Market Commentary - Q2 2022

Heading into 2022 investors pondered, but remained unconcerned about, the implications of mounting inflation pressure and the removal of historic monetary and fiscal policy accommodation that acted as an economic lifeline during the pandemic. Amid the early stages of this monumental policy regime shift, market participants remained focused on the shift’s tangible benefits over its potential costs.

The Federal Reserve’s (Fed) uber-accommodation, combined with free-flowing fiscal stimulus, spurred a strong domestic economic growth momentum (5.7 percent GDP growth in 2021), as unemployment rates headed back to pre-pandemic levels just two years after reaching the highest levels since The Great Depression. By the end of the first quarter the unemployment rate fell to 3.6 percent, close to the historic low of 3.5 percent seen in February of 2020.

Most important for equity investors, the rapid economic recovery supported a monster comeback for corporate profits in 2021, surpassing even the rosiest of expectations at the beginning of last year. According to FactSet, S&P 500 companies reported earnings growth of 48 percent in 2021. While nowhere near last year’s feat, the consensus of analyst projections calls for a healthy 9 percent growth rate in 2022.

Unfortunately, the optimistic tone of the market that carried into early 2022 did not last long. Investor sentiment abruptly pivoted as a new paradigm set in: persistent inflation pressure meant the tide of policy accommodation would likely recede faster than anticipated. Financial markets already accounted for what became known as the “fiscal cliff,” with U.S. fiscal spending expected to decline substantially in 2022. But, in concert with an increasing expectation that taming inflation required a hastened tightening of monetary policy, investors were forced to quickly recalibrate to a less sanguine growth outlook.

Not So Fast

The S&P 500 index hit an all-time high on January 3, 2022, with the expectation that the Fed (and other global central banks facing the same issue) could bring inflation in check through a gradual tightening cycle without choking off economic growth. However, the unrealistically optimistic “inflation is a manageable issue” narrative hit a snag as data and anecdotal evidence suggested pricing pressure was broadening and becoming more entrenched. In turn, investors began to wake up to the reality that a more hawkish Fed policy stance was required, seriously questioning the ability of central banks to engineer a soft economic landing.

To make matters worse, in addition to the unimaginable human tragedy, Russia’s war with Ukraine further complicated the inflation battle as energy prices surged following the invasion. As well as the spike in energy prices, supply chain issues already stressed by the pandemic worsened as exports of key raw materials from both Russia and Ukraine were disrupted.

Under a weakening growth and rising inflation outlook, the S&P 500 index fell into correction territory for the first time in two years. A strong risk-on rally as the quarter ended led to a recovery of more than half of the drawdown, leaving the index down just 4.6 percent (including dividends) for the first quarter. The pain was not evenly distributed. More interest-rate sensitive large cap growth stocks suffered losses for the quarter of 9 percent, while value counterparts lost a mere 0.7 percent.

Bond markets took the most direct hit from rising interest rates as demand for Treasuries from the Fed (also known as quantitative easing or “QE”) was expected to transform quickly into a source of supply (quantitative tightening or “QT”). The yield on the bellwether 10-year Treasury Note began climbing last summer after bottoming at 1.17 percent on August 3, 2021. After climbing to 1.51 percent by the end of 2021, the pace of yield increases found a new gear in 2022, adding 82 basis points to end the first quarter at 2.33 percent—territory not seen since May of 2019.

Even more pronounced was the move for shorter-term maturities, reflecting the likely path of The Fed’s most conventional policy tool, the Fed Funds Rate. In the first quarter of 2022, the yield on the 2-year Treasury Note rose 1.5 percent to 2.28 percent. The rapid increase and flattening of the yield curve led to the worst performance for the bond market since the Volker Fed Era of 1979 to 1987, with the broad Bloomberg U.S. Aggregate Bond index down nearly 6 percent for the quarter.

Looking Forward

We expect financial market volatility to continue throughout the year as policy tailwinds transform into headwinds. If history is any guide, there is a chance that the Fed will hike rates and shrink its balance sheet until something breaks: either inflation, the economy, or the stock market. While investors hope for a soft-landing scenario, the Fed is walking a very narrow path. In other words, the hill of worry that investors must climb has become steeper but remains climbable, in our view. Investors should take comfort in the fact that corporate and consumer fundamentals are embarking on this journey of policy normalization from a very strong position.

