John Gorlow
| Mar 22, 2022
In early 2022, the economic outlook appeared to be improving despite ongoing challenges. While Covid-19 and its variants proved impossible to eradicate, new strains appeared to be less deadly. Job creation and unemployment data were encouraging. Inflation topped the list of concerns for investors as prices continued to rise amid mismatched supply and demand. But everything changed on February 24, when Russia invaded Ukraine, layering an urgent humanitarian and geopolitical crisis on top of a fragile world economy.
The news since then has been disturbing and visual, with images of Ukrainian citizens sheltering in underground stations, jammed into packed trains, and rescuing loved ones from collapsed rubble. The horror is magnified by tactics used by Russian forces, including cutting off encircled cities from food, water and supplies, bombarding civilian targets, and employing devastating long-range missiles. One month into the war, the United Nations refugee agency estimates that some 3.5 million Ukrainians have fled their country. Reports of forced evacuation of thousands of Ukrainians to Russia add to the nightmare. For many, the images of brutal warfare against a peaceful, neighboring country evoke World War II.
Geopolitical realignment has been swift among democratized nations. But despite harsh sanctions on Russia, the interdependency of the global economy remains a fact. Western Europe looks to Russia as an important fuel source, while China, Russia and Western Europe rely on Ukraine as a primary source of grains and seed oils. In addition to energy and food, Russia and Ukraine supply significant amounts of important materials and components for manufacturing. Commodity prices have skyrocketed, stirring fears of out-of-control global inflation. Meanwhile, work has stalled on other urgent issues, including global warming and efforts to bring Covid under control.
Economic forecasts have been revised downward. Following its two-day meeting in mid-March, the Federal Open Market Committee (FOMC) raised the federal funds rate target range by one-quarter of a percentage point, from .25% to .50%. The FOMC’s Summary of Economic Projections includes sharply higher inflation and significantly slower economic growth for 2022 and beyond. The median fed-funds rate by the end of 2022 is now 1.9%, more than double the rate anticipated three months ago. By the end of 2023, the median is now projected to be 2.8%, significantly higher than the previous forecast of 1.6%. In the same meeting, the FOMC shaved forecasts for 2022 GDP from 4% to 2.8%, but left projections for 2023 and 2024 unchanged from 2.2% and 2.0%, respectively.
If there was any doubt that the Fed now perceives inflation as a major threat, Fed Chair Powell had this to say on March 21: “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level,” adding that a more restrictive policy may be needed down the road. He also acknowledged that “no one expects that bringing about a soft landing will be straightforward.”
Balancing the effects of quantitative tightening with interest rate increases will be a delicate act. Many believe Powell has acted too slowly and spread too much money through the economy to avert the most serious consequences, which could include slower growth, a weaker job market, an even more expensive housing market, recession and stagflation. Meanwhile, the firehose of money aimed at the economy during Covid has swelled the Fed’s balance sheet to $8.9 trillion, higher than any time since World War II.
Stagflation—a lethal combination of sluggish economic growth and soaring prices—is a growing fear, given the war’s impact on oil prices. Some pundits compare the current situation to the 1970s, when the Yom Kippur War caused skyrocketing oil prices which then combined with existing inflation to create a brutal two-year bear market. In 1973-74, the S&P 500 lost nearly half its value. A recent Bank of America survey of professional investors shows that some 60% believe stagflation is on the horizon again.
Volatility By the Numbers
In stocks, the crisis in Ukraine roiled global markets, sending the S&P 500 lower in February for a second straight month. Russian markets plunged. The S&P 500 and Nasdaq lost 8.2% and 12%, respectively, over the first two months of the year, each posting their worst such stretch since March 2020.
Oil and natural gas prices thrashed about wildly after a US push to ban Russian crude faced resistance from Germany. Shaken by the threat of sanctions on the global economy, markets sought direction in an extraordinary day of volatility. The international benchmark Brent Crude surged to a high of $139 after President Biden signaled that he was open to a freeze on Russian imports, before falling back to around $120 after Germany expressed reluctance to restrict trade of “essential importance” to Europe’s economy. The day’s high of $139 was last seen some 14 years ago.
Bond investors, many of whom believed inflationary pressures would begin to subside in 2022, have also faced a challenging year. Their hopes of temporary, subsiding inflation were dashed with Fed Chair Powell’s comments in February. The only significant bond rally of the year occurred when Russia first invaded Ukraine. Many now believe that higher commodity prices sparked by the Russian incursion will stoke further inflation, spurring the Fed to further action.
Yields on U.S. government bonds surged to their highest levels since 2019. As of 22-March, the yield on the benchmark 10-year U.S. Treasury note settled at 2.32%, up from 1.96% when the invasion began, and its highest close since June 2019.
Gold prices gained more than 6% higher in February, capping the best month since May 2021.
Further volatility was seen in a dip and recovery of European stock markets. The Stoxx Europe 600 fell 10% from immediately before the invasion in late February to its low point on March 7, its worst performance since March 2020. But defying expectations, the Stoxx then clawed back its losses after the biggest weekly rally in global stock markets since late 2020.
Likewise, the S&P 500 Index rallied 8% from its recent bottom on 24-February, the day Russia’s invasion began, leaving it down 7.5% from its record touched in January. That essentially puts the S&P benchmark back to where it ended Q3 2021.
The Nasdaq Composite, packed with high-tech stocks that are considered most vulnerable to tighter monetary policy, recently had its best week in a year. Nonetheless, it remains down by nearly 12% so far in 2022. More than half of the 1,000-plus Nasdaq stocks in the index have fallen by at least 25% from their 52-week highs. Almost 35% have lost more than half their value, and nearly one-fifth have tumbled over 60%. The carnage has been particularly brutal in speculative technology stocks. This shift is almost predictable, says the Financial Times: “Interest rates have an almost mechanistic impact on how many investors value so-called growth stocks. The more distant a company’s profits, the greater the adverse impact of rising rates on valuations.”
As a whole, market gyrations of the past month reflect the tragedy and courage on full display in Ukraine. Investors are right to feel unsettled both about the unfolding humanitarian crisis and the potential impacts of conflict on their long-term goals. Russia’s aggression is an important reminder that geopolitical risk is a part of investing in global markets—and that all markets are affected by global crises. The non-provoked invasion of a sovereign nation is a reminder that we cannot predict when events will occur or what form they will take. The only way to plan for them is to have a portfolio strategy that reflects your personal goals and timeline. Feeling sad, fearful and confused is natural at times like this, but changing strategy based on those feelings is unwise.
If you have questions or concerns about your asset allocation, please contact me. I am here to help.
Regards,
John Gorlow
President
Cardiff Park Advisors
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