April Investment Comments
Vladimir Putin’s attack on Ukraine jarred global financial markets. Western democracies have responded with financial sanctions against Russia and its citizens, causing the ruble to suddenly lose roughly one-third of its value relative to major foreign currencies. Global investors are rushing to divest their Russian assets, but their efforts are frustrated by a lack of natural buyers and by the fact that the Russian stock market has been closed since February 25th. Nobody knows what Russian financial assets are currently worth.
Commodity prices and defense stocks jumped after the invasion. In the midst of a broad stock market selloff, Merrill Lynch sardonically proposed a new list of FAANG assets replacing the old investor favorites of Facebook, Amazon, Apple, Netflix, Google. The new FAANG according to Merrill? Fuels, Aerospace, Agriculture, Nuclear, Gold.
Russia’s decline is stealing attention from China’s ongoing financial problems. The Hang Seng Index has been in steady decline for the past year, a decline that recently accelerated after the U.S. Securities and Exchange Commission threatened to delist many Chinese stocks from U.S. exchanges due to opaque ownership structures and questionable audit quality. Following last year’s default by property developer Evergrande Group, foreign investors are questioning whether the secular growth of China’s economy is attractive enough to justify owning the ugly financial assets attached to it. Price action dictates the narrative in financial markets. Buying speculative assets looks wise when prices are high and foolish when prices decline, the exact opposite of investing’s fundamental maxim of “buy low, sell high.”
Europe faces a risk of falling into recession, as many European countries rely heavily on Russian energy imports and also on Chinese demand for their exports. The natural tailwinds of a post-Covid rebound may not be strong enough to power through the twin headwinds of Russian military aggression and Chinese financial unrest.
Things look brighter here in America. The Omicron wave of Covid-19 appears over, as U.S. case counts have plummeted below their year-ago levels. Masking requirements and travel restrictions are being lifted, and people are returning to the workforce. February’s unemployment rate was 3.8%, down from 4.0% in January, while the participation rate rose from 62.2% to 62.3%. That sounds like a very small increment of improvement, but having both metrics—unemployment and participation—rising together paints a bright picture for the U.S. job market.
It helps greatly that the U.S. does not rely on Russian energy imports. Although rising global energy prices still act like a tax on American consumers, higher prices also stimulate the country’s domestic energy sector. America is approximately neutral in energy trade, fluctuating between a small importer and small exporter depending on market conditions and political policy adjustments. It is therefore hard to imagine energy price fluctuations having a major impact on the overall U.S. economy, in the aggregate, although volatility will create regional winners and losers.
On a related note, inflation remains a problem. February’s CPI report showed a 0.8% sequential increase. 12-month trailing inflation is 7.9%. Backing out volatile food and energy, the trailing inflation rate is 6.4%, the highest tally since August 1982. We have written before about the pent-up inflationary impact of housing prices, which rose 19% in 2021 according to the Case-Shiller index but only slowly enter into the CPI market basket due to quirky methodology. If housing prices plateau in the presence of rising interest rates, then we could eventually hit a point where CPI methodology starts to overstate rather than understate current-period inflation. We are not there yet, however.
The Federal Reserve officially concluded its pandemic-relief quantitative easing program on March 9. Going forward it may attempt to reduce its balance sheet through outright sales. Even without any sales the balance sheet should gradually shrink as bonds mature. That said, some observers noticed that the Federal Reserve continued buying bonds on a small scale after the official end of the program, implying it is not quite ready to start shrinking its balance sheet. This last gasp of buying is probably intended to keep the balance sheet neutral and allow the Federal Reserve Open Market Committee to set an official balance sheet wind-down strategy at its March meeting.
That balance sheet strategy will have to be considered with the cadence of interest rate increases. The bond market appears to be bracing for multiple rate increases. After pausing at the beginning of the invasion, interest rates have generally resumed their prior trajectory higher, with the most dramatic increases occurring at the shorter end of the yield curve. However, the Fed is clearly reluctant to turn hawkish, and global unrest has complicated consensus expectations around interest rates. Global investors initially fled to safety in U.S. Treasuries and other dollar-denominated assets, producing a dollar rally that could possibly provide cover for the Fed to slow-walk its interest rate path.
Short-term rates have been rising, producing a “flatter” yield curve. There has been some concern that the increasingly flat yield curve could signal recession. Another interpretation is that the flat curve expresses investor confidence in the Fed’s ability to subdue inflation. As we mentioned above, it has been decades since inflation ran this hot. Nobody really knows what to expect next.
Global tensions, rising interest rates, and a strong dollar are all bad for U.S. stock prices. The S&P 500’s intraday peak occurred on the second trading day of 2022. The index has since fallen 13% and currently trades at a level it first surpassed in April of last year. The NASDAQ 100 is down over 20% from its peak and trades at a level first achieved in January 2021. Every sector is negative except for energy, which Finviz.com reports has gained 19% year to date. The market has exhibited a strong rotation, as last year’s laggards have generally held up better in 2022, while many technology and consumer discretionary stocks have crashed. We are starting to see some interesting values, especially where areas of market weakness overlap. A further market decline would probably produce some screaming opportunities.
Even though stock valuations remain somewhat stretched by historical standards, we remind readers that stocks are real assets which tend to keep up with inflation over time. Bonds yield less than inflation right now and look highly likely to lose some purchasing power over time.
Miles G. Putnam, CFA