The inflation genie has escaped its bottle. There are various reasons why–some supply side, some demand side–and there are numerous ways inflation has or could rear its head. The genie will eventually be stuffed back into the bottle, but the result will likely put downward pressure on economic growth and, potentially, put an end to the 40-year bond bull market.

It’s no secret the inflation genie is running rampant. Headline CPI (Consumer Price Index) increased 7.9 percent year-over-year during the month of February; 6.4 percent, excluding the volatile food and energy components. The headline PCE (Personal Consumption Expenditures) price index increased 6.4 percent year-over-year in February; 5.4 percent if you exclude food and energy components. Inflation figures are reaching their highest levels since the 1980s.

There are various causes of the inflation spike:

• Pandemic-related supply chain issues and post-pandemic pent-up demand for goods and services;
• China’s zero-COVID policy exacerbating strained supply chain issues;
• Overly accommodative global central bank stimulus measures causing “too much money chasing too few assets”;
• Unprecedented pandemic-era U.S. fiscal stimulus supporting consumer wallets;
• Labor force participation rate declines;
• Depressed year-over-year price comparisons;
• Energy, agriculture, and metal prices impacted by Russia/Ukraine war; and
• De-globalization trends which began with the 2019 trade wars.

Inflation was initially more prevalent in goods-related prices, such as new and used cars, due to supply chain issues, as well as in home furnishings, due to increasing work-from-home arrangements. Recently though, pricing pressures are finding their way into service-related sectors, such as restaurants and accommodations, as demand returns and labor supply remains scarce, and housing-related rents are also being affected as home prices continue to appreciate. In the spotlight, high energy prices, initially spiking due to post-pandemic demand and depressed production, have been further impacted by Russia’s invasion of Ukraine and subsequent sanctions on Russia which in combination are stoking the inflation fire even higher.

Some of the drivers fueling inflationary pressures should ease relatively soon, such as supply chain disruptions, post-pandemic demand, and year-over-year price comparisons. Other issues, such as labor shortages and resulting wage inflation, as well as housing rental costs, might take longer to ease and could become more embedded in long-term price pressures. The long-term implications of the Russia/Ukraine war could lead to further de-globalization, resulting in an increase of the low prices U.S. consumers have enjoyed from manufacturers taking advantage of global competitiveness.

The Fed and Soaring Inflation

Monetary policy is one of the best tools for reducing demand-based inflation. After adding unprecedented amounts of monetary stimulus to offset the pandemic shock, the Fed now faces an extremely delicate balancing act to slow inflation without causing a severe economic slowdown or recession. Further complicating matters, the Fed’s extended and overly accommodative monetary policy, combined with a belief inflation would soon subside, have put its inflation-fighting credibility at risk.

To slow inflation and regain credibility, the Fed raised the Fed Funds rate 25 basis points at its March meeting and became extremely hawkish in both their economic projections and recent public statements. The median projection for the lower-bound of the Fed Funds target rate for the end of 2022 increased from 0.75 percent at the December 2021 meeting to 1.75 percent at the March 2022 meeting, and from 1.5 percent to 2.75 percent between meetings for 2023 year-end projections.

In addition, several Federal Open Market Committee members had Fed Funds forecasts (“dots”) for 2022 and 2023 above the estimated long-term neutral policy rate, indicating a greater focus towards fighting inflation as opposed to maintaining economic growth. Recent Fed rhetoric has also hinted at the possibility of one or more 50 basis point hikes.

Financial markets have more than priced in the newly-aggressive Fed stance. As signaled by the Fed Funds futures market as shown in the chart above, bond investors now forecast a 2.5 percent Fed Funds lower-bound target rate by the end of 2022 (a rate more than the Fed’s own forecast) and a 3 percent rate at the end of 2023, also higher than the Fed’s forecast, followed by a 0.5 percent rate cut in 2024.

Increases in short-term interest rates are just one of the ways the Fed can tighten monetary policy. Shrinking the Fed balance sheet through quantitative tightening is another method and is expected to begin in May or June. With the Fed’s balance sheet reaching approximately $9 trillion, an increase of $5 trillion since the start of the pandemic, a gradual reduction should reverse the “too much money chasing too few assets” phenomenon over time.

Significant and well-anticipated changes in monetary policy should slow demand-pull inflation, but won’t reduce supply shock-related inflation which, ultimately, should fade over time. Further, fighting inflation through monetary policy comes at a cost of slowing future economic growth and potentially inviting a recession, although a recession is not currently in our economic forecast.

