Joe Zidle: Seeing Through the War Clouds

by Andrew Dowler, Managing Director of Government Relations for Blackstone in Europe

Before Russia’s invasion of Ukraine, the political consensus was that Vladimir Putin was all “jaw jaw” rather than “war war”. Many argued that for him to enter a war he could never win, with or without huge suffering on his own side, would be wholly illogical. US and UK military intelligence said differently but were ignored. The West’s 20-year policy of giving Putin the benefit of the doubt held, paving the way for the greatest failure of European political due diligence since the Russian tanks rolled into Hungary in 1956.

Dissenting voices had long argued that Putin’s risk appetite was different. They didn’t need hindsight to know that his annexation of Crimea was a clear sign of a gambler with a penchant for recklessness. And they didn’t need it when he invaded Chechnya and Georgia, used polonium in a London hotel, downed a passenger airline, and used chemical weapons in Syria and on the streets of Salisbury in the West of England.

Despite all this, ideologically right-wing and left-wing extremists gave him comfort. And the mainstream forgot the traditional doctrine of deterrence and made a naïve foreign policy mistake. 

A new geopolitical landscape  At the time of this writing, the military implications are unclear and publishing deadlines would likely render hollow any forecasts. Whatever military scenario plays out, this war will fundamentally change the world’s geopolitical landscape.

Cold War II looms. A new wall may not be built, but seeing a Europe that is not sharply divided between West and East again is difficult. In Russia, future living standards look as grey as they did during Cold War I, with a depression following a 30% contraction in GDP and hyperinflation. 

The impacts in Western Europe will be different. For one, NATO, perhaps with Finland and Sweden as new members, will be strengthened, as the threat from Putin is finally clear to all. Helping the cause will be a US recommitted to international defense and the Atlantic Alliance.

In addition, the EU has been remarkably emboldened since the invasion, quickly discovering the need for rearmament and the benefits of strategic autonomy and self-sufficiency. It will now surely grasp the opportunity to become a defense union and superpower in its own right, taking its place alongside the US and China in international affairs. That opportunity has been made possible by Germany’s policy volt-face after a decade of Russian appeasement to full and active military involvement. Chancellor Olaf Scholz has promised to increase German defense spending to 2% of GDP and to invest a one-off sum of €100 billion, twice the country’s annual defense budget.

Critical to the EU’s rise is Emmanuel Macron, now the de facto leader of Europe. He will now be re-elected easily as president of France. (His main opponent, Marine Le Pen, had to pulp her election brochures, as they included a picture of her shaking hands with Putin.)

Energy crisis to strain wallets, democracies  Energy prices, soaring as a result of an oil and gas supply crisis complicated by perhaps ten million displaced Ukrainians entering Western Europe, will put severe strains on less temperate democracies than France and Germany. Expect that extremists attempt to exploit shakier democracies, but fail. Their tacit support for Putin has undermined them, and the politics of war has strengthened the case for internationalism and underlined the dangers of nationalism. 

The cost-of-living increases will hurt, particularly in the UK. Russian gas represents just 5% of UK supply, compared to 50% in Germany and Italy and almost 100% in Finland and Latvia. But while the Brits may get most of their gas from the North Sea and Norway, they’re sold on the open market. With UK gas storage capacity now minimal, the UK depends on fluctuations in prices, which will remain high as Europe turns away from Russian supply. There could be a real political impact from the combination of diminishing disposable income and Chancellor Rishi Sunak’s limited ability to offer tax cuts and other economic sweeteners. 

Russia, an uncertain future  Many expect the invasion of Ukraine to bring about fundamental change in Russia, but it took 12 years for the USSR to collapse after its invasion of Afghanistan. The fear is that the rest of the decade will be spent arguing about war reparations and whether to seize Russian Central Bank assets to pay for them. We can certainly expect a war crimes investigation that lasts for many years. And if Putin remains in power for that process, it will poison Russian relations with the West for that much longer.

While I am optimistic that policy decisions can be made in Europe and the UK to prevent a near-term recession, the business cycle works at a different speed than the overall economy. Lower growth, higher inflation, and rising interest rates (i.e., the discount rate for stocks) present challenges for the markets, and I expect continued volatility, lower multiples and wider credit spreads to ensue. 

There’s more to it than valuation  Most major European indices are down roughly twice as much as US stocks, despite recovering sharply from early March lows. At 15x trailing 12-month earnings, the Euro Stoxx 50 is at recessionary valuation levels. But in my view, valuation alone is not enough to signal a buying opportunity. 

Record high producer prices, such as the 25.9% year-over-year German PPI reading in February, will challenge companies’ ability to pass along cost increases. Higher interest rates in Europe and the US will also push up the discount rate for equities. Slowing activity is another headwind, as industrial activity, PMIs and global growth trends are hugely important to earnings of European companies, given their global exposures. Continued caution is warranted in my opinion. Higher-quality companies—those with consistent cash flow and less leverage—should provide a relative degree of safety for investors. 

Selectivity required in fixed income  European high yield markets are down nearly 5% this year, and the cost of insuring against EU high yield defaults moved to its highest level since the COVID outbreak. I expect this pressure to continue. As lower-rated credits struggle amid difficult operating conditions, sector selection will be critical. Higher-rated investment grade provides some cushion, though rising interest rates—driven by an aggressive Federal Reserve—may end up being the larger factor in returns. I expect shorter-duration fixed income, loans and other assets with the floating rate features to outperform, as a rising 10-year US Treasury yield lifts rates higher around the world. 

This latest crisis can be expected to be a tipping point for major long-term structural shifts, ranging from globalization to the role of the US dollar in global financial markets. I plan to share my thoughts around these in the coming weeks and months.

For now, volatility is likely to continue as markets work through the war’s implications. The energy shocks are readily apparent; consumers see them at petrol stations and in their heating bills. But in periods of heightened risk, investors should look to the fundamentals as a guide. Currently, I see growth cushions in the EU and UK, and a newly unified Europe with policy solutions ready-made to support the economy. The path forward for investors will be more challenging as slower growth, higher inflation, and rising interest rates call for higher quality, greater selectivity, and a sharp focus on duration management.

With data and analysis by Taylor Becker.