The Debate Over Guns or Butter Returns

The Russian attack of Ukraine will redefine national spending priorities for the foreseeable future. This has important implications for investors. While many see the invasion as the opening salvo of a new cold war, the reality is that one has been underway for a long time, just not politically acknowledged. The Russian aggression makes this reality unavoidable. President Putin exploited the West’s tolerance of a post-Communist Russia and reaped appeasement for his authoritarianism. No longer will Russia be naively expected to join the international community of democratic nations. For investors, a shift in governments’ spending priorities should provide secular support for specific industries, stall much needed reforms of entitlement programs and frustrate a broader social agenda.

US equities are essentially flat since the invasion of Ukraine, but that does not imply the market is doing fine. The S&P 500 Index was down over 9% prior to the onset of the war. Continued uncertainty and spiking oil prices have added to the volatility. It is easy to blame the conflict for poor year-to-date returns, but global economies were already slowing due to inflation, higher bond yields and tighter monetary conditions. The combination of the military conflict and slowing economies has driven a shift to a ‘risk-off market’ positioning. Assets deemed safe, liquid, stable or low-risk have been preferred.

A reactionary flight to quality or financial safety is to be expected. The bigger question is what the Federal Reserve will do in light of the additional stress on the financial system. Rising short-term rates, higher energy prices, and slower economic growth are historical culprits of a recession. We continue to expect that the Fed will raise short-term rates soon to combat inflation and return the Fed Funds rate to a neutral level it considers neither simulative nor restrictive. Given the additional uncertainty caused by the Ukraine-Russia conflict, the tightening cycle could be more measured than previously anticipated.

The phrase “Guns or Butter” was popularized by American Politician, William Jennings Bryan, around World War I and has since come to define the debate over the economic impact produced by government spending on defense versus social programs. The invasion of Ukraine will tilt this debate firmly in favor of categories associated with the “guns” categories, specifically military, energy and industrials. Sectors now deemed in the national interest, including as oil, cybersecurity, and defense should benefit from better appropriation, less regulatory pressure and bipartisan support.