Thoughts on Current Events

February 23, 2022

Following our market update on January 24, the market rallied for a few weeks but has since come right back down to where we started, with the S&P 500 closing today at $4,226 (the low on 1/24/22 was $4,223). Recent headlines have been dominated by the Russia/Ukraine saga, and this is playing into investors biggest fear at the moment: that high inflation forces the Federal Reserve to tighten monetary policy faster than the economy can handle, causing a recession. This scenario is still just one possible outcome of many, but recent events have increased its probability and led to the market decline since February 9.

Summary and implications of major news since January 24:

  • Corporate earnings season for Q4’2021 has finished up along with several recent industry conferences. The overall results and outlooks showed continued strong demand but slightly disappointing margins due to (1) supply chain/COVID-absenteeism issues and (2) wage and input cost inflation. We would expect the supply chain/COVID issues to continue resolving themselves now that the omicron wave has subsided, but wage and input cost inflation will continue to weigh on margins for at least the rest of 2022.
  • Economic data has come in mixed, with both growth and inflation data coming in higher than expected for January/February.1, 2 The next major datapoints for the US economy will be the January PCE on 2/25 (this is the Fed’s preferred inflation measure), the Michigan consumer sentiment survey on 2/25, and the PMI and ISM economic growth data for February on 3/1. As we have written prior, the key thing to watch for inflation is not what the percent increase was last month, but what expectations are going forward. The Michigan survey has both a 1-year and 5-year expected inflation question. If the 5-year inflation expectation remains close to the Fed’s 2.0% target (currently it is 3.1%), then the Federal Reserve should be able to raise interest rates at a gradual pace that the economy can handle.3 If medium and long-term inflation expectations become unanchored from the 2% target, this is a sign that the Fed’s inflation-fighting credibility is in trouble and could force it into acting more decisively, potentially sending the economy into recession. The historical parallel here is what former Fed chair Paul Volcker did in the early 1980s, raising rates dramatically to restore the Fed’s inflation-fighting credibility. This event is seen favorably through the lens of history, as it ushered in a long era of low inflation, but it caused a great deal of near-term pain for the US economy.
  • The Russia/Ukraine scenario is evolving by the minute with the key question at the moment being whether Russia will send its troops beyond the borders of the Donbas region deeper into Ukraine. While President Biden has already ruled out sending in US troops to defend Ukraine, a deeper invasion would trigger much harsher sanctions from the US and Europe and likely cause global energy prices to move even higher, further stoking the inflation fire. A recent investor survey pointed to oil prices dropping roughly 10% from current levels if Russia/Ukraine is fully resolved peacefully, especially if there is also a new nuclear deal with Iran.4 If things get worse, prices will move the opposite direction.

Bottom line:

As we wrote in our January 14 Investment Outlook, the key market focus this year is navigating the removal of the accommodative monetary (and fiscal) policy of the past several years. Since then, higher than expected inflation and the Russia/Ukraine situation have conspired to make the Fed’s job look much more difficult to achieve without significantly impacting economic growth. How global events transpire from here will determine the path of the market going forward. We continue to recommend clients avoid trying to time the market and stay fully invested to their target risk level in good times and in bad. By investing in the market you are being paid to assume risks such as those above, and history has repeatedly shown that when the risks look the worst, this is the most important time to stick to your long-term plan and stay invested.

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