The Bond Bull is Hibernating

Persistently high inflation, a hawkish U.S. Fed, and strong but decelerating economic growth have caused U.S. interest rates to move significantly higher off historically low levels, leading to a flattening of the yield curve as shown below.

Higher short-maturity rates are largely a result of market expectations for significantly higher Fed Funds rates through 2023. Increases in longer-maturity rates are influenced by numerous factors, including:

• Long-term expectations of Fed Funds policy rates;
• Term premiums;
• Current inflation and inflation expectations;
• Supply/demand considerations including budget deficits, quantitative tightening, foreign demand for U.S. Treasuries and currency hedging costs;
• Forward growth estimates;
• Global interest rate differentials; and
• Real interest rates (nominal rates less inflation expectations).

We believe the relatively flat yield curve is anticipating slower economic growth, elevated inflation expectations (yet significantly less than current data indicators), modest rate cuts after 2023, and reduced Treasury issuance partially offset by quantitative tightening. With short-maturity rates near those of long-maturity rates, the potential for a yield curve inversion is significant. In the past, significant Treasury curve inversions have often forewarned of future recessions.

Our View Going Forward

Ultimately, we believe the market is pricing in a Fed Funds policy rate higher than what will be achieved over the next two years. Over the near-term, however, interest rate curves should remain relatively flat and could even invert. Longer term, we believe longer-maturity nominal rates will continue to creep higher as real rates normalize back toward zero due to the Fed shrinking its balance sheet while part of this move higher could be somewhat offset by declining inflation expectations.

However, should the Fed prove to be more hawkish than anticipated, a significant interest rate curve inversion would be likely with higher short-maturity rates and flat or lower long-maturity rates. Irrespective, significantly higher interest rates already seen across maturities in bond land should ultimately provide investors with better income-earning opportunities from fixed income investments going forward.

A perfect storm of headwinds, including a lack of investment, low excess capacity, and the first European land war since WWII, collided with fiscal stimulus spending, pandemic-related spikes in demand and low interest rates to drive prices of oil and select metals to levels not seen in decades.

Starving the Spigot

Due to ten years of over-investment and negative free cash flow in the energy sector, returns of energy-related stocks suffered, leading investors to sour on the sector. The resulting decline of capital available to oil-producing companies, combined with an unprecedented drop in demand due to pandemic shutdowns, has shifted producers’ capital allocation strategies.

While investors drained capital from the sector, the Organization of Petroleum Exporting Countries (OPEC) implemented supply cuts during the COVID era to support crude prices. As demand for energy began to slowly return, OPEC remained united and drove crude oil inventories below normalized levels even as spare global capacity approached decade-low levels. Oil prices began to respond to improving supply and demand dynamics in late summer last year as the economic backdrop improved.

Geopolitics has always played an ebb-and-flow role throughout history in energy and commodity markets. In the U.S., technological developments led to fracking becoming economically feasible and even lower cost than other extraction methods. After importing the vast majority of our crude oil needs for an extended period of time, this has allowed for greater energy self-sufficiency, a U.S. goal since the oil crisis of 1973 when long lines at gas stations plagued the nation.

Europe, on the other hand, has maturing oil and gas fields and imports much of their natural gas needs, with Russia supplying over 39 percent. This reliance, and concerns over climate change, are at the forefront of Europe’s attempts to shift away from fossil fuels as renewable energy sources become economically feasible and policy measures encourage changes in energy consumption.

Consequences of the Invasion

The tragic Russian attack of Ukraine has broad but, as of now, unknowable consequences for the energy and commodities complex. While Russia represents only about 2 percent of global Gross Domestic Product (GDP), it has a much larger share of food and energy production. Russia’s economy is driven by commodity exports and the global economy relies on these products to operate. Both Russia and Ukraine export large quantities of energy (oil, natural gas and coal), agriculture (wheat and corn), and commodities (aluminum, nickel, palladium, platinum).

Many of these commodities are already in tight supply and the war will only exacerbate global shortages. Food-related commodities are of particular concern with Russia and Ukraine combined supplying some 27 percent of global wheat demand. Ukraine will soon harvest the winter wheat crop and begin planting the spring corn crop. But a lack of fuel and infrastructure destruction could cut planted acreage by half or more. Logistics, given significant structural damage, will be strained to get product to market and the world will rely to a greater extent on Brazil and the United States to offset wheat and corn shortfalls.

