Rising inflation rates, higher borrowing costs and tensions in Eastern Europe have weighed heavily on equity markets the first two weeks of February. Growth and small capitalization stocks have been the weakest groups, but no sector has escaped, especially since reports last week indicating that inflation is still accelerating, with energy leading the way.1
Today’s release of the January Producer Price Index (PPI) was expected to show a 0.5% increase from December, but a 1% increase was reported, with a trailing 12-month rate of 9.7%.2 Crude oil prices have responded to Russia’s threat to Ukraine’s borders and the leverage it can exert over Western European countries dependent on its natural gas supply. Closing prices for Unleaded Gasoline (wholesale) futures over the past 13 months are below. Consumers are being squeezed at the pump.
Source: Quotestream online quotation platform, www.quotemedia.com
Bond prices have also been weak as investors attempt to divine the Federal Reserve’s next move(s). At this writing, the 90-day Treasury bill is yielding 0.4%, up from essentially zero in early January. Credit markets are pricing in the Fed’s tightening next month, but already, yields at the shortest maturities are approaching the upper end of the Fed Funds target range if the boundaries only increase ¼%. It appears increasingly likely that March’s Fed hike will be ½%.
The intersection of foreign and economic policy created by Russian aggression in Eastern Europe has occupied investor attention over the past several weeks but in recent days tension has been ratcheted higher by Biden Administration warnings that invasion by the roughly 150,000 Russian troops massed on three sides of Ukraine is imminent. Certainly, the current military disposition suggests Mr. Putin has designs on annexing territory as he did in Crimea in 2014.
President Biden’s National Security Advisor, Jake Sullivan, has repeatedly asserted that an invasion could occur “any day now.”3 Yesterday, Ukraine’s president stated that he has intelligence that a military strike by Russia will occur on February 16 and called for a “National Day of Unity.”3 Diplomacy continues.
But is Putin manipulating the West? After all, at $90/barrel, Russia’s 10 million barrel/day production is netting $900 million/day.5 He has exposed fissures in NATO, perhaps his greatest foreign policy goal. So does he gain by invading or has he already attained the goals of this exercise?
This morning, Russian military authorities indicated that a withdrawal of 10,000 troops is underway.6 Only time will tell, but so far, Putin appears to be one step ahead of his adversaries, countering the Biden Administration’s strident narrative with a nominal de-escalation at the eleventh hour.
Earnings season is in full swing and while not as uniformly strong as Q3 2021, numbers are still impressive, showing growth in both revenues and earnings. There have been some misses and several far better than expected reports but overall, corporate earnings remain robust. The most notable change in guidance has been in the inclusion of inflation concerns. As of today, 73% of companies reporting have cited inflation and pricing pressures as influences on current and future results.
Corporate earnings remain a positive, but consumer sentiment is eroding. The Conference Board’s latest report was surprising for the magnitude of decline in optimism. The main reading dropped from 67.2 in January to 61.7 this month. Of course, present circumstances drive opinions about the future, but this decline is noteworthy for its severity.7
We expect that supply chain issues are closer to being resolved now that many states and locales are dropping mask and vaccine mandates, which should inspire workers on the sidelines to reenter the workforce. But wage increases are not fully compensating for inflation’s undermining of purchasing power. As price gains pinch pocketbooks, it is reasonable to expect a slowdown in consumer spending, which accounts for more than 60% of GDP.8
The current inflation cycle began with a supply/demand imbalance as the US emerged from pandemic lockdowns and restrictions in 2021. Supply chain bottlenecks created shortages in finished goods at the same time the Biden Administration was restricting the production of American energy, and the Fed was steadily printing money. We are now witnessing the result of this “perfect storm.”
Undoubtedly, inflation will be with us for the foreseeable future, especially if the Fed “slow walks” raising rates. The Treasury bond market is seemingly inexorably moving toward inversion of the yield curve, which, historically has been a precursor of an economic slowdown. Wringing price spirals out of the economy will take time. The danger to the economy of Fed overreaction is as great as that of underwhelming action. The chart below shows yield increases since December 31.
Source: Quotestream online quotation platform, www.quotemedia.com
Equity and energy markets have responded favorably to the overnight Russian move, but Mr. Putin remains unbending in his campaign to have NATO renounce extending membership to Ukraine. His overnight “mini withdrawal” may be an attempt to extract this concession from the alliance.
Investors will be faced with rising living expenses, higher borrowing costs and foreign policy uncertainty over the next several months, at least. Note that current inflation readings reflect oil at roughly $75/barrel. Markets will be volatile and, depending on whether the Fed chooses to act as previously outlined by Mr. Powell or to become more proactive as some on the Open Market Committee advocate,9 interest rates will play a significant role determining the direction of equity returns over the balance of this year.
As always, markets, both bond and equity, are looking beyond current events and evaluating the possibility that the Fed may mismanage its return to “normalcy.” Clearly, Chairman Powell and his colleagues are behind the curve as they are still adding bonds to the Fed’s balance sheet, but once this artificial support is eliminated next month, credit markets will be faced with near double digit inflation and real interest rates at roughly negative 5%. To successfully quell inflation and inflationary expectations, significantly higher rates, and a slowdown in growth of both government spending and the money supply will all be necessary.
1 “CPI for all items rises 0.6% in January; food, electricity, and shelter indexes increase,” www.bls.gov, February 10, 2022. 2 “PPI for final demand advances 1.0% in January; services rise 0.7%, goods increase 1.3%,” www.bls.gov, February 15, 2022. 3 “Biden's national security adviser says Russia could invade Ukraine 'any day now',” www.cnn.com, February 13, 2022. 4 “Ukraine president calls for 'day of unity' for Feb. 16, day some believe Russia could invade,” www.reuters.com, February 15, 2022. 5 “Energy Markets Are Jittery as Russia-Ukraine Tensions Drag On,” www.nytimes.com, February 14, 2022. 6“Russia Says Some Troops Pulling Back From Ukraine Border but Exercises Continue,” www.wsj.com, February 15, 2022. 7 “Consumer confidence tumbles to 11-year low as inflation skyrockets,” www.foxbusiness.com, February 11, 2022. 8 “Consumption as percent of GDP by country: the latest data,” www.theglobaleconomy.com, data a/o 12/31/21. 9 “Fed’s Bullard says the central bank’s ‘credibility is on the line,’ needs to ‘front-load’ rate hikes,” www.cnbc.com, February 14, 2022.
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