Mid-Quarter Letter to Clients
As you are undoubtedly aware, overnight, Russia launched an invasion of Ukraine. While the situation is rapidly evolving, Russia's apparent goal has gone from occupying a couple of relatively small eastern provinces to one of total occupation. Troops appear headed directly for Kyiv, and there are reports of fighting and bombing near the capital city. The markets reacted violently overnight and continued throughout the day.
Our hearts go out to the many Ukrainian people whose lives and property are at risk today. This is a tragic development that leaves us all saddened. While financial matters are probably the furthest thing from many people's thoughts today, we feel compelled to address the market situation for those worried about the implications.
We don't pretend to have any great insights into how the situation on the ground will evolve in the coming days and weeks. Still, we do think there are some timeless concepts concerning investment strategy during times of crisis that are worth reiterating.
- First and foremost is the idea that making emotional decisions during times of crisis is generally unwise. If the advent of COVID in early 2020 taught us anything, it is that a crisis is exactly the time not to make large portfolios changes. All too often, what seems obvious at the time turns out to be exactly the wrong strategy in retrospect. A crisis seems to make us think our crystal ball is clear when it is far cloudier than usual.
- Secondly, markets tend to react to military events in similar ways. At first, there is an immediate emotional and volatile reaction followed by a drawn-out process of weighing the true economic and market fundamentals. Rarely have military conflicts resulted in either global recession/depression or deep, prolonged bear markets. More usually, the direct impact is localized and regional.
The following table illustrates this point. It shows some of the major conflicts from WWII forward and the subsequent market reaction:
Source: Gemmer Asset Management, LLC
The tragic circumstances in Ukraine are going to dominate headlines for some time. Congress now sees bipartisan support for passing the most crippling sanctions against Russia, which is something of a silver lining considering the heavily partisan combat we've seen for years on Capitol Hill. In fact, it's the first full-throated denouncement of Putin from U.S. elected officials we've seen since 2014 when Russia invaded Crimea.
Until now, this year has been dominated by rising inflation, the Fed's pivot on rates, and upbeat corporate earnings. Last year, the stars aligned for strong returns, as there were few headwinds to distract investors. Today, the Fed has changed its tune, and talk of up to seven rate hikes this year has put investors on edge.
1. Investors cautiously eye the Russia-Ukraine crisis
Investors are now grappling with the crisis between Russia and Ukraine. Heightened uncertainty always adds to volatility, as it increases the possibility of unwanted outcomes. We've seen that in recent days, as short-term traders trade on headlines. How might an invasion affect U.S. economic activity? This is important, as it will have a longer-term effect on stocks.
According to the U.S. Census, U.S. exports of goods to Russia last year totaled $6.4 billion. That's a tiny percentage of U.S. GDP. The indirect impact is more of a concern, as the EU is the largest Russian trading partner. Russia is Europe's fifth-largest trading partner and accounts for 40% of Europe's natural gas imports. Russia is the number one supplier of natural gas to Europe. Using gas as a weapon would be far more problematic for Europe. Sanctions and rising energy prices will likely add to inflation, complicating the Fed's job, especially if we see a U.S. economic slowdown, but consumer psychology here in the U.S.is less likely to be affected by an invasion. Without a U.S. slowdown, the impact on U.S. earnings should be limited.
There are plenty of unknowns. Historically, geopolitical events have only created short-term market volatility, as investors re-price risk. It doesn't seem likely that an invasion will disrupt U.S. economic activity and corporate earnings, but stocks could be affected in the medium term. When Russia invaded Crimea in 2014, the market declined around 6% for a short time but ended the year positively.
Geopolitics aside, investors are carefully eyeing the Fed's next move. When it comes to a rate hike or hikes, it's "how much?" not "if….". The March 16 meeting will most likely be the start of the rate hikes. As of December, the Fed's own projections put their inflation gauge, the PCE Price Index, at 2.6% in 2022, which is lower than many other forecasts.
The question—how aggressive will the Fed be?
