March 04, 2022
Countries that trade goods don't trade bombs.
There is truth to the aphorism. It's partial inverse is getting tested. Can countries not trade goods, in order to not trade bombs? We're about to find out.
As you know, after a tepid response, the worldwide community decided to clamp the economic shackles on Putin. All of that fun comparative advantage and lean supply chain stuff from economics is great when trade actually occurs, but when SWIFT shuts you out of the worldwide banking system and Sabre/Amadeus from the worldwide travel system, the value of interconnectivity becomes obvious. Like oxygen, they make themselves known when they're gone.
In 1987 historian Paul Kennedy wrote The Rise and Fall of the Great Powers. One thesis from that book is that the size of the economy matters and ultimately determines winners. China was pretty smart about this over the past 50 years - it's better to be a dictator layered on top of a semi-capitalist state than a dictator on a failed communist state. To give you perspective, Russia's GDP is about the size of the northern half of California (they don't even get Hollywood!), clocking in at about 7% of the U.S. GDP.
And that doesn't include the rest of the world. Putin brought a knife to an economic gunfight, with the qualifier that his nuclear weapons are not figurative.
There is a lot of weird financial stuff going on. In most financial analysis, you look at gains and losses, and you think about marking portfolios up and down. You do not think "the entire exchange just disappeared." How can you divest out of something if there is no way to sell? How can you receive a bond coupon if there is no way to pay?
Let's back up a bit. We don't normally do this, but at One Day In July we took the step of representing all of our clients and asking our index fund partners, primarily BlackRock and Vanguard, to consider divesting all Russian positions. These are not in every client portfolio, and they run about 3% of the emerging markets index where they exist. BlackRock and Vanguard are much larger firms than we are, but we wanted to add our vote.
They were already on it. Next week this is scheduled to happen on the index side, but the funds are still working on mechanics. The index itself may remove Russia, but the index is not the fund. The fund tracks the index. What is the fund manager to do if he/she needs to reduce positions to zero, but there is no market in which to trade? Do you, as the fund manager, mark the value down to zero but hold the position, and in between sips of Starbucks DoubleShot Energy ask yourself what, in fact, you just accomplished?1
Even if you could sell your stock position back to a Russian, or maybe a Russian firm, there's an argument that perhaps you're benefiting them even more by handing over securities that are too cheap. (This argument applies to other areas as well, like ESG). I don't know. I'm not sure anyone knows on Friday March 4th 2022.
In any case, we think these actions will stop purchases of new shares. And there is no debate on the morality, just the effectiveness.
People who study investing at some point have to learn that foreign securities have "government risk." This is usually one of the things in a long list of risks which is super boring to read but you feel like you have to memorize it for a test. I walk around at One Day In July and talk about government risk a lot, because I think, with some exceptions, most countries should trade at lower multiples than the United States. In the news we see often how XYZ country is trading at a discount to the United States, and I often think "yes, and they should be."
This week provided a prime lesson here. Across the firm, we hold very little international debt. Debt is supposed to be protective - so watching the risk factors is critical. It's not supposed to go down a lot, and it's certainly not supposed to go to zero. But Russian bondholders are looking at a two-fer: due to sanctions, they have no way to receive coupon payments from even supposedly safe Russian government bonds, and the value of the bond has dropped to, or close to, zero. That's a long way from safety.
Dan Cunningham
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