As we write, one topic dominates the headlines: the Russian invasion of Ukraine. The armed conflict began on February 24th when Vladimir Putin, the president of Russia, announced a “special military operation” to “demilitarize and denazify” Ukraine. In response, Ukrainian president Volodymyr Zelenskyy enacted martial law and invoked the mobilization of his country’s troops and defense mechanisms. The United States, alongside other world nations, strongly denounced Putin’s actions and acted swiftly to provide aid to Ukraine and impose severe sanctions on Russia.
The ongoing war has resulted in a humanitarian crisis, extensive damage to Ukraine’s infrastructure, and triggered economic and financial consequences worldwide. In the past week, Ukraine has indicated it may be open to committing to a neutral status, unattached to any outside military alliance including NATO, as part of a peace deal with Russia in return for security guarantees and the departure of Russian troops. Also on the table is the status of Crimea, annexed by Russia in 2014, and the recognition of Ukraine’s southeastern Donbas region as separatist provinces.
We condemn the aggression and hope for a peaceful resolution that ends the ongoing losses and suffering and avoids a direct military clash between NATO members and Russia, both armed with nuclear weapons.
Following on from extremely strong performances last year for all the major U.S. equity indices, the markets started the year by relinquishing some of these gains, even before the added uncertainty caused by recent events. The S&P 500 ended the first quarter of 2022 at 4,530, delivering a negative return of -4.59% for the year to date. The Dow Jones Industrial Average (DJIA) ended March at 34,678 for a similar first-quarter return of -4.09%. Both the S&P 500 and the DJIA did, however, stage a rally going into the end of March despite the negative news cycle.
The pullback has been driven by a reassessment of valuations with P/E (stock price/earnings) multiples contracting alongside a widening of credit spreads (difference in yield between U.S. Treasury instruments and other debt securities). In short, investors were exercising more caution. Critically, we are still seeing a strong earnings trend, supported by sales growth and sustained operating margins. Raymond James currently forecasts EPS (earnings per share) growth for the S&P 500 at 9.3% for 2022, compared to the anomalous 50.3% for 2021 bouncing off pandemic lows.
March 23rd marked the second anniversary since the pandemic-shutdown market lows. Over those two years, the S&P 500 was up 99% and all sectors were up over 50%, with Energy leading at an outsized 224%. Going into the final trading week of this quarter, the only sector in the S&P 500 exhibiting a positive return was the Energy sector. By positive, we mean a resounding 39%. Cyclicality, pandemic shutdown and recovery, policy decisions by leading oil-producing nations, and now supply disruptions are all exerting influence. Many of the major oil multinationals, alongside other global industries, have taken steps to stop conducting business in or with Russia.
While the price of oil starting the year at $76 / barrel for WTI crude, surging to $123 / barrel at the beginning of March before coming back down closer to $100 / barrel at the end of the quarter, has benefited energy stocks, the pain has been felt by end consumers. Rising energy costs have been a major contributor to what has become a hot topic for the domestic economy, high and persistent inflation. While the Ukrainian conflict and U.S.-imposed sanctions, which included banning all imports of Russian oil and gas (roughly 8% of U.S. oil and gas imports), exacerbated the situation, inflation pressures were already being felt.
Consumer-price inflation in the U.S. came in at a 40-year high in February, at 7.9% year-on-year. The Federal Reserve, having abandoned its ‘transitory’ narrative regarding inflation, is now increasingly hawkish. Much of the economically-advanced world has become accustomed to near-zero interest rate policies and it has been over a decade since any G-7 central bank has set interest rates above 2.5%. For context, in 1990, all were above 5%. In the United States, much of Europe, and Japan, central banks have kept short-term policy rates below the inflation rate since 2008.
Such an environment has been a boon for asset prices and growth stocks, in particular, fueled unprecedented government deficits, and forced the adoption of other policies, such as quantitative easing or bond-buying, to further bolster economies. Now we see the interest-sensitive Information Technology sector is the second-worst performing year-to-date and the Fed has enacted its first rate rise since December 2018.
As was widely expected, the Federal Open Market Committee (FOMC) at its March 16th meeting raised the target range for the federal funds rate by 0.25%. The new target range is now 0.25%–0.50%. In addition to “elevated” inflation, the Fed also cited strong job gains and a falling unemployment rate, at 3.8% for February and close to a pre-pandemic level, as reasons for its decision. The committee also penciled in increases at each of the six remaining meetings this year, indicating a consensus funds rate of 1.9% by the end of 2022.
The committee sees this tightening cycle extending into next year with three more hikes in 2023. Fed Chairman Powell noted: “We continue to expect inflation to decline over the course of the year as supply constraints ease and demand moderates because of the waning effects of fiscal support and the removal of monetary policy accommodation.”
