Stocks fell last week for the fourth week in a row, a combination of inflation fears and the war in Ukraine. Bond yields fell amid a flight to safety.
The news from Ukraine is discouraging, to say the least, but it isn’t unexpected. Russia has overwhelming military advantages and continues to make progress in its efforts to overpower Ukraine, albeit much slower than desired. The Ukrainian resistance is heroic but there appears to be little it can do to stop the Russian advance. Western nations do not want to engage militarily precipitating a world war. Sanctions are its best weapon and herein lies the rub, economically. Sanctions isolate Russia. They will send the Russian economy into a tailspin. What impact that ultimately has on Russia’s war effort is open to speculation, but its impact on commodity prices, especially oil, wheat, and other commodities that Russia sells worldwide is quite clear. We all see it at the pumps. It will get much worse quickly. $4 gasoline will quickly become $5 gasoline. Food prices are rising and so are other key commodities from aluminum to copper. These increases will flow through our economy increasing costs for essentials, thus robbing all of us the purchasing power to buy non-essential items. As bad as it is for Americans, it is much worse for Europeans and Asians that do not have adequate local sources of oil, gas and other key commodities. Our markets have been falling 1-2% weekly. Those in Europe and elsewhere are falling faster. What is a headache here is a catastrophe overseas. It may be a price to pay to inflict necessary pain on the Russians, but it means tough times here.
Friday’s employment report was impressive, but it was also backwards looking. It represented data before any Ukrainian incursion. We won’t see that impact for another month or two. Right now, many Americans have built up savings to allow them to maintain lifestyles for a while, but not indefinitely. Many without savings will see the impact quickly.
We have witnessed similar events in the past. When OPEC first flexed its muscles in the mid-1970s, oil and gasoline prices spiked. A recession ensued. Today, higher oil prices alone won’t necessarily create a recession, but they will slow growth. One can use any projection of rising wages; they won’t be enough to offset the ripple effect of a 30-50% rise in the price of oil and related products. It isn’t just gasoline. Airfares will soar so will freight costs. Wheat price increases impact bread, cereals, cookies and spaghetti. Copper and aluminum impact the cost of homes and cars. It’s all pervasive.
The likely end game in Ukraine may be a military Russian takeover, followed by a messy prolonged occupation. Hopefully, the Russians don’t choose to extend further. I have no insight, but sanctions won’t disappear. What an economically crippled Russia means in the future is subject to speculation. The goal of sanctions is capitulation, but I can’t think of even one instance where that has been the outcome. We aren’t here to speculate on military or political outcomes. We focus on the investment environment. It is quite clear at the moment that earnings estimates for 2022 will most likely have to be lowered as commodity spikes squeeze margins and kill demand. An early look at 2023 would suggest lower forecasts as well. If there is “good” news, it is that economic deterioration lessens the need for the Fed to step in and raise interest rates aggressively to lower demand growth. The Fed is still likely to start raising rates in March (by 25 basis points). What happens after that will depend on economic data. If the pinch of higher prices diminishes demand, then inflationary pressures, beyond the impact of Russian-related commodity price increases will lessen. The Fed may continue to raise rates slowly but the rise in commodity prices related to the Ukrainian war are not demand driven, but rather to a shortage of supply. The Fed’s inflation-fighting task is to soften demand. It has little ability to impact supply. Indeed, short-term, the Fed will be more focused on maintaining market liquidity than accelerating any fight against inflation.
Thus, let’s not kid ourselves. The last two weeks have changed the near-term economic picture. The situation in Ukraine may reach a military conclusion in a matter of weeks or it could take far longer, but the economic impact will be more far reaching. If Russian oil and wheat can find their ways to market, prices may settle back. If economic and banking sanctions instituted by the West restrict the flow of goods, prices will remain elevated. There is some excess OPEC and U.S. oil capacity that could be an offset, but it will take weeks or months to find a balance. It is unlikely that elevated prices are permanent, but they could endure long enough to have material economic impact.
Does this mean recession is inevitable? No. Markets are still absorbing years of monetary and fiscal stimulus. Demand today is very strong, but the odds of recession rise. It will take a few months to see the new economic world order. In the meantime, there will be elevated volatility in commodities and the stock market as events unfold and evidence of a new world order emerge.
The spike this time isn’t the 1970s all over again. There aren’t gasoline lines. The U.S. is reasonably self-sufficient in key commodities to keep operating without material disruption, but pain overseas will impact multi-nationals and crimp overall demand. Uncertainties will lower job listings and could eventually lead to some unemployment. Don’t read too much into the numbers just reported for February. Those all occurred before the war. It will be March, April and May numbers that will begin to tell the tale. Given robust accumulated savings, damage may not appear right away. Maybe it never will if prices stabilize or recede. Eventually, higher prices reduce demand and change behavior. In today’s world, higher gasoline prices will drive some back to their home offices, for instance.
For now, all we can say is that the war has created change. Most of those changes are negative economically. We have no data yet to calculate the impact. I don’t want to overstate the negative, but I don’t want to understate the uncertainty. Before the invasion, markets were obsessed with the impact of demand driven inflation and the Fed’s likely path to reduce it. The war has changed the landscape. Inflation is still the problem, but for different reasons. Supply constraints caused by war and sanctions will spike prices faster even if demand recedes. Even if Russia achieves its military objectives, it faces a messy occupation. Economically, it is now isolated from the West. That means supplies to Europe are gone. If supply falls faster than demand, it means higher prices. Less supply, less demand, and higher prices is a nasty combination. I haven’t even discussed the threat of cyber attacks.
Long-term, balance will get restored. It always happens. This war will come to an end, but sanctions almost certainly will stay in place. It will take time to find a new normal. Significantly tighter monetary policy may have to wait. Fortunately for many, the heating season is coming to an end. That will allow some time to reset. Higher gasoline prices will adjust our daily behavior. Demand for fuel will drop. High prices will bring on new supply, but this all takes time. If you simply look at the military picture today and compare it to late last week, it doesn’t look very different. The economic impact is becoming clearer as we watch gasoline prices rise close to $0.10 per day, food prices soar, and 1.5 million refugees resettle outside Ukraine. Markets generally don’t like change and they certainly don’t like this change.
Today, former tennis star Ivan Lendl is 62. Bryan Cranston turns 66.
James M. Meyer, CFA 610-260-2220
February 2022 Economic Update – The New Normal?