- The outbreak of war on the European continent and dramatic financial and economic sanctions rattled equity markets, sending major equity indices into correction territory during the quarter
- The Fed pivoted to a far more hawkish stance following persistently high inflation data, leading to the worst quarter for Treasury bonds in recorded history
- While it is too early to gauge the full effects of the war in Europe, its greatest and most immediate impact on the US economy will be through inflation effects
- The reduced diversification implied by higher correlations between stocks and bonds has prompted some important portfolios changes in Q1
“There are decades when nothing happens; and there are weeks when decades happen.”
Just as the prolonged economic disruption of COVID-19 seemed to be disappearing in the rearview mirror, the world got a lot more complicated again in the first quarter of the year. In addition to the immediate brutality of the war, Russia’s unprovoked invasion of Ukraine and ensuing sanctions by the West shocked financial markets at the same time persistently high inflation prodded the Federal Reserve into a far more hawkish stance. Equity markets experienced a sharp downturn in January and February as they digested the events in Europe. Fixed income yields, on the other hand, rose throughout the quarter making bonds a terrible hiding place from the geopolitical upheaval. Given that these two dynamics are likely to persist for the foreseeable future, they have important implications for portfolio construction in 2022.
It is too early to gauge the full effects of the war in Europe, partly because we don’t know about the length or severity of the conflict or how economic sanctions will reverberate throughout the global economy. For the US, the greatest and most immediate impacts are through higher energy prices and renewed supply chain disruptions. While Russia’s economy represents a tiny 3% fraction of global GDP, it is a major supplier of oil and natural gas. Higher energy prices will likely slow the European economy but have a lesser effect on US growth, given our relative energy independence. By February 2022, the amount of household budgets dedicated to spending on energy had declined to just 4% of total US consumer spending. At the same time, growth in the shale oil industry has allowed the US to become essentially self-sufficient in oil and natural gas. This stands in stark contrast to our economic vulnerability to the oil price shock in the 1970s.
Secondarily, however, the effect on inflation via higher commodity prices and continued supply chain disruptions will be a headwind to growth. Energy, agricultural commodities, timber, precious metals and base metals – each important inputs of production – have all jumped since the outbreak of the conflict. Additionally, the Ukraine invasion along with China’s renewed lockdowns as part of its zero-COVID policy have extended supply chain issues that emerged during the pandemic. Together, these will factor into the Fed’s calculations on monetary policy.
Even before the advent of war in Europe, inflation was becoming an increasingly entrenched problem. Prices heated up significantly throughout 2021 as strong consumer spending and massive fiscal support drove demand for goods at a time that supply constraints across major sectors of the economy limited availability of those goods. More recently as the economy has reopened, a general recovery of airfares, rents, hotel rates, restaurant prices and so on have contributed to rising prices, in large part due to the low base established when prices initially collapsed at the outset of the pandemic.
The extended period of high demand and rising input costs is giving way to a third front of inflation growth which is more worrisome. Inflation that persists tends to be sticky and self-perpetuating; a rise in prices results in higher wages, higher wages increase the cost of production which in turn drives the price of products higher. Inflation can also pull demand forward as consumers spend in the present to avoid paying more for goods in the future, further amplifying this problem. This so-called “built-in” inflation cycle, coupled with a rapidly improving labor market has the Federal Reserve concerned.
In March, with the CPI at a 40-year high of 8.5%, the Fed increased short-term interest rates by .25% and signaled its intention to raise rates for each of the remaining six meetings this year. More importantly, it abandoned its earlier assertion that the current inflation cycle would be transitory in favor of a far more hawkish stance indicating an urgency to its mission. Since that meeting, Fed governors have further sharpened this message to markets expressing a need to urgently decrease the Fed’s balance sheet and return interest rates to a neutral stance on a more “expeditious” basis. Several have indicated that may likely mean .50% hikes in coming meetings, the largest single moves in 20 years.
While the Fed ostensibly believes it can engineer a soft landing – reigning in growth and controlling prices without triggering a recession – bond markets are indicating that the Fed may be forced to favor price stability over economic growth. Even as equity markets bounced back from February lows on the back of robust earnings growth, strong labor market data and a unified Western response to Putin’s adventurism, bond markets have flashed a number of recession warning signals. Last year, Treasury bonds lost money as yields backed up and in the first three months of this year, they registered their worst quarter on record. Also this quarter, shorter term interest rates exceeded longer term rates indicating future pessimism and a dynamic that has preceded most recessions since the 1940s. Other late cycle indicators, however, like decelerating earnings, margin compression, high debt to corporate profits among others are absent for the time being.
There are a few possible explanations for the dissonance between the bond market and equities. One is that bond traders believe the Fed will overshoot with interest rate hikes, prematurely pushing the economy into recession. Higher interest rates, more restrictive fiscal policy, labor shortages, and the ebbing of the post-Covid surge in consumer spending are expected to slow growth by the fourth quarter of 2022 to 3% or less and further to 2% in 2023, closer to longer-term trend growth. However, throughout 2022, the labor market will continue to tighten, and inflation will likely remain well above the Fed’s targets, giving the central bank little excuse to relent from its more hawkish stance. Given the extended lag in the impact of monetary policy on economic activity, the Fed’s hawkish trajectory this year may very well add to recession risks in 2023. Another, explanation – that the Fed will have to act far more decisively to break long-term inflation expectations – could also be spooking bond markets. After years of gradual rate hikes in the late 1970s, it was clear the Fed was not able to get ahead of inflation expectations; the solution, now known as the Saturday Night Massacre, was a sudden, dramatic and unexpected hike in rates to 12% over the weekend of October 6, 1979. The idea was that a shock-and-awe approach to fighting inflation would convince markets that the Fed was serious about slaying the inflation beast, irrespective of the likely recession it would trigger. It worked. This tear-the-Band-Aid-off approach has some adherents within the Fed now because our current debt burden gives us less room to experiment with the gradualist approach.
A final argument – that bond markets have it wrong and the enthusiasm in equity markets is justified – is harder to make. Looking forward, rising interest rates will make it difficult to justify higher P/E multiples while rising wages and interest rates, along with slowing nominal GDP growth are likely to hinder earnings gains.