The Fed also just lowered its expectation for 2022 real GDP growth to 2.8% (from 4%), but this is still above-trend growth, and indicative that the probability of recession over the next twelve months, barring major escalation of global risks, remains low. The course of future monetary policy has contingencies attached. On Ukraine, the committee noted: “The invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.” The Federal Reserve Bank of Dallas went so far as to warn that “if the bulk of Russian energy exports is off the market for the remainder of 2022, a global economic downturn seems unavoidable.”
Bondholders are experiencing a level of pain this year not seen since the 1980s, with lower bond prices due to higher rates and real risk-free returns (inflation-adjusted) deeply negative in both America and Europe. The August 2020 trough of 0.52% on the benchmark 10-year Treasury note may be seen as the end of a 40-year bull market in bonds. That rate has been on an upward trend since and is now at 2.38%, having started this year at only 1.51%. The bond market has traditionally been a barometer reflecting certain aspects of real-world fundamentals but now it also increasingly reflects market expectations about central bank moves.
On a related topic, in the U.S. home prices rose at a record pace in 2021 with buying demand strongly outpacing the supply of homes for sale. This continued at the start of 2022 and the S&P CoreLogic Case-Shiller National Home Price Index, which measures average home prices in major metropolitan areas, rose 19.2% in the twelve months ending January. However, since then mortgage rates have climbed to close to 4.5%, the highest level since 2019, constraining homebuyers and potentially bringing downward pressure to prices.
President Biden has been visible front and center on the world political stage. He led the way in announcing severe punitive sanctions against Russia. These sanctions against businesses, banks, and individuals have been swiftly enforced by America and a group comprised of mainly Western advanced economies. Sanctions have included the European Union barring Russian banks from the Society for Worldwide Interbank Financial Telecommunication (SWIFT), cutting them off from the global financial system, and the U.S. imposing a ban on Russian crude oil imports. The U.S. Treasury has also wielded sanctions against 328 members of the Duma, Russia’s parliament. In addition, over 400 multinational corporations have pulled out of Russia as a result of its invasion of Ukraine.
On the aid front, the EU approved a €500 million ($554 million) package for the Ukrainian military, the International Monetary Fund approved $1.4 billion in emergency financing, and the U.S. Congress has greenlighted $13.6 billion in spending for refugee and military aid. The United Nations estimates that over 10 million Ukrainians have been displaced, including those who have fled the country.
At the beginning of March, the U.S., the EU, and Japan denied Russia’s central bank access to billions of foreign reserves, except for approved purposes. China stands out as the only major issuer of foreign reserve currencies that has not cut Putin off. China’s banking regulator said it would “not participate” in sanctions against Russia, adding that sanctions “do not work well and have no legal grounds.” Joe Biden warned Chinese President Xi Jinping of “consequences” should China offer Russia “material support” in the conflict.
At home, President Biden’s budget proposal was put forward during challenging times. On top of the Ukraine conflict, we have not moved completely past the pandemic, and elements of the Democrat base continue to push for a huge social spending package. The $5.8 trillion budget request unveiled emphasized deficit reduction, additional funding for police and veterans, some new social spending programs, and higher taxes targeting the very wealthy.
A flaw in the budget forecasts, acknowledged by the White House, is that interest rate assumptions are already outdated, a significant factor with the U.S. National Debt hitting over $30 trillion for the first time in February, and the federal deficit of nearly $2.8 trillion for the 2021 fiscal year, or approximately 13% of GDP (up from 4.7% in 2019, pre-pandemic).
Over in Europe, while EU leaders strongly condemned Putin’s act of aggression, the bloc is deeply reliant on the energy it imports from Russia. The European Commission has unveiled a plan to reduce dependence on Russian natural gas, which accounts for around 40% of European needs, by two-thirds by the end of the year. G-7 energy ministers have unanimously rejected President Vladimir Putin’s demand that “unfriendly” countries settle payment for Russian gas in rubles citing breach of contract.
So far 2022 has not brought the calm after the Covid-storm that many had hoped for, neither for the economy nor the markets. Global supply chains are worsening again at every phase of production, not just because of the war in Ukraine but also due to new Covid lockdowns in China. Meanwhile, Fed Chair Jerome Powell is looking for a soft landing whereby short-term interest rates are normalized to dampen inflation without tipping the economy into recession. Quite a tightrope to walk. Powell has pointed to the fact that soft, or soft-ish, landings have been achieved in 1965, 1985, and 1994.
Here at Stolper Asset Management, we remain steadfast amid these complicated market forces. Our approach is both patient and opportunistic as we continue to focus on fundamentals, quality, and durability in our investment decisions. We are selective and focus on resilience in diverse market conditions. Earnings trends remain encouraging, the U.S. economy is growing at a healthy pace and a period of lower price multiples can broaden investment choices.
Spring is a time of renewal and optimism and we wish to share in that spirit. Thank you once more for your continued support and we remain grateful, as always, for the trust you place in us as your financial advisor.