Not so quiet on the East front – Thoughts on the Russia-Ukraine situation
Montreal, February 25, 2022
BRIEF NOTE FROM THE CHIEF INVESTMENT OFFICER
Let us preface this note by saying that our thoughts are with all Ukrainians whose Canadian diaspora is the largest in the world after Russia’s. We are praying for a rapid de-escalation of the situation.
One of my favorite music band at the moment is an Ukrainian folk quartet called Dakha Brakha. Many of Dakha Brakha’s songs are about the reminiscence of what life was in pre-communist Ukraine.
The reason I mention this while some western media outlets are describing the situation that is unfolding in the eastern province of Donetsk and Luhantsk as something totally unexpected, it is worth noting that this is nothing new to Ukrainians who have been indirectly controlled or outright repressed by Moscow for centuries. In fact, the regions that are enduring Russian military strikes today have been under a state of emergency order since 2014.
Admittedly, I didn’t think that Moscow would have to act on its open threats but despite this having escalated further than I thought, I still believe that Moscow is prepared to order a general cease fire and a withdrawal of its troops as soon as NATO agree to its demands.
Moscow claims that the military operation was needed to protect civilians in eastern Ukraine but I believe this is an excuse as at the same time, it has made abundantly clear, repeatedly, that it wants NATO to promise not to expand into any more Eastern European countries that border Russia. For the context, Russia already shares a border with five NATO members. NATO, on the other hand, refuses Moscow’s demands on the grounds that all countries have a right to self-determination.
With that in mind, I believe that Moscow’s actions in the last 48 hours are designed to verify if NATO’s resolve to protect Ukraine independence is as firm as Moscow’s determination to bring it under its tutelage. Implicitly, Moscow’s actions also signal that it is prepared to have the Russian population and Russian international conglomerates face the cost of severe sanctions, thereby showing that is not constrained by public opinion at home in the way that NATO countries are. In fact, I believe Moscow’s is counting on the fact that the American public has little appetite for another foreign military campaign as it is finally figuring out how costly and difficult it is to help small countries secure independence from belligerent neighbors. Afghanistan, where the US failed to establish political order or a functioning national economy after two decades is just the latest example of that. Prior to that, there was South Korea (1948-50 – North Korea invaded south Korea with the support of China and the Soviet Union), Vietnam (1955-75 – North Vietnam invaded South Vietnam, Laos and Cambodia with the support of China and the Soviet Union).
To summarize, I believe that Moscow has concluded that NATO has little willingness to engage in a new war and that in the interim, whatever Moscow does maximizes the odds of keeping Kyiv under its influence.
INVESTMENT STRATEGY IMPLICATIONS
If the omicron variant or the prospect of runaway inflation were insufficient, it seems that Russia’s invasion of Ukraine has finally provided the excuse to send capital markets into a tailspin. To this point, global equity markets are nearing double digit losses year to date and volatility indicators are on the rise again.
This is the kind of scenario that is prompting investors to question their investment strategy. That being said, just like we argued against cutting dramatically the exposure to risky assets when the first cases of Covid-19 were revealed outside of China on the grounds that it was already too late, I believe that selling now, when so much fear and uncertainty is being discounted is not the best option. At the same time, I’m not suggesting to buy either. After all, while I don’t believe that the situation in Ukraine will deteriorate much further, an attack on the Russian natural gas pipelines that cut across Ukraine to supply Germany and other parts of Europe cannot be ruled out at this point. I also do not think that Russia will inspire Beijing to consider similar options for Taiwan but may it will.
I would simply point out that while our models still suggest that broad equity markets will continue to appreciate by 5% to 7% per annum on average in nominal terms in our base case scenario, that does not mean that they will appreciate by 5% to 7% every year. We are reminded periodically, as we are now, that markets do not go steadily go up. There will be down years and there will be double digit up years. As we have mentioned on numerous occasions, the key is to ensure that the proportion of an investor’s capital that is invested in risky assets is consistent with such investor’s risk or loss tolerance.
From that stand point, I am very comfortable with the positioning that we’ve adopted for our clients. For instance, through the managers that we have selected, we have largely avoided long term government bonds which are proving quite vulnerable to interest rate increases. We have also avoided the most speculative segments of the equity markets which are also proving vulnerable to monetary policy adjustments. We have entirely avoided crowded flavors of the day like companies that had recently IPOed and we never held cryptocurrencies. On the private markets side, we systematically declined opportunities to invest in start-up software firms on multiples not witnessed since the dot-com era. We were instead focused on establishing a portfolio of hedge funds in which underlying funds that would place bets primarily on relative value, higher volatility, higher dispersion and trend following strategies. We saw that as the best strategy to avoid being caught off guard in the event that equity and fixed income disappointed simultaneously. These little actions together contributed to enhance the resilience of our clients portfolios.
Lastly, I remain optimistic that I will get the chance to appreciate Dakha Brakha live in Montréal in the not too distant future.
Dimitri Douaire, M. Sc., CFA
Chief Investment Officer
 The title is a paraphrase of the 1930 world war I themed movie “All quiet on the western front” based on the 1929 Erich Maria Remarque novel.
 Census Profile, 2016 Census: Ethnic origin population, Statistics Canada, 8 February 2017
 Since the collapse of the Soviet Union, Russia’s western buffer has been reduced to Belarus