Market Commentary - February 2022

Monthly Update

We entered 2022 with worries about higher inflation and the central bank response via tightening monetary policy. Those topics dominated the news headlines in January, but as the month of February progressed, the threats and ultimate invasion of Ukraine by Russia took over. What is going on in Ukraine is an absolute tragedy, but this piece will focus on the economic and market impact. We will leave the geopolitics for another time. 

The job of the Federal Reserve and other central banks was tough to begin with as inflation rose sharply over the past two years while they kept monetary policy too easy for too long. The commodity spike created by the Russian invasion has made this job even more difficult because it also threatens economic activity. This leaves us with the high probability of a stagflationary environment that was last seen in the late 1970’s. 

In response to the above, the S&P 500 fell 3.1% in February after a 5.3% drop in January. The tech-heavy NASDAQ was not immune as it was down 3.4%. The small cap Russell 2000 avoided the damage rallying by 1%, but only after falling by almost 10% in January. Globally, there was no place to hide, as the MSCI All World Index ex US (ACWX) declined by 3.3% after a 2.6% fall in January[1]. 

Because of the inflation worries, and expectations for rate hikes throughout the world, interest rates continued higher into month end. However, they have since fallen sharply in response to the Russian invasion. This, in turn, might result in less tightening notwithstanding higher inflation. 

Concerning inflation, the CRB Food Stuff index was up 10% in February and higher by 37% y/o/y as of this writing, mostly driven by higher grain prices. The CRB Raw Industrials index rose 1% in the month and is up 18% y/o/y[2]. The price of aluminum, of which Russia is a big producer, is at a record high. Outside of food, the dramatics were certainly in the energy space. WTI crude oil rallied by 11% in February, after a 16% rise in January[3]. The price of natural gas in the US fell almost 6%, but after rising by 33% in January. The real pain with natural gas though was in Europe, as the price there was up by 16% in February, and more than double the price seen last summer. Gold, a beneficiary of higher inflation and a trapped Federal Reserve, along with the war in Ukraine, was higher by 5.8% in February and silver by 8.6%[4]. 

Commodities and Trade

According to a Wall Street Journal article, here are some examples of the breadth of the impact on the global economy of the Russian/Ukraine war. Russia and Ukraine combined have about 1/3 of the world’s exports of wheat and 19% of corn. Wheat prices were up 22% in February, and corn by 11%. Even with the production of grains, the ports around the Black Sea are now closed, so it is difficult to even ship out anything that is produced. Ukraine is a large exporter of iron pellets that are used in the production of steel. They cannot get shipments out to their steel customers around the world. 

Global auto companies cannot get certain wiring systems from plants in Ukraine and are shutting auto plants in response. The global semiconductor industry might also get disrupted as Russia and Ukraine are producers of neon gas that is used to make chips. Norilsk Nickel, a company in Russia, produces 40% of the world’s palladium and 11% of nickel, which goes into making steel and electric vehicles[5]. 

Concerning energy, the WSJ also reports that Russia exports around 40% of Europe’s natural gas, whose price has now skyrocketed. Natural gas does not just heat people’s homes. It provides electricity to the industrial sector as well. 

Also hurting Russia, and dramatically impacting trade and finance, is the prohibition of some large Russian banks and other institutions from accessing SWIFT (The Society for Worldwide Interbank Financial Telecommunication). SWIFT is a global financial messaging system that gives instructions to financial entities when sending money around the world. Without this access, Russian businesses are very much impaired. With respect to Russia’s all important oil exports, about 5% of the global total, the US and the UK have decided to ban them while many other private entities overseas have decided to avoid them entirely. China is now Russia’s best friend. 

Central Banks and Inflation 

On TOP OF what was already a tough inflation situation for the Fed, ECB, and others, the war is only making things more difficult for them. They need to tighten policy because it is still ridiculously easy. They will, but “to what extent?” is the question. The Federal Reserve is expected to end QE and raise interest rates by 25 bps at their March meeting, with another 25 bps expected at the May meeting[6]. The ECB is ending its Pandemic Emergency Purchase Program in March as well, and it will scale down its existing Asset Purchase Program. The question then is will they start raising rates toward zero? Before the invasion, it was very likely. Now… who knows?

While the developed world has dragged its feet, due to past negative experiences with inflation the emerging market central banks have been more aggressive with rate hikes. You can be sure that when push comes to shove for the Fed, ECB, BoE, and even the Bank of Japan, they will be more afraid of slowing economic growth than having inflation too high. The problem is that the latter is weakening the economy. This is a very difficult position to be in. 

The Economy 

All eyes are now on how the global economy handles this new round of supply disruptions after it seemed that the worst of the stress was easing after the holidays and the Chinese New Year. The Atlanta Fed’s GDPNow forecast currently estimates zero economic growth in Q1. We can assume that Europe’s economy will slow as they deal with the spike in energy prices and major supply disruptions. At the same time, China’s economy is facing a sharp deceleration in its residential real estate sector that makes up about 1/3 of its economy in total. 

On the positive side, I believe that Covid is over in terms of being a dominant force in our lives. The US, the UK, and Europe are ridding themselves of Covid restrictions and the rest of the world is following. What we need now is for China to get off its strict approach. They are likely looking at the sharp increase in cases in Hong Kong as a test case for what they will do from here. If China can fully open up, that would be a welcome support to the world’s economy. 

Credit

I would define most of the selloff in many high-flying stocks, which really started last year, as a valuation rethink after the pivot in Fed policy. The question now is how the economy responds to both higher interest rates and the issues discussed here. This is why it is so important now to watch corporate credit, particularly high yield, which will reflect investor expectations of the impact on company financials. The Bloomberg high yield spread index has widened this year by 76 basis points off US treasuries, from 283 to 359 basis points at last look. For perspective, it started 2020 at about 330 basis points but was over 400 basis points at times in 2019[7]. 

The bottom rung of high yield is the CCC rated category. Its spread to treasuries has widened by 58 basis points this year to 622 basis points[8]. Though that is still well below the 885 basis point spread it stood at year end 2019. Thus, credit quality is not a concern of the markets yet but it is something we are watching closely. 

Conclusion 

It has been a tough start to the year for markets and higher inflation is making it tough on families. Wage growth, which is accelerating, is still not keeping pace. The tragedy in Ukraine has Russia turning the whole world order on its head. This is all at the same time when central bankers have no choice but to pull back from their emergency Covid policies. 

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy and volatile time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets. 

Disclaimer

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