Stocks soared on Friday after Thursday’s huge comeback. The reversal on Thursday was triggered as market watchers were relieved by the modest package of sanctions initially put on Russia by President Biden and Western allies. From a technical viewpoint, the two-day recovery of close to 6% was a typical relief rally within a market correction.
However, for that rally to be real and enduring, there has to be follow through today. This morning that’s unlikely. Futures are down 1-2% again. On Friday, conventional wisdom was that Russia would conquer Ukraine in a matter of days based on overwhelming military superiority. That conclusion, combined with modest sanctions, could suggest that Ukraine, as an economic story, would quickly be in the rear view mirror.
Truth doesn’t always line up with consensus forecasts. Ukraine hasn’t fallen. In fact, to date Russia hasn’t taken over any major cities. The world response has been universal, totally anti-Russia. Over the weekend, sanctions have been toughened on both Russia and its three dozen largest oligarchs. Russia has been increasingly cut off economically from the rest of the world. It’s access to banking systems have been impaired. Russian planes have been denied rights to travel over much of Europe and the Ukraine people continue to hold their ground. Face-to-face negotiations will take place today for the first time. Last week, many expected the Ukraine leaders to be captured or killed by now. The outcome is clearly in doubt.
What isn’t in doubt is the economic impact, at least in the short-term. Wheat, soybean and oil prices have spiked, adding to world inflation and supply chain woes. The Federal Reserve meeting in three weeks is expected to start raising rates, but the roadmap has become more cloudy courtesy of the Ukraine war. Hopefully, three weeks from now, there will be greater clarity of the situation in Ukraine.
Aside from Ukraine, the focus this week will be on February economic data with the biggest single report likely to be the employment report coming out on Friday. February should show some economic recovery from January as Omicron’s impact continues to recede. The CPI report doesn’t come out until later next week but it’s clear that inflation hasn’t slowed one bit over the past month. If anything, it has accelerated as company after company faces less resistance to price increases. If there is any good news to be had, it would be in anecdotal evidence that supply chain snarls are starting to get resolved. Starting to get resolved doesn’t mean they are over. Try to order a new car and see what your delivery date might be, but at least there is movement in the right direction.
Technically, the market has set a new support level at last Thursday’s lows. Will they be rechallenged? If so, will they hold? Until those questions are answered it is hardly safe, technically to sound the all-clear signal. Right now, there are few reasons to be overly enthusiastic. Growth is slowing as Americans are forced to spend more money on essentials leaving less for discretionary items. In the short-run, they have accumulated pandemic savings that some estimate to be in the $1 trillion range to fall back on, but those savings won’t last forever. Inflation devalues savings. It forces us to buy now before prices rise further. Despite 15-20% price increases over the past year, and despite a one percentage point increase in mortgage rates, housing demand is still robust. Builders have limited supply and continue to raise prices. There will come a point where buyers are priced out, but it hasn’t been reached yet. Bottom line: the Fed has a lot of work to do to slow demand. It has three tools, higher rates, shrinking its balance sheet, and jawboning markets that it is on the case. It will ultimately use all three. Goodbye easy money. Goodbye all that cash coming from helicopters that has fueled speculation for over a decade.
Most of us are optimists by nature. We hope the Fed will succeed without recession. There is a path there. At best, however, it won’t be traversed without some speed bumps. Maybe the market decline the past eight weeks is just that, one of those speed bumps caused by investor overreaction. The other side, that is more logical, is that higher rates will slow activity, raise interest rates, lower P/E ratios, and reduce speculation. Notice I left out any conclusion about recession. It’s way too early to determine that possibility. Certainly, some of the speculation has been expunged from markets. I don’t think it all has. It took more than 12 years to build. It’s hard to believe it has been purged in eight weeks.
If one looks at nominal GDP or nominal corporate sales the numbers look great. 5-7% inflation on top of any level of real growth looks great, but are margins being squeezed? Are volumes increasing? Is there any real growth? The answers vary from company to company. The hairy declines we saw recently in big names like Meta Platforms# (Facebook) and Netflix demonstrate what happens when growth slows for a company priced to high expectations.
Thus, for investors, the next few days and weeks will be critical. Will there be a real enduring economic impact from Ukraine? Are there any serious signals that supply chains are healing? Will the labor force participation rate start to rise as Omicron fades? What path is the Fed most likely to travel? Will the first rate increase in three weeks be 50 or 25 basis points? Some of those questions will be answered soon; some won’t.
I want to make one last point related to the yield curve. It has been flattening as we approach the start of Fed tightening. Conventional wisdom is that the Fed can control short term rates but market forces control long rates. Normally, that would be true, but the Fed has a balance sheet with $9 trillion in assets. It can let some bonds roll off that effectively shrinks the size of its holdings. It can accelerate the decline by selling other assets, soaking excess cash out of the market. It can sell either short- or long-term maturities. If it sells long dated bonds, it will have the effect of driving prices down and rates up. If long rates go up, the yield curve stays upward sloping. In other words, this time around, because of its immense holdings, the Fed can exert some control on the yield curve. Expect it to do so, at least in the earlier stages of its war against inflation.
Today, Jason Aldean is 45. Eric Lindros is 49. Gilbert Gottfried, the comedian with the annoying voice, is 67.
James M. Meyer, CFA 610-260-2220