Stocks went on a roller coaster ride yesterday in an extremely volatile session. The intraday lows reached almost two weeks ago held. Although prices fell sharply at the close, the volatility suggested that a lot of the selling pressure has been exhausted in the near term. There can be violent rallies in bear markets. Futures in the overnight hours suggest that markets could open strong today, but one-day rallies have little meaning without follow up. The setup for a decent rally is there. We will have to watch for at least a couple of days to judge whether it might be real.
Stocks have fallen sharply so far this year. The NASDAQ Composite is down over 18%, while the S&P 500 has fallen more than 13%. From peak to trough, the NASDAQ has already entered bear market territory. Other averages are headed in that direction. On the news front, the war in Ukraine has morphed from an initial jolt to a slow deadly slog by the Russian invaders. While they make some headway in spots, they meet heavy resistance elsewhere. There isn’t likely to be a quick ending. Even where Russia acquires military control, civilians are defiant. Under almost any conceived circumstances, occupation is going to be difficult. The West has responded with sanctions that led to higher prices for key commodities. U.S. companies active in Russia are pulling back, closing businesses in that country at least temporarily. While that seems to be an easy decision politically, tens of thousands of Russian civilians are losing their jobs and businesses as a result. Russia accounts for about 2% of world GDP, Ukraine a tiny fraction of 1%. For many U.S. companies there is no direct impact. Few generate even 5% of revenues from these two nations.
The bigger impact comes from the spike in prices of oil, wheat and other commodities. Some commodity markets (e.g., nickel) have had to shut down as price spikes have created untenable trading losses. But calm will ultimately be restored. The U.S. ban on Russian oil imports is largely symbolic, as the loss of supply can be replaced from other sources. Prices for oil have spiked much faster than extraction costs, leading to supersized margins that won’t be sustained over the long term.
Look at the chart below which highlights the price for a barrel of oil dating back to the 1960s. You will see spikes in the early 1970s caused by OPEC holding back supply, a spike later in the 70s when the regime changed in Iran, and in the early 2000s as we recovered from the bursting of the Internet bubble while the Fed was stimulating too much (sound familiar?). In between, you see sharp drops typical of commodity markets, as prices retreat toward extraction costs. The same is likely to happen over the next few years here. Any loss of Russian oil on world markets will be offset by added supply and reduced demand, courtesy of both rising prices and the use of alternative energy sources. In the Fed’s words, the surge in energy prices is transient, although in this case transient could be many months or longer.
The oil shock will definitely ripple through the economy. Recessions followed spikes in 1973 and 1979. The 2008 peak happened in the early days of the Great Recession, but that recession was more related to a financial crisis than the spike in the price of oil.
A few weeks ago, investors faced two major concerns. The first was the rise in inflation caused mostly by a demand surge, aggravated by supply chain difficulties at least partly related to the pandemic. The second was a purging of speculation as the Fed announced it would end monetary expansion and work to slow demand growth via higher interest rates. The first increase is expected in a couple of weeks. The war added a third concern. Remembering that markets focus on economic issues, not political or humanitarian ones, the war further crimped supply, adding to the likely surge in prices at least temporarily.
The obvious issue today is that while the problems have been identified, the solutions have not. We know the Fed is about to start raising rates, but will the war change the pace? We see the speculative surge of the past two years reversing course. The NASDAQ Composite has fallen 20%, and some stocks are down 50% or more. Is that enough? History says no. Are we closer to the end than the beginning? History doesn’t give us clear answers to that one. In part the answer depends on how high interest rates must go to dampen demand.
Another unknown is the lack of real time data. Gasoline is now $4+ per gallon in most areas. It is likely to go much higher quickly. Logically, that will create demand destruction as will the necessity of passing on other commodity costs to customers for everything from a box of cereal to everyday plastic containers. No one knows how much yet. Economists are lowering first quarter growth forecasts, but that relates to Omicron more
than the consequences of sanctions. By Q4 expect growth forecasts to fall to 2-3%, perhaps lower.
That raises the specter of stagflation, very slow growth in real terms accompanied by a steady diet of higher prices. But that might not be accurate. Certainly, there will be short-term price surges caused by sanctions, but a new world order will reset the balance. Higher prices encourage more supply while destroying demand. Some suggest the demand decline that will inevitably follow a sanctions-induced price spike will do the Fed’s job of stifling demand better than the Fed could do itself. But here the lessons of the mid-1970s are apt. Oil price spikes and long gasoline lines created a recession in 1973-74. The Fed, which was targeting inflation prior to the OPEC embargo, backed off and stimulated. When the embargo ended, demand returned and inflation surged. It wasn’t until the very end of the decade, when Paul Volcker took over the Fed, that monetary discipline finally beat inflation.
The commodity spikes that are impacting us now won’t last forever, but the impacts of overindulgent central banks and Congress have to be reversed. Markets can tolerate a deliberate pace of rate increases at least to the point where there is a real cost of money. The bond market is telling us that. After modest rate declines over the past couple of weeks, rates are rising again in front of the Fed meeting in two weeks. Rates are rising across the board. Two-year Treasury yields, now over 1.6%, clearly forecast that the war is not going to halt a steady stream of rate increases over the next 1-3 years. Of course, if the economy were to weaken much faster than expected, that could change. But up to date survey data so far shows no demand destruction yet. If anything, the end of the Omicron surge is elevating demand.
So where does that leave us as investors?
Weak markets increase talk of a pending recession. So does a flattening yield curve, but so far demand is strong. Does that mean the yield curve won’t invert? No. However, the longer growth remains positive and the impact of sanctions becomes more evident, the more it is likely that our economy can stay on course. There are two key areas to watch. One is the impact on travel and leisure. Higher prices will cause us all to spend a greater portion of our income on necessities. The other is behavior changes for low-income Americans, as they will have the most difficulty adjusting to higher prices. But as long as jobs are plentiful, that pain could be muted.
We appear to be at a new inflection point. Daily war news isn’t quite as shocking. Most sanctions are in place or being put into place. The Fed is two weeks away from the inflection point between monetary easing and tightening. The purging of speculation continues. Given that markets look ahead, it may be time for a breather. The spike down in equity prices has moved in concert with the spike up in commodity prices. Interest rates have held in a narrow range. The S&P multiple on forward earnings is now under 17. At one point last year, it was closer to 22. Of course, it could go lower as markets today overall are close to fair value, and the impact stock to stock will vary. Some remain overpriced while others are very cheap. At a minimum, it is time to get your wish list ready.
Today, actor Oscar Isaac is 43.
James M. Meyer, CFA 610-260-2220