and the last troops left in 1973. During this time period, there were many drastic events that occurred, including a mild recession in 1970. However, when looking at the bigger picture, the Dow actually grew 43% during these years, producing a mild annualized return of about 4%. More recently, the war in Afghanistan is more difficult to assess due to its prolonged lifespan and the events in between. However, one takeaway is that defense stocks outperformed the larger market by 58%. Of course, the major caveat in the historical data is that there has never been a direct war between two nuclear powers. However, overall, historically stock prices tend to decline in the pre-war phase and typically recover quickly. Pre-war volatility does not generally last, and investors can experience buying opportunities and long-term stability. For investments, panicking and selling has typically been proven to be one of the worst actions you can take. Times of uncertainty are frightening, but most investors will receive even harsher losses if they cannot be patient and go through periods of turbulence to experience the long-term gains. In conclusion, investors need to be patient and exchange short- term pain for long tern gain.

Sources:

Ben Carlson. “The Relationship between War & the Stock Market.” A Wealth of Common Sense, 14 Jan. 2020, https://awealthofcommonsense.com/2020/01/the-relationship-between-war-the-stock-market/.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Inflation has reached a 40-year high with consumer prices and wages reaching excessive levels, competing in a wage-price spiral. With inflation running well above the 2% target, 2022 will consist of the Federal Reserve fighting for their credibility. It is anticipated that the Fed will raise interest rates at consecutive policy meetings for the first time since 2006, and a half-percentage-point increase, which has not been done since 2000, has not been fully ruled out. Some investors are fearful that Fed Chairman Jerome Powell will lead the economy into a recession in the effort to quell inflation. The Fed hasn’t had to combat inflation of this magnitude since the 1980’s, and historically when inflation has been this high, the Fed has not been able to push it down without a subsequent recession. Even with the Fed’s efforts, inflation may remain high due to factors outside of the Fed’s control, such as worsened shipping delays and supply chain issues from the pandemic. As an investor, it is critical to have an experienced portfolio manager guiding your investments. Portfolio managers must implement risk management techniques to evaluate the potential impact that these negative events can have on your portfolio, and to ensure that you are not exceeding your desired risk tolerance. Risk measurements and models, including VaR, modified versions of VaR, scenario analysis, and stress testing can provide insights focused on these concerns.

Skillful portfolio managers may utilize risk models in combination with their judgement to exploit the strengths and limitations of your portfolio. VaR, or value at risk, is the minimum loss of portfolio value that would be expected to occur a specific percentage of the time over a certain period of time. This is easier to understand with an example. A 5% daily VaR of $1,000 would mean that on 5% of days, a portfolio is expected to lose at least $1,000. Portfolio managers have the flexibility to choose the best percentage threshold and time horizon (e.g., daily, monthly, yearly, etc.) to meet their requirements.

An effective portfolio manager must understand the advantages of VaR, but also its limitations. VaR is a simple, yet valuable risk measure that allows one to see the potential losses that can danger a portfolio. There is a substantial amount of information shown in a single number. This number can provide a basis for risk comparison across asset classes and portfolios to see where the majority of risk is emanated from. This allows a portfolio manager to see adjustments they may need to make to realign its VaR, or they may realize that a reallocation of the portfolio is necessary. Although useful, VaR does require discretionary choices, such as choosing the data sources. There also may be more extreme, “left-tail events” that occur which VaR may not capture. VaR also has difficulty taking illiquid assets into account and is often understated for these assets. It is also important to understand that VaR does not portray the worst-case scenario and that losses can exceed it. It is also sensitive to correlation risk. Correlation risk is the risk that when markets are under extreme stress, correlations among assets tend to rise which can significantly decrease diversification benefits in a portfolio. VaR can be oversimplified, and these limitations are not unique to this specific risk measure. However, if a portfolio manager fully understands this, they can still receive valuable information. Rather than using VaR by itself, risk management is most effective with a combination of risk measurements and models.

A portfolio manager cannot obtain all the necessary information through one single risk measure; there are numerous variations of VaR that aim to provide additional information where VaR lacks. CVaR, also referred to as conditional VaR, expected tail loss, or expected shortfall, represents the average loss that would occur in the left tail of the distribution whereas traditional VaR only represents the minimum loss. For example, consider the aforementioned portfolio with a 5% VaR of $1,000. The CVaR of this portfolio will be more than $1,000. VaR represents the minimum loss on the worst 5% of days whereas CVaR represents the average loss on those same days. CVaR can be more useful to a portfolio manager than VaR since it captures more information about the extreme left tail of the distribution. IVaR, or incremental VaR, determines how the VaR will change if a certain position size in the portfolio is altered relative to the other positions or if a position is added or removed. If a portfolio manager wants to increase a holding in the portfolio, they would recalculate the VaR under the assumption that this change has been made. The IVaR is calculated by finding the difference between the before VaR and the after VaR, which reflects how VaR is affected due to this certain change. A portfolio manager can compare the new VaR, whether it is higher or lower, and make any changes they see as beneficial for the portfolio. MVaR, or marginal VaR, can be used to determine how each asset contributes to the VaR; it measures the change in VaR when a very small alteration is made in a portfolio position. Although IVaR and MVaR are both risk measurements that determine the impact of an anticipated change, MVaR is more focused on smaller changes within the portfolio. The last variation of VaR is the ex-ante tracking error, also known as relative VaR. The ex-ante tracking error delineates the degree to which the performance of a portfolio may deviate from its benchmark. Although VaR and its variations support the risk management process, a portfolio manager must also understand the factors that are driving the risk.

Scenario analysis and stress testing can allow portfolio managers to analyze the risk drivers and address the shortcomings of other probabilistic risk measures. A scenario analysis can look at any event and evaluate how a portfolio may perform under these conditions. This risk model has two different methods: historical and hypothetical. A historical scenario analysis looks at what the return on a portfolio would be if a repeat of an event in history, such as The Great Inflation, were to occur. To determine this return, the value of each portfolio position is calculated before and after the changes to see the effect. This analysis can be run over a timeline to include different actions the portfolio manager may make throughout this event to alleviate the potential repercussions. Alternately, a stress test allows the portfolio manager to change multiple variables at once. This allows a portfolio manager to apply extreme, negative stress to a portfolio and assess the impact. This is a productive way to reflect on the impact that certain adverse market movements may have on a portfolio. However, it is unlikely that a historical event would happen in the exact way that it once did. The solution to this is a hypothetical scenario analysis, where one can evaluate the impact of an event that has not previously occurred on an investment portfolio. To construct a reliable hypothetical scenario, one must complete a reverse stress test, which involves targeting exposures to determine how they behave in different environments. Scenario analysis and stress testing provide an opportunity to review the potential impact from events and to understand the risk exposures. There is no certainty to how the markets will behave, and hypothetical scenario analysis, in combination with the other risk measurements, can provide a portfolio manager with a framework to best prepare for varying market conditions.