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Pain-gain tradeoff for Russia sanctions

by Community Manager

‎07-23-2014 11:12 AM

market commentaryBy Matt Freund, CIO of USAA Mutual Funds

 

The European Union has ratcheted up its rhetoric against Russia since the downing of Malaysian Airlines Flight 17 over Ukraine. But with the EU’s economy still struggling for growth, it remains to be seen whether the stern words from Berlin, Paris and even Amsterdam turn into meaningful action.

 

Here’s the rub: The strong economic interdependence between the EU and Russia means that any EU sanctions aimed at punishing Moscow for its involvement in Ukraine would also result in serious self-inflicted pain.

 

The EU and Russia are among each other’s top trading partners, with the total value of imported and exported goods and services topping $325 billion last year (roughly 10 times the scale of U.S.-Russia trade). We all know about the EU’s reliance on Russian oil and natural gas, but it’s less known that in 2013 the EU exported nearly $120 billion in machinery, chemicals, medicines and farm products to its eastern neighbor.

 

It would be a high-stakes gamble for Europe that the payoff from strict sanctions would end up being worth the substantial cost. The EU says it will announce any new sanctions against Russia tomorrow, but we expect the bloc’s reaction will be more bark than bite, at least for now.

 

Global stock markets fell after last Thursday’s news of the Malaysian Airlines tragedy, but they didn’t stay down long. By Tuesday, the Standard & Poor’s 500 had more than recovered all of its lost ground. This fleeting impact may be surprising, given that significant geopolitical events in the past have typically had a more enduring effect on markets. A big difference in the current market is that investors don’t expect the negative impact to last, and we’ve all been trained to “buy the dips.” It’s an approach that has worked well in recent years, and investors will keep doing it until it stops working.

 

What allows it to work is that the Federal Reserve and other key central banks are protecting investors against downside risk by providing both access to vast quantities of cheap money and explicit assurances that interest rates will stay low. Until the central banks take away that safety net, buying the short-term dips will likely continue to work.

 

 

The Fed is scheduled to fully wind down its monthly liquidity program known as quantitative easing in the next few months, but the European Central Bank is said to be considering its own QE to try to lift the lagging eurozone economies. Weak current conditions reveal a fundamental rift among the eurozone members regarding how best to get on the path to recovery. Germany, the dominant economy in Europe, believes the weaker members should accept more austerity to rein in deficit spending and reduce their sovereign debt loads, while the rest of the eurozone believes the better solution is for the inflation-phobic Germans to accept slightly higher prices.

 

Inflation in the eurozone is now running at under 1 percent annually, less than half of the 2 percent target rate. A QE program by the ECB would be intended to raise price levels toward the target level and reduce real interest rates, which could in turn benefit export-dependent members, led by Germany, by lowering the value of the euro.

 

QE might also provide economic cover in the event that the EU decides to impose tough sanctions against Russia for its role in destabilizing Ukraine. Germany alone accounts for nearly a third of the bilateral trade between the EU and Russia, so it would take the biggest hit from sanctions. But easier access to low-cost money within the eurozone and a weaker euro could partially offset the pain of sanctions by boosting Germany’s export sector, which has been flagging in recent months.

 

There are a lot of “ifs” in any geopolitical scenario, and we don’t think trying to guess the next headline is much of an investment strategy. Our focus is on long-term results, so we place the most weight on fundamental valuation. That said, if current events in Eastern Europe, the Middle East or elsewhere create short-term market volatility, we stand ready to take advantage of that opportunity.

 

USAA Investments Managed Portfolio Outlook

Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs.

 

We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.

 

We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.

 

We are overweight non-U.S. developed markets and emerging markets based on relative valuations.  Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.

 

As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.

 

This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.

 

Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.

 

Investing in securities products involves risk, including possible loss of principal.

 

Past performance is no guarantee of future results.

 

Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.

 

As interest rates rise, existing bond prices fall.

 

Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.

 

Some income may be subject to state or local taxes or the federal alternative minimum tax.

 

Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.

 

The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.

 

Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market.  S&P 500 is a trademark of the McGraw-Hill Companies, Inc.

 

The Russell 2000® Index is an unmanaged index which consists of the 2,000 smallest companies in the Russell 3,000 Index, and is a widely recognized small cap index.

 

USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.

 

High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.

 

USAA Managed Portfolios-UMP™ is a service of USAA Investment Management Company, a registered investment adviser and broker dealer.

 

Financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # 0E36312), and USAA Financial Advisors, Inc., a registered broker dealer.

 

Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.

 

The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.

 

Managed Accounts is a service of USAA Investment Management Company (USAA), a registered investment adviser and broker dealer.

 

Diversification does not guarantee a profit or prevent a loss.

 

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