For the first quarter of 2022, the major market indexes finished down for the first time in two years, with the technology heavy Nasdaq falling over -8.9%, despite an impressive relief rally over the last several weeks. In this commentary, we will talk about why we believe the market has rallied, and why we still see geo-political tension, inflation, and a more aggressive Federal Reserve Bank as headwinds for the remainder of 2022.
We believe the relief rally has been tied to geo-political events. In fact, the U.S. stock market has been moving up and down based on the perceived perceptions of how the war is going for Ukraine, and how long the war might last. The market perceives that a Russian victory, and/or long war is negative for the market and economy. In February, when Vladimir Putin ordered his forces into Russia, he implied that Ukraine, as well as many former Soviet Republics, still belong to the “Russian Empire.” At the time of the speech, Russia had amassed 190,000 troops along the Ukraine border. Over the last ten years, the Stockholm International Peace Institute, estimated that Russia had increased its military spending by 30% in real terms between 2010 and 2019 and by 175% between the year 2000 and 2019. NATO (the North Atlantic Treaty Organization), which was set up during the Cold War to stop the former Soviet Union, created a doctrine that said “an attack on one member was an attack on all members”. However, after the fall of the Soviet Union, NATO countries reduced their defense budgets in comparison to Russia, and routinely failing to honor the 2% rule (NATO countries are supposed to spend at least 2% of their GDP on defense). Moreover, the United States had moved most of its forces out of Europe and repositioned them in the Pacific to counter China’s growing power. Europe has rarely been as weakly defended as it is now. While NATO was down-sizing its forces, the Russian military has paraded a laundry list of new weapons and scored victories in the Georgian war (2008), annexed Crimea in 2014, and officially ended a ten-year war with Chechnya in 2017, with Chechnya under Russian control. Western analysts feared that the Russian army would roll over Ukraine and then move on against relatively under defended eastern European countries and even NATO countries, like some of the former Soviet Baltic states. As a result, when Russia invaded Ukraine in February, many feared the worst, and markets around the globe quickly tumbled over fears of World War III, as the United States would be treaty bound to defend the NATO countries.
After a short bit of fighting, the financial markets began to rally and make back some of their losses. The Ukrainians, despite lacking in military equipment, have proven to be tough fighters, united in their desire to protect their country, and ingenious in their defense. Western aid has also helped. When the Russians destroyed much of the Ukraine communications systems, Elon Musk directed part of his Star Link satellites to provide free wireless service to Ukraine. The Ukrainians have used this internet service to command inexpensive drones, which fly too slow to be picked up by Russian radar, and are almost impossible to see at night, to scout and find Russian positions and supply lines. This information is then sent by Star Link satellites and relayed back to relatively obsolete Ukraine artillery, but when combined with ubiquitous internet and cheap drones has been able to decimate Russian forces. American and British anti-tank weapons have also proven very effective against Russian tanks and trucks. Twitter is reporting that the Russians have lost so many logistics trucks that they are commandeering commercial vehicles in Russia to be used to send supplies to their forces. Moreover, despite all of Russia’s new weapons, their military is showing glaring weaknesses. Russia’s lack of encrypted communications has allowed the Ukrainians to intercept and triangulate the location of 3 Russian generals. Ukraine claims to have already killed 13 Russian generals, a shockingly large number which could affect Russia’s ability to conduct operations. Furthermore, Russia has very advanced aircraft, but very few precision weapons. The lack of precision weapons has forced their aircraft to fly low to drop their bombs. This has made their aircraft vulnerable to portable man carried anti-aircraft systems such as the Stinger missile supplied by the U.S., as well as obsolete truck mounted guns still in the Ukrainian inventory. Even now, over seven weeks into fighting, Russia still does not have control of Ukraine airspace. Thus, the fear of Russia rolling over Europe and even attacking a NATO country in a 1940’s style German Blitzkrieg seems increasingly unlikely, and we believe the market has recouped some of its losses on this news.
Making matters worse for Vladimir Putin, his actions have galvanized the West. NATO countries have vowed to increase and modernize their militaries, something the United States has been trying to get them to do for years. Germany, one of the lowest per capita contributing NATO countries, announced they would spend an immediate $100 billion on defense (almost as much as Russia spends in two years) as well as buying new American F-35 fighters. Germany even announced they would close the Nord Steam pipeline, an important economic loss for Russia, and Germany said they would supply weapons to Ukraine, breaking from post WWII tradition. In addition, Western companies have ceased doing business in Russia, Western governments have frozen Russian assets, and Russian banks have been expelled from the SWIFT (SWIFT- Society for Worldwide Interbank Financial Telecommunication facilitates trillions of dollars in cross-border payments among all the world’s leading banks in over 200 countries) banking systems. Because of these actions, the Institute of International Finance believes the Russian economy will sink over -15% this year.
Unfortunately, the economic fallout of the current conflict will not be felt in just Ukraine and Russia. As President Biden has stated, the U.S. will feel the economic effect as well, both domestically and internationally. The S&P 500 represents the 500 largest market capitalization companies in America. Standard and Poor’s estimated that roughly 40% of the S&P 500 earnings come from overseas. Because of the conflict, we believe food prices are going higher, which will negatively affect both Americans and international consumers. According to Germany's Federal Office for Economic Affairs and Export Control, Ukraine's wheat production accounts for 11.5% of the world market, while Russia's share is 16.8%. The conflict in Ukraine is causing production to be dramatically cut, which in turn is causing prices to soar, leaving less money in consumer’s pockets.
