As we look on in horror at the brutality in Ukraine, it is emotionally difficult to detach into the realms of economics and finance. It is also difficult to know what to say. Most observations are platitudes, understandable statements about the way the world is forever changed, yet simultaneously banalities devoid of deeper insight.
We doubt we can offer much better. Yet it occurs to us that when confronted with the unthinkable, our collective tendency is to ignore or downplay its potential implications, above all for those of us who sit at a comfortable distance.
Behavioral sciences have long understood our biases when judging risk. We tend to seek reward and downplay risk, particularly following a winning streak. We are deceived by past actions, treating decisions based on sunk costs rather than marginal analysis. We treat the future as unknowable, and place too much stock in historic events that appear like the present, whether they are or not.
Mental shortcuts—heuristics—are also problematic. They are invaluable in times of immediate danger. They dictate instantaneous decisions of fight or flight, and stem from the survival instincts of our prehistoric past. But they don’t rely on analysis—indeed they temporarily suspend it.
Human reasoning and the ability to make connections between seemingly disparate events is what makes us the superior species on the planet. But our biases and instincts often disrupt our reasoning faculties, sometimes to our individual and collective detriment.
Which brings us to the financial markets. It would be wrong to say that markets have not been disrupted by the impacts of war, sanctions, and the risks both pose for the global economy. Equity markets have tumbled 10% this year—in the parlance, a ‘correction’ is underway. Bond yields have fallen nearly 25 basis points from their recent highs, as investors have shifted into safer plays. Energy, agricultural and mineral commodity prices have soared on concerns about disruptions to distribution amid already tight global supplies.
Yet it is also fair to say that investors have only partially adjusted their views. A fundamental re-think is not yet on display.
Two data points drive home that conclusion. First, according to FactSet, today’s forward price-to-earnings ratio is around 18.5, near its five-year average and above its ten-year average of 16.7. Second, fixed income markets continue to discount a series of rate hikes this year from the Federal Reserve. Those two observations drive home the point that investors have concluded that war and sanctions will only marginally change the outlook for growth, inflation, and corporate profits.
Perhaps that is correct. As horrific as the human cost of war in Ukraine is, the conflict appears contained. The US and NATO will not risk military escalation.
Moreover, Russia and Ukraine are mere ‘rounding errors’ in the arithmetic of global GDP or global stock market capitalization.
Finally, spectacular market recoveries from previous financial crises, wars and pandemics offer powerful evidence that pessimism does not pay.
Yet we cannot help but ask, could today’s consensus be overconfident in its assessment of risk? Might collective bias blind us? And given that human bias is embedded in the statistics of the financial algorithms that drive large trading volumes, might technologically embedded human bias compound systematic error?
If there is a fault line, it will be the failure to make connections that genuinely exist, but hitherto have remained unobserved or underappreciated. What if, for example, soaring energy and food prices disrupt markets, politics, and international relations far from today’s battlefields?
Consider the following statistics, courtesy of a recent University of Illinois study:
- Russia and Ukraine account for 14% of global wheat production and 30% of global wheat exports
- Russia and Ukraine account for nearly 20% of global corn exports. Ukraine is a dominant exporter of corn to China
- Russia and Ukraine account for 19% of global barley production and nearly one third of global barley exports
- Russia and Ukraine account for 60% of global sunflower oil production and 75% of global sunflower oil exports
Grains and corn are food staples around the world. The top-ten wheat importing countries in 2021 were, in order: Egypt, Turkey, Indonesia, China, Algeria, Bangladesh, Iran, Brazil, the Philippines, and Nigeria.
Since 2016, global wheat prices have been on a tear, rising nearly 300%. In the past three months alone, wheat prices have jumped another 50%, largely because of feared disruptions to Ukrainian, Russian, and Belorussian supplies.
In shops worldwide, bread and other staples’ prices are rising rapidly. In many emerging and lesser developed countries that are experiencing currency weakness, domestic food prices will jump even more. In some case, governments will attempt to shield consumers via subsidies, but the size of subsidies will grow rapidly and may prove financially untenable.
Or consider this: Belarus is a major producer and exporter of potash. Potash is a key input for fertilizers, and is essential for modern, monoculture agribusiness. Potash improves water retention, crop yields and disease resistance. Together, Russia and Belarus produce approximately 40% of the world’s potash. Sourcing potash from Canada and other producers is becoming much more expensive. Global spot potash prices are currently $800 per metric ton, up more than 200% since the beginning of the year.
In short, what is happening in Russia, Ukraine and Belarus could unleash significant food inflation, shortages, and food insecurity across Africa and much of Asia. History is replete with examples—from the French Revolution to Arab Spring—where soaring food prices were the springboard to social and political unrest.
Nor is this just about a few small countries at the margins of the global economy. How will vulnerable democratic institutions in Europe and the US cope with the frustrations and anger of rising home heating, cooling, gasoline, and food prices? What might that portend for the 2022 US mid-term elections or even the fate of US democracy in 2024?
The Federal Reserve and other central banks are not equipped to address these supply shocks. The reverberations of soaring energy and food prices place them in the untenable position of choosing lesser evils—fighting inflation or unemployment, but not both. After the events of recent years, can we blithely assume they can make those choices while retaining their independence?
In short, might investors today be ignoring social, political, and institutional fragilities exposed by populism, war and pandemic that could fundamentally alter the calculus of market pricing? Could our collective biases render us incapable of recognizing fault lines below the surface?
In economics and finance, there is a long history of thinking about how markets process risk and uncertainty. Perhaps the best way to think about it is via ‘fan charts’ that display confidence intervals about an outcome over time. Typically, those confidence intervals widen over time, as the future becomes less certain.
But in times like ours, those fan charts begin to gap wider for the immediate future. The expected outcome becomes not just less reliable, it is increasingly determined by the variance and skew of possible outcomes. When the future becomes hostage to uncertainty decision-making is paralyzed.
Maybe that calamity won’t befall us. But can we collectively be so certain that it won’t that we value equity markets 10-20% above their long-term averages? Are we so sure about the future that we only marginally change our expectations for the Federal Reserve’s monetary policy response this year and next?
Risk and uncertainty are strange things. Investors are taught to approximate them and to seek adequate compensation for what they have estimated. But within that approach, reside the biases and frailties of our psyches, including our reluctance to consider what might occur until it is too late.
Let’s hope now is not what one of those times.