As we film this commentary, our hearts and minds are with people of Ukraine. Like much of the world, we are in awe of the strength and fortitude of the Ukrainian people and are encouraged by the global display of unity in support of their defense. While we watch with sadness, we remain hopeful that a resolution will be achieved.
While the humanitarian consequences of the Russian invasion are severe and top of mind, part of our job is to assess the economic consequences and ensure the best possible outcomes for client portfolios.
In our last commentary, we discussed how various factors were causing some early-year turbulence in the market. At the time, markets were adjusting to expectations of interest rate hikes as the Fed seeks to combat inflation and reign in an economy that is essentially bursting at the seams. High growth sectors of the market were deflating while traditionally defensive and cash generative sectors outperformed. Now, the situation in Ukraine has added in a new layer of complexity, as commodity prices risk both driving inflation higher as well as slowing growth. This development has complicated the picture for the Fed as it fine-tunes its approach in the coming months.
Economically speaking, the US economy is fairly insulated from the crisis in Ukraine, at least relative to its partners in Europe who have more direct trade ties to the region. Rather, the effects in the US will be felt more through exposure to rising commodity prices, most notably oil and gas, wheat, and industrial metals that are key inputs into US goods and services. While the West is already making moves to offset these supply shocks, persistently higher commodities could begin trickling into the economy, increasing costs, reducing demand, and driving consumers to a more defensive stance. In particular, gas prices threaten to eat up a higher share of disposable income at the expense of discretionary purchases. This underscores the delicate balancing act the Fed faces as it seeks to rein in inflation, as hiking too aggressively could risk spurring a recession.
However, there are a number of factors working in the Fed’s favor. US energy intensity, or the amount of energy consumed per dollar of GDP, has been falling for decades and is now 60% lower than it was in the 1970s. This has coincided with the economy shifting away from manufacturing and towards services sectors, most notably digital goods. This means the US is less exposed to a supply shock in oil than it was 50 years ago, even if it stands to sting in the near-term. Secondly, Western Europe, which serves as a buffer between the US and Eastern Europe, has high savings coming out of the pandemic and is already boosting fiscal spending to counteract Russia. This should help mitigate their own economic impact and by extension, their impact to the US. Lastly, despite the commodity surge, there are factors suggesting inflation pressures could soon stabilize. Oil & gas demand in Europe will wane as the winter heating season ends, and supply chain logjams are showing signs of thawing in some key areas. Oil prices are already down 20% from their recent peak as OPEC members signal boosts in supply. Collectively, these factors should help buffer the Fed as it attempts to “thread the needle”.
While we certainly aren’t in the business of market timing, there are statistical factors offering some cautious optimism. Bearish sentiment is currently high and at levels that’s historically been associated with positive market returns a year forward. Further, a survey of prior geopolitical conflicts shows that after the initial drop, markets subsequently recovered into positive territory assuming a recession was averted. While this conflict is certainly broader in scope, the market has mostly consolidated in a range, trading in a 5% band for the last month. This stability is encouraging and may indicate that a fundamental level of support is building. Regarding market fundamentals, corporate earnings are continuing to beat estimates, albeit at a slightly slower rate. Coupled with the price declines, this has contributed to a substantial rerating of valuations, with the S&P 500 forward P/E now closer to its 10-year average.
Clearly, there are lots of moving pieces to the puzzle, and several of them have the potential to change at a moment’s notice. The speed and magnitude of Fed rate hikes as well as developments in Ukraine will likely remain the biggest near-term drivers, with perhaps the latest COVID outbreak in China causing some pause as well. But you can be assured that we are constantly monitoring these events and stand ready to act in portfolios as opportunities present themselves. Times like this often offer the watchful investor the best windows of opportunity.
We welcome your question and comments and wish you and your families well. Thank you for watching.