Rising food prices are already affecting American families. In international markets, the situation is much worse. The USDA reports that the average American household spends 6.5% of their budget on food (this number is over 15% for the lowest quartile of American society). In emerging markets, the USDA estimates that consumers spend between 20% to over 50% of their disposable income on food. The Food Price Index, which tracks the international prices of items such as vegetable oils and dairy products, averaged 140.7 points in February, or up nearly 4 percent from January. This is also 24.1 percent over the level a year earlier and 3.1 points higher than the previous peak in February 2011. This is important because the last time food prices were this high, high food prices helped to usher in the “Arab Spring” which caused unrest and ravaged the Middle East as consumers in those countries could not afford to eat, as well as obtain life’s other basic necessities. This time around could be worse because not only have food prices risen, but fuel costs are also at multi-year highs. Moreover, natural gas, a by-product of oil, is used to make fertilizer; rising natural gas prices mean higher fertilizer prices, leading to even higher food prices. When consumers in these emerging markets have nothing left to spend after buying food and fuel, it is sure to act as a headwind to S&P 500 companies with operations in those countries, as well as create conditions for possible violence.
Another headwind is the changing Federal Reserve monetary policy. Accommodative monetary policy and the expansion of the Fed balance sheet has driven down borrowing costs and driven up asset prices over the last ten years. Now with inflation at forty year highs, the Fed has reversed course and on March 17, raised interest rates for the first time in three years, with the Fed dot map indicating rate rises coming at each of the remaining six meetings in 2022. As of the last week in March, Mortgage News Daily reported that the 30-year fixed mortgage jumped to 4.95%. Freddie Mac reports the average 30-year rate for the year 2021 was 2.96%. For someone borrowing $1 million, this represents an additional $19,900 in borrowing cost.
Higher interest rates also act as a negative headwind on stocks. As interest rates move higher, yields on fixed income investments go up, making them more attractive and stocks relatively less attractive. Valuations on riskier assets that are not yet generating profits get hit the most because when valuing those companies, future earnings have to be discounted back to the present using higher interest rates, thus reducing their current value. Rising interest rates will also make the U.S. debt harder to pay back and will cause the U.S. budget deficit to widen. Larger debt loads and budget deficit leaves policy makers less choices in dealing with future problems.
As the Federal Reserve continues to raise short term interest rates, the fear of a sustained interest rate inversion increases. In an interest rate inversion, short term rates rise higher than long term rates. This happens as the Federal Reserve raises interest rates to fight inflation, but investors keep long term interest rates relatively low, because they think the Federal Reserve’s actions will create a recession and short-term rates will soon reverse. Remember the Federal Reserve only controls short term interest rates. When this situation happens, short term rates rise and long-term rates do not rise as much. Short term rates are defined as 2-year treasury rates, and long-term rates are defined as 10-year treasury rates. Once an inversion happens, banks begin to pullback on making loans because they pay depositors interest based on the short-term rates, and loan money out at the longer time period at higher rates. If the banks cannot make money on their loans, they stop making loans, causing the economy to move into a recession as new production and consumption is not financed. The difference between the 10-year rate and shorter 2-year rate is called the interest rate spread. The larger the spread, the more money banks make on loans, and the more anxious banks are to make loans, and the smaller the spread, the less likely banks are to make loans.
The lag between once an inversion starts and the beginning of a recession has averaged about 22 months but has ranged from 6 to 36 months for the last six recessions (Bloomberg Research). Thus, we do not see an immediate recession threat, but storm clouds are gathering in the distance. Moreover, recessions usually do not start when the employment outlook is strong, 8 and there are currently more jobs listed as available than actually people looking for jobs. In addition, money market balances at banks are near all-time highs.
This cash cushion historically has helped fuel recoveries after market sell-offs. In previous downturns, people stockpiled cash out of fear, and that cash later helped to sustain recoveries, such as what happened in the Tech bubble of 2000-2002, and the Financial Crisis during 2008-2009. As those problems slowly worked themselves out, cash in bank accounts was put back to work and fueled large market rallies. Likewise, the buildup of cash due to COVID-19 has not yet been put fully back to work. Thus, pent-up demand and lots of cash in the bank system will likely keep the economy growing this year. Although the growth will be reduced by high inflation, and rising interest rates.
In conclusion, we believe the equities markets have had a relief rally, as investors do not see Russia being able to move beyond taking control of Ukraine and invading other parts of Europe, and Russia may not even be able take over Ukraine. Having said that, the market still faces headwinds of inflation (especially food and fuel inflation), and rising interest rates. We believe this will lead to volatility, but nothing the financial markets haven’t seen before.
As the chart above of equity returns over 90 years shows, market returns can swing widely over the course of a year, even though most of the years end positive. As a result, we believe that large capitalization, brand name companies that can continue to grow their earnings, who 10 provide goods and services that consumers need to use on a daily basis, and who are returning cash back to investors from both dividends and stock buy backs offer the best risk adjusted returns in an increasingly volatile world.
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