April 1, 2022
It is a challenge to make sense of the geopolitical and economic events unfolding around the globe. The phrase “land war in Europe” is one many thought and hoped would never be uttered again. A new iron curtain appears to be descending across Europe, as Russian troops spread across Ukraine wreaking senseless destruction. The resulting scenes of human misery are reminiscent of the grainy, black-and-white Pathé newsreels of the early 20th century. The Kremlin demands a geographic reset to the post-Cold War landscape so it resembles a latter-day version of the old Soviet bloc. Take this all together and the echoes of Churchill’s 1946 speech in Fulton, Missouri — which warned of the closing of eastern Europe by Communist Russia — ring loud.
War is a miserable affair. Regardless of the end, the means are mournful, wasteful and profoundly disruptive. On the economic front, Russia’s war threatens to thrust a recession on Europe, food and energy shortages upon Africa and the Middle East, and social unrest upon countries that suffer from the insecurity that agricultural inflation brings. Using terrorism as a proxy for societal unrest, when food prices rise suddenly and sharply, the seeds are sown for societal instability that manifests itself a few years later (Exhibit A).
Ukraine, with its fertile steppes, is the food basket of Europe. It is a major exporter of corn, wheat, sunflower, and rapeseed. It is the second largest provider of grains for the European Union and a major food provider for the Middle East and Africa.1
Ranking as the 40th largest economy in the world, between Sweden and Kazakhstan, it is a western-oriented society.2
Along with human misery, war brings with it inflation. Given Russia and Ukraine’s importance in agriculture and energy, this war will exacerbate the inflationary forces already in place as the global economy reboots from pandemic-wrought disruptions. Inflation is on the rise in the Eurozone, United Kingdom, and the United States and is proving to be anything but transitory. Never on the vanguard, central banks are responding by lifting interest rates and reconsidering their money printing programs. The Bank of England and the Federal Reserve have lifted interest rates and the latter is expected to raise the Federal Funds rate six more times in 2022 (Exhibit B).
Truly, inflation does appear to be rearing its ugly head. Furthermore, it threatens to be stubbornly persistent. Supply chains already disrupted by the pandemic suffer further stress with the rerouting of air corridors from Europe to Asia around the Central European war zone. Sea shipping has also been negatively impacted by the sanctions levied on Russia. The American labor market remains extremely tight as job openings are well over twice the number of people unemployed (Exhibit C).
Food and energy inflation threatens the living standards of all, but it hits those with lower incomes especially hard. While national measures of gasoline prices average $4.23 per gallon, these figures understate the price many see at the pump. Regional prices can soar to $5.82 per gallon. One estimate reckons that consumers will spend an additional $3,000 annually on energy and food due to the recent surge in commodity prices.3 This is money that lower- and middle-income families will not have to spend on other things. It changes consumer behavior and buying patterns, which does not bode well for economic activity.
More troubling is savvy investors’ expectation that oil prices, currently at $100 per barrel, may be on their way to $150 to $250 per barrel as sanctions restrict supply and energy companies are unable to restart idled production quickly enough to relieve shortages.4 Economies are not built to absorb price shocks of this magnitude, so recession is almost unavoidable if it materializes (Exhibit D).
As expected, markets reflect the darkened times and stock price gyrations are setting teeth on edge. The Nasdaq Composite Index fell into a bear market whilst the S&P 500, MSCI Europe, and MSCI Emerging Markets Indices fell into correction during the quarter. Indeed, our forecast at the start of the year for a market drawdown of 8% to 15% materialized a bit more quickly than we had thought.
Performance in the fixed-income complex remains as challenged as last year. Returns are grim as the Bloomberg Global Aggregate Bond Index is down 10.7% from its peak in January 2021. This decline is the largest since the index inception in 1990.5 In the US market, municipal, investment grade, and high-yield corporate bonds are all sporting losses this year. Leveraged loans, the favorite of investors seeking protection against rising interest rates, offer no harbor of safety as this market is also down this year (Exhibit E).6
Wall Street’s 2022 profit expectations remain remarkably unperturbed. The forecast for S&P 500 earnings growth has risen since the start of the year from 9.0% to 9.4%, whereas profit expectations for 2023 have fallen from 10.3% to 9.8%.7 We will be watching not only the financial results that unfold over the course of the year but also how management describes the operating environment and the challenges they face with the supply of labor and material. Intense focus will be placed on the pricing dynamics of inputs and final goods. Ultimately profit margins will rise or fall on the interplay between the two. At this juncture, we are skeptical that the Olympian profit margins of 13% to 16% over the last five years can be maintained as price pressures assert themselves.8
Lurking in the background is the idea that the age of globalization is dead and so are the systemic disinflationary forces that it offered. It is an idea that has currency given the state of play of domestic and global events. A modicum of supply chain resiliency does seem prudent, given the fragilities of the current system, which stretches thousands of miles and is dependent on people who have very different values, expectations, and individual and societal freedoms. Resiliency comes with costs and those costs may very well mean lower profit margins as global commerce comes to terms with a more fragmented commercial landscape than the one that has prevailed for more than 20 years.
Forecasting markets during periods of extremis is an impossible task. We take the Fed at its imperfect word, as it finds itself rushing to catch up with market expectations for higher interest rates. Indeed, the central bank’s credibility as a guardian against inflation is at stake should it blanch at market protestations of its inflation fighting (Exhibit F). The long march to a higher price of money will undoubtedly place a headwind on both equity and bond market returns. Volatility, extreme at times, is likely a feature of the remainder of the year.
Some in the financial commentariat argue that the equity market has already registered the lows of the year. This seems like a fanciful conceit given the state of play. From our perch, the first quarter is likely the warmup for more event-driven volatility to follow. Imagine the market’s reaction to an intermeeting Fed interest-rate hike or to the use of a massive thermobaric bomb on a Ukrainian city. How will markets respond to events such as these?
Considering an environment where the improbable becomes increasingly possible, we have changed our recommended portfolio posture to reflect current realities by raising cash from domestic, international, and emerging market equities. We also trimmed the recommended exposure to structured credit – all to create a cushion for the market ructions we think lay ahead and to provide the wherewithal to take advantage of opportunities that are likely to emerge. In sum, we were significantly underweighting cash, and we are now slightly overweight in it, relative to our strategic recommendation.
The stakes are high in the battles now waged against conquest and inflation. Geopolitically, the hopes that Francis Fukuyama wrote of in The End of History and the Last Man seemed to materialize with the fall of Communism and the Berlin Wall. The peace dividend, integrated commerce, rise of democratic forms of government, and falling inflation raised living standards across the globe, creating a new and truly Panglossian Golden Age. Events now unfolding place all this at dire risk.
It is a fight that cannot be lost.
1 “Ukraine agricultural exports-what is at stake in the light of invasion.” IHS Markit/S&P Global, March 7, 2022
2 CIA World Factbook. Calculation based on GDP Purchasing Power Parity
3 Yardeni Research via CBS News
4 “Top oil traders warn prices could breach $200 a barrel,” Financial Times, March 24, 2022
5 “Bond markets in historic downturn as central banks battle inflation,” Financial Times, March 23, 2022
6 S&P/LSTA Leveraged Loan Price Index
7 Fact Set Earnings Insight, March 25, 2022
8 Operating margins for the S&P 500 Index