Stocks fell sharply once again as the war in Ukraine intensified and the West increased the level of sanctions against Russia. Bond yields fell sharply amid a flight to safety. There was no significant economic news during the session that moved prices.
Clearly the war and the attendant economic isolation of Russia will have economic impact. Russia is just 2% of the world economy and Ukraine is a tiny fraction of 1%, but the two nations have different impact on different companies. For many, they have no direct impact, but for others, with operations or joint ventures within Russia, the impact is meaningful. More importantly, the war has pushed oil prices sharply higher, and they continue to climb. That is without any formal sanctions on the sale or production of oil to or from Russia to date. China has announced that it will not participate in the sanctions imposed from the West, providing a safety valve for Russian exports as well as a flow of money. China has an exchange system similar to SWIFT, but it doesn’t yet have a true international presence. While Russia can divert more oil toward China, natural gas travels by pipeline. Gas aimed toward Europe still will have nowhere to go.
As Ukraine resistance stiffens, Russia is intensifying its military efforts. Few expect Russia to consider a cease fire or to leave in defeat. Its alternative is to inflict more pain and impose its will on the Ukrainian people. It’s likely to get uglier and more costly, both in human and economic terms. No wonder energy, commodity and defense stocks are rising, while almost everything else is in decline. Short term, the war also adds inflationary pressure as commodity prices (oil, wheat, etc.) rise and filter through world economies. In one sense, that makes the Fed’s inflation fight tougher. On the other hand, the war and sanctions should slow growth thereby reducing inflationary pressures.
Not long ago, meaning anytime before the start of the conflict, it was thought that a 50-basis point increase in the Fed Funds rate could start the rate tightening process this month, followed by 6-8 further increases over the next year. The war has changed that calculus. Very few speak of a 50-basis point rise today. Instead, the Fed will likely take a much more cautious start, especially if markets remain as volatile as they are today. A VIX reading of 32 or higher suggests daily price swings in the equity markets of 2% daily. 2% is almost 700 Dow points. Markets don’t need to deal with any Fed drama at the moment on top of that.
Indeed, any slowing of the economy serves to do the Fed’s job without the need for rate hikes. Remember the Fed has two missions, price stability and full employment. Clearly, the latter has been achieved. Today there are two job postings for every unemployed American. No wonder wages are rising rapidly. It’s easy for the most unskilled worker to trade up today. At the same time, as rapidly as wages are rising, they aren’t keeping up with the pace of inflation. A 4% wage increase doesn’t help anyone when inflation is 7% and rising. A new surge in gasoline and heating costs isn’t about to help.
Predicting the future in the non-economic world is hard. How long will the war last? Where will the price of oil settle? Are today’s increases a sign of temporary fear or long-term reality? What happens with China? China wants to stay out of this conflict as much as it can, but it will be forced at times to take sides. Russia is an ally but the U.S. and the West are much more important commercial customers. China has abstained from UN votes (no surprise) and won’t abide by Western sanctions (not a big surprise either). But too much support for Russia risks further sanctions against itself. Putin’s unpredictable behavior clearly is concerning to the Chinese. So is a unified NATO alliance. The Western reaction to the Ukraine invasion certainly impacts any Chinese thoughts of consolidating Taiwan into One China.
Economically, there is a lot of uncertainty. Interest rates have backed off amid a flight to safety. But inflationary pressures are rising, suggesting the long-term Fed challenge only gets harder. At the same time, the conflict will likely push 2022 earnings estimates down, with the obvious exceptions of commodity and defense companies. Markets are adjusting. The sector hurt the most yesterday was the financial sector. While few banks or other financial institutions have large direct interests in Russia, other businesses in Europe and elsewhere do. Situations like this always have ripple effects. Thus, the stocks of large banks and related institutions, like credit card companies, took a big hit this week. The reaction may be overdone, but the direction, at least in the short term, is correct.
Last night, President Biden gave his State of the Union Address. Everything was entirely predictable. He condemned Putin, praised the Ukrainian resistance, acknowledged inflation, and repeated his pleas for Congress to pass the rest of his progressive agenda. But he didn’t advocate more defense spending, blamed everyone but the administration and the Fed for inflation, and continued to travel down the same social and climate paths knowing his chances of near-term success were almost nil. It was a political posturing speech rather than one offering new direction. Markets will ignore it given its lack of substantive economic impact.
Futures this morning suggest a tepid try to rebound from yesterday’s rout. But in the current market correction, morning rallies rarely last. While the leading averages are down a bit over 10%, almost a third of stocks are down 25% or more. While the speculative purge continues, a lot of high-profile big-name companies are taking large hits, from Caterpillar to Home Depot#, despite good earnings. There has been a lot of damage so far and it threatens to reverse most of 2021’s gains. At the same time, earnings continue to rise rapidly. Market P/Es, based on forward 12-month forecasts, have fallen from 20-25 times to 15-20 times, a meaningful correction. 15-20x is still high historically, but not if compared to 1.75% 10-year Treasury yields.
That doesn’t mean the correction is over. First, the initial phase of the war has to end and the full extent of sanctions has to be discounted. Second, the Fed has to set its course. Undoubtedly that will be somewhat different from what was expected just two weeks ago. Then the possibility of a near-term bottom, at least, will exist. Technically, the lows of last Thursday’s purge set a floor, a level of temporary support. Hopefully that will hold, but it is much too early to conclude that. Markets look ahead. If they discount sanctions in place and see a path toward a better inflation path later this year, stocks can rally. However, if Fed tightening and the negative impact of war intensify the risks of recession, any rally is likely to be temporary. It is simply too early to draw any definitive or rational conclusion.
With the overall market now close to fair value based on P/Es, much of the damage has been done. Wholesale selling here makes little sense. The world ahead is going to look very different from the world we just left behind. Interest rates will rise. Investors can argue the pace. It will be a better world for lenders, a worse one for those dependent on credit. It will be a more dangerous world. Europe will need to boost its own defense levels. China’s future path is uncertain. We are in a full employment economy. Pricing power has shifted from buyer to seller. That will remain true until central banks win the war against inflation. QE (quantitative easing) is being replaced by QT (quantitative tightening). The flood of excess money created by QE will need to be withdrawn if the fight against inflation is to be won. That means there will be less fodder for speculation. All these changes require portfolio adjustments. Many of the winners over the past ten years won’t continue to outperform.
Let me end on an optimistic note. Nothing supersedes great ingenuity. The creation of the smartphone and the success of Apple#, just to pick one name, was never dependent on current levels of economic growth or interest rates. Some of the greatest companies were born out of recessions or tough times. Great companies are more than one exciting new product, but they require a great product or service to start. Of course, price matters. Bear markets give everyone a good entry opportunity. Look forward. Our world tomorrow will be different than today. Some of the changes, like streaming, or electric vehicles, have too many wannabes that have to be sorted out. Great companies find a way to separate themselves from the pack. There are dozens of smartphone alternatives but there is only one iPhone. So, use these moments to sift through the rubble to find that true diamond. Set your price target. If it gets reached, nibble. Don’t dive in all at once.
Today, Coldplay lead Chris Martin is 45. Daniel Craig turns 54 and Jon Bon Jovi is 60. Mikhail Gorbachev turns 91 today. I don’t suppose he will be in a very celebrative mood.
James M. Meyer, CFA 610-260-2220