Stocks continued to rally as peace talks progressed, trying to end the Ukraine war. Bond yields fell sharply, especially at the long end of the curve.
Any movement toward a secure and enduring peace is going to be difficult. There is much distrust. You can never listen to Russian words without watching their actions, often in direct contradiction to their statements of appeasement. Any settlement would have to involve the U.S. and NATO, as conditions would almost certainly require some reduction in sanctions. Putin, of course, is his own boss. It would seem unlikely that he would simply return to the pre-war status quo. But with all that said, anything that reduces the pains of sanctions, both on Russia and the West, would be heartening. My only conclusion is that the situation can’t get much worse than today under all but the most apocalyptic outcomes. Russia is losing economically, losing soldier lives, exhausting its military arsenal, and losing face around the world. It has isolated itself as a nation with insufficient resources to carry on unilaterally. The path it’s on isn’t working, and it needs to find a new path.
Economically, and that’s what we really talk about here, the war is a distraction. The market found a bottom around the start of the war. While the battle has trudged on, the economic consequences were pretty well delineated at the beginning. Oil, once near $130 per barrel, is now back near $100, even acknowledging the supply gap related to fewer Russian exports. Markets look ahead. In part, the rally of the past few weeks is tied to the likelihood that Russia will be unable to extend its goal of reuniting the former Soviet Union and its Iron Curtain, given it can barely hold the limited territory already annexed in Ukraine. From the market’s viewpoint, always subject to change, the war’s impact is largely in the rearview mirror. Should a peace accord be reached, there might be a blowoff rally, but much of the reaction has already been priced in, and any enduring peace is still sometime in the future.
Thus, we turn to other coming events to determine the market’s future direction. Friday will see the release of March employment data. It should show ongoing growth. There continue to be over 11 million job postings and few layoffs. The unemployment rate could fall even further. Investors will be watching the growth in wages as much as the number of jobs created. Inflation data will then center on the April 12th reading for consumer prices in March. We already saw a hint of how strong inflation is this week when the Case-Schiller housing price index recorded a year-over-year gain of over 19%. It is likely that the pace of inflation peaked in March, simply given the retreat in prices of certain commodities like oil. Core inflation will likely come in around 6%, three times the Fed’s goal.
Investors remain primarily concerned about (1) the ongoing pace of inflation and (2) how the Fed plans to use its monetary tools of interest rate increases and balance sheet decreases to attack inflation. The most recent consensus, and it seems to change almost daily, is that the Fed will begin to use one-three 50-basis point increments to get the Fed Funds rate closer to the target rate of inflation quicker. Under that scenario, the Fed Funds rate could be 2.0-2.5% by the end of this year, and close to 3% next year before receding again in 2024, assuming inflation settles back into an acceptable range of 2-3%. Later this year, the Fed could start to reduce the size of its balance sheet by not replacing bonds that mature, or even through outright sales. That would be a lot of firepower if that is the way the situation plays out. Undoubtedly, it would have the impact of reducing demand and soaking up excess cash that has been sloshing around and feeding speculation for years. It would cause short-term rates to rise more quickly, which explains recent strength in the yields of 1–5-year maturities. It also may explain the flattening or even an inversion of the 2-10 year curve. Some would take that as a warning sign of impending recession, but while the 2–10-year curve has flattened, the 3-month to 10-year curve remains upward sloping. Many believe that’s a better indicator. In plain English, markets are still uncertain whether recession is pending or not. Clearly, yesterday the verdict was no, as early cycle stocks like retailers and homebuilders were leaders in the rally. But one day, or even a week or two, hardly define a trend.
After we get past all the March data releases, earnings season will begin. As noted before, first quarter results will be quite variable depending on which companies were most impacted by Omicron and the Russian sanctions. What is clear is that in a tight labor market with intense inflationary pressure, companies would be well served to invest in ways to increase productivity. Using machines to replace humans is an obvious step, but that is a simplistic view. A company like McDonald’s will spend millions to shorten the time one takes to go through the drive-thru process by a few seconds. One can talk about the kiosks inside, but more and more traffic goes through the drive-thru, never seeing the inside of the store. At a retail store, using touch pads versus inserting a credit card at checkout saves seconds. I use these examples because you can relate to them, but companies focus on hundreds of such examples every day. Companies today are flush with cash. Using it to increase productivity is a valuable use. Indeed, the rate of future growth depends on the pace of productivity improvement.
In 2021, our economy grew at an extraordinary pace as Covid’s grip faded a bit and we collectively started to spend all those government handouts. Final sales, however, faded to about 3% in the fourth quarter and are likely to be less in the first quarter. Inflation, over time, will shift spending toward necessities instead of discretionary items. It will also rob us of real purchasing power until it subsides. Government support programs will be much less this year than last. Real growth is likely to fade to 2-3%, even without Fed tightening. With tightening, growth could fade closer to 2% by year end. That’s normal, not a recession. Housing and autos will stay strong due to pent-up demand, and there is still an excess of over $1 trillion in savings to fall back on. What remains unknowable is the impact of the Fed’s coming headwinds against a backdrop of full employment, rising net worth, and higher wages. We also don’t quite know the impact of improved supply chains. Can they alone balance supply and demand as they resolve? Another unknown.
Markets in between will have their fits of optimism and pessimism. We saw the pessimism in January and February. We are seeing the optimism in March. We are even seeing a return of speculation. The Fed hasn’t drained excess liquidity quite yet. The original meme stocks, GameStop and AMC, have had extraordinary runs this week. So has Bitcoin, but as the Fed soaks up excess money, one can’t expect this wave of speculation to continue for long. On the other hand, investors seeking safety can’t look to bonds in a rising rate environment for protection. Even though stocks are almost certain to end the first quarter in the red, they will outperform all but very short-duration bond portfolios. Indeed, a lot of the money pouring into stocks in March has come from bonds.
Right now, the sun is shining on equity markets. I have no idea how long that will continue. Will the war intensify or move toward peace? Will the Fed give signals of intensified tightening? Is Washington able to spend more money? I continue to believe that volatility will be with us for at least the next several months. Keys to watch are the pace of inflation into the Summer as well as the sustained economic growth rate of the economy. It is unlikely that current Fed actions will impact growth until later this year, but inflation isn’t going to be defeated while growth is elevated and wage growth accelerates. The Fed likes to point to tightening cycles that didn’t lead to recession, but not since the 1970s has inflation been this high. Few tightening cycles started with an economy this strong or inflation this powerful. As time passes and the Fed’s actions start to take effect, hopefully coinciding with some improvement in supply chains, guesses will become informed predictions. Today we know both inflation and growth are headed lower, but we don’t know how long it will take to get inflation toward 2%, and we don’t know if growth can be sustained above zero in 2023 or 2024. Uncertainty breeds volatility. It also creates opportunity. If you own individual stocks, the future fortunes of companies will depend as much on the capabilities of management as the course of the overall economy. As Jim Cramer likes to say, “There’s always a bull market somewhere.”
Today, Celine Dion is 54. Eric Clapton turns 77.
James M. Meyer, CFA 610-260-2220