Let's look at history. The last truly aggressive rate-hike cycle was in 1994. Then Chairman Alan Greenspan and the Fed engineered a mid-cycle economic slowdown. It was a preemptive strike against inflation, as CPI was relatively low, and the economy was far from full employment. It included three 50bp rate hikes and one 75bp rate hike. The fed funds rate rose from 3% to 6%, doubling in one year, see Figure 1. Stocks finished the year nearly unchanged, with a maximum peak-to-trough drawdown of 9%.
Figure 1: Fed Funds
Cycles Source: St. Louis Federal Reserve; January 2022
In June 2004, the Fed embarked on 17 consecutive 25bp rate hikes. So as not to unnerve investors, Greenspan's Fed telegraphed that rate hikes would likely be "measured." Rate hikes during the last decade were even more dovish. Powell used the term "gradual" to guide markets. As with prior cycles, inflation was low, and the economy was not at full employment. As with prior cycles, rate hikes were preemptive against inflation.
It's a different world today
The CPI is at 7.5%, the jobless rate is 4.0%, the Fed funds rate is 0%-25%, and Q.E. continues, though it will end in March. Powell's end-of-January press conference was decidedly hawkish. The emphasis in January was on inflation, not employment. Fed Comments included: "I think there's quite a bit of room to raise interest rates without threatening the labor market.", "This is, by so many measures, a historically tight labor market—record levels of job openings and quits", Wages are moving up at the highest pace they have in decades."
Powell did not provide any rate-hike guidance—no use of "measured" or "gradual." And he didn't rule out a 50bp increase at a meeting. The last time the Fed hiked by 50bp was in 2000.
The March meeting
The Fed funds futures have been volatile. As of February 14, fed funds futures put odds of a 50bp hike at 61%. The larger-than-expected January CPI markedly increased odds of a 50bp rate increase in March. Most Fed officials are not yet convinced an aggressive response is needed. Currently, fed funds futures are pricing in a year-end fed funds rate of 1.75%-2.00%, or seven 25bp rate hikes this year if the Fed moves in 25bp increments at each meeting.
Risks include the following:
• How does the Fed rein in inflation and not create a recession?
• Can the Fed engineer a soft economic landing that brings inflation back to target?
• The Fed needs help from the supply chain and a shift in demand toward services and away from goods. But rising wages could complicate the picture, as job openings remain near a record.
2. CPI at a 40-year high
The CPI rose from 7.0% in December to 7.5% in January. The core CPI, which excludes food and energy, rose from 5.5% to 6.0%. Goods less food/energy are up nearly 12%—see Figure 4. The rate of change in services, which had been more muted, has now accelerated, up 4.6% in January, and the 1% rise in the Producer Price Index suggests inflation is still running hot.
Figure 4: Pain at the Cash Register
Source: U.S. BLS; January 2022
3. It's not all gloomy—earnings are strong
Earnings reports have been strong for Q4 2021 for S&P 500 companies. Profits for the last quarter are projected to rise 31.0% versus one year ago (Refinitiv, with 72% of companies having reported through February 11). While we have seen some high-profile misses and there has been no shortage of talk about higher prices and higher costs—75% of companies have cited inflation on earnings calls per FactSet.
4. A peek ahead
Looking to the March meeting, if the dots line up with fed funds futures, that would be a 1.75%-2.00% fed funds rate at year-end, or seven 25bp rate hikes this year (if the Fed were to hike in 25bp increments). Are investors prepared for such an outcome? It's difficult to believe that they will be able to raise rates that much that quickly after over ten years of holding rates near zero. Some say that rates in that range are still accommodative, although it is a huge jump from where they have been. The Fed could adjust its inflation forecast as new data comes in, especially if inflation starts to moderate, but they are playing catch-up after 20 months of rising inflation since they were so late in reacting. They have a careful balancing act to perform, slowing the economy to lower inflation but not enough to tip us into a recession. The question is whether they have the political will to slow it down enough to really bring inflation down. Stay tuned.
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