Consumer pain from inflationary pressures in both food and energy will come down hardest on developing nations and those lower on the economic ladder. Because developing economies spend a greater portion of their income on food-based commodities, inflationary pressures from demand elsewhere will cause increasing costs and slowing global economic growth. Increasing food insecurity in many parts of the world is a growing concern.

Further, the agricultural industry is energy-dependent with a key ingredient, nitrogen-based fertilizer, requiring both minerals and natural gas. Higher energy costs are already impacting farmer costs which in turn increase the cost of all agricultural products.

Sanctions Bite Deeply

As sanctions target the Russian regime, its oligarchs and Putin’s inner circle, the measures taken by key demand centers including the U.S., Europe, China and India will dictate how much of Russia’s products are exported and thus the price of each commodity. While the current trajectory of the war looks to be drawn out, its direction and duration will determine how global supply and demand shape up and influence global pricing. Russian crude is trading at a significant discount of around $28 per barrel versus the price of Brent crude and, even at a significant discount, is finding a limited set of buyers.

Russian oil exports, amounting to about 4.7 million barrels per day, will see a reshuffling of trade routes to those willing to accept product--often requiring payment in Russian Rubles.

The current tight supply situation, exacerbated by less Russian oil on the market, will likely need to see demand destruction to balance supply and demand. The most likely supply response is from U.S. shale, but pressure on management teams to return capital rather than grow production will hold back a return to extraction efforts. In tandem, labor constraints, oil field service costs and logistics will drive inflationary concerns and uncertainty of returns on investment.

Global governments, already shifting energy policies to accommodate climate goals, are now addressing energy security concerns as well. The chaotic nature of the process suggests further volatility in markets. In the short-term, U.S. shale producers will be relative winners given quicker time to market, low-cost positions, and shorter time periods from investment to payback.

In a protracted Russia/Ukraine crisis, commodity flows will be disrupted by the war and increasing sanctions. Even with a diplomatic solution, Europe will focus on lowering its reliance on Russian natural gas through three avenues--supply diversification, demand destruction, and increased storage capacity. Increasing natural gas imports from other providers including Qatar, the U.S, and West Africa is ambitious and will take time to fully execute. Europe might also reembrace nuclear generation while adopting a favorable view of natural gas as an energy transition fuel on the way to renewables. This in turn could lead to signing long-term liquified natural gas contracts with global suppliers.

Economic sanctions, including Russian banks’ removal from SWIFT and the freezing of Russian central bank offshore reserves, are severely limiting Russia’s financial and economic transactions, hampering exports. This economic war, previously unused even in WWII, aims to drive Russia into a severe recession with the goal of causing sufficient economic pain to force a diplomatic solution, regime change, or other outcome.

China would like to stay neutral in the war given internal economic issues and the fact that its exports to Europe are an important, and growing, component of the domestic economy. Yet China also imports much of its energy and commodity needs from Russia and is likely disturbed by the freezing of Russia’s Central Bank reserves. As they push trading partners to increase Yuan usage rather than U.S. dollars, the ultimate outcome--if pushed too hard--drives the rebalancing of their economic model.

While desired, a shift away from the greenback has large implications to Chinese economic growth and those who benefitted from the previous economic regime. While this regime shift has been a long time coming, there is a reason why it has been so hard to implement. President Xi and other world leaders clearly have some decisions to make.

China’s recent COVID breakout is causing disruptions in the production of commodities, including steel, aluminum, and coal, as well as impacting domestic demand for commodities. China’s slowing economic growth, exacerbated by real estate issues, will have a negative impact over the medium term for commodity demand.

The Russian war likely adds to the list of reasons for China to shift its economic growth model to one that is consumer-focused and less commodity intensive than the current infrastructure-reliant model. While fossil fuels power some 80 percent of today’s global economy, the shift towards “electrifying” transportation and manufacturing will drive demand for specific commodities such as copper, lithium and, potentially, nickel. If nuclear generation sees a renaissance, demand for uranium should also increase.

Prices for many energy, metal-based commodities, and agricultural products are well above incentive-based levels for reinvestment, with many at decade highs. As the old saying goes, the cure to high commodity prices is high commodity prices. Continue to expect volatility.

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