Highlights this Month
- The beginning of a recession? Or just a correction in the markets?
- Geopolitical conflict continues to shake the markets but may present opportunities to investors.
- The yield curve may be flashing warning signs.
- Russia’s attack on Ukraine could push up already sky-high inflation.
- Even before the fighting started in Ukraine, consumer confidence had begun to turn lower.
February in Review
Last month, it was another rough month for markets, with the S&P 500 down nearly 3% in February. Combined with January’s 5.2% decline, the S&P 500 has lost just over 8% in the first two months of the year. While negative returns are always disappointing, a slow start does not mean negative returns for the rest of the year. Historical data shown by Strategas indicates that in years when the S&P 500 has been negative through February, returns for the next four and ten months averaged 4.7% and 5.0%, respectively.
Canadian markets appear to be positioned to do even better. After returning 0.3% in February, Canadian large-cap stocks were one of the few markets in the world to post positive returns. Year to date, the S&P/TSX is flat, with Base Metals, Energy, Materials, and Gold helping offset losses in the Technology and Health Care sectors. The world seems to be looking for more real assets, and Canada has what it may want. According to Scotiabank, foreign investor interest in Canada has inflected higher, as have quarterly earnings estimates for Canadian companies.
We do not see investor interest in Canada changing anytime soon. In an early-February Bank of America survey, Fund Managers cite hawkish central banks and inflation as the most significant “tail risks” for markets, an environment seemingly well suited for Canada’s resource-heavy exchanges. While the survey was before Russia invaded Ukraine, and the conflict will likely move up in the tail risk rankings in next month’s survey, we would argue that this will only reinforce the risk of inflation and higher interest rates to markets.
Inflation and higher interest rates tend to be hard on fixed income investments, even when stocks come under pressure. Typically, investors can count on some capital appreciation from bonds when stocks come under pressure and capital heads for the safety of fixed income. Investors don’t treat bonds as a haven when inflation is driving higher rates; however, as was the case in the first two months of 2022, a 60/40 portfolio (60% stocks and 40% bonds) suffered a rare drawdown. That said, stocks can still go higher even with the Federal Reserve increasing interest rates.
A recent article by Barron’s indicated that the S&P 500 continued to appreciate during the last Fed tightening cycle from December 16, 2015, until December 19, 2018, increasing a total of 28.6%, or an annualized 8.7%. Central banks typically tighten monetary conditions to prevent economic growth from overheating. Stocks begin to suffer only once tighter financial conditions negatively impact corporate earnings. We are arguably not at that point.
The beginning of a recession? Or just a correction in the markets?
The above does not necessarily mean stocks cannot go down for some time. In truth, a correction can be healthy in a bull market. A vital differentiation for investors to determine in 2022 is if markets are experiencing a growth scare and correction or if it is the beginning of a recession. BCS Research shows that recessions and bear markets go hand in hand. Alternatively, growth scares are barely noticeable on longer-term price charts, even major ones.
According to Strategas, the typical cyclical bear market has historically lasted 115 days and seen the S&P 500 decline nearly 24%. Add in the secular bear market periods of 1968 to 1982 and 2000 to 2013, and the average drawdown increases to almost 40% with a duration of 20 months. Alternatively, BMO’s Investment Strategy Group estimates the average market correction lasts a mere 110 days with a decline of just over 13%.
Geopolitical conflict continues to shake the markets but may present opportunities to investors.
Even geopolitical events have not bothered the markets for very long. According to Bloomberg, the largest geopolitical market event on record was the attack on Pearl Harbor in 1941, which caused the S&P 500 to decline 19.8% and take 307 days to recover. The second worst event was Iraq’s invasion of Kuwait in 1990, which resulted in the S&P falling 16.9% but needing only 189 days to recover. Finally, 9/11 caused just under a 12% decline, which the S&P 500 made up in a mere 31 days.
Geopolitical events can also be good buying opportunities. A report by Strategas shows that total returns 12 months after select geopolitical/military events have averaged 13.0%. The Russia/Ukraine conflict may be worse, but markets tend to move on fairly quickly historically; humanity less so.
Unfortunately for investors, the timing of the Russian invasion of Ukraine came at a particularly tricky time for markets. Expectations for how many times the Federal Reserve would increase rates in 2022 had reached upwards of 6 or 7 last month as the realization tighter financial conditions were urgently needed as inflation continues to surge higher. At the same time, the yield curve began to flatten, a potential early indicator that economic growth was starting to roll over. According to Fund Managers surveyed by Bank of America Global Research in early February, most investors believed this trend would continue. More investors expected a flatter yield curve than any period since February 2005. A flatter yield curve in combination with rising inflationary expectations has the potential to be a powerful harbinger of bad news for future returns, as most risk assets suffer in a stagflationary environment.
The yield curve may be flashing warning signs.
While higher two-year yields and a flatter yield curve are certainly something to notice, they are not necessarily a sign of imminent danger. The S&P 500 has historically performed very well when the yield curve is relatively flat but not inverted. According to BMO’s Investment Strategy Group, the market has delivered average annualized returns of 14% when the yield spread between 10-year and 2-year Treasury’s have ranged between 0 to 50 basis points. Furthermore, Strategas points out a flat curve is more problematic when long rates are falling, which hasn’t been the case. Ten and 30-year yields have been rising, just not as fast as 2-year yields. A flat yield curve can stay flat for an extended period, but even when the curve inverts, BMO estimates the average lead time before the economy goes into recession is 17 months. The bottom line, markets appear to have time.
How much time markets have will likely be determined by the future path of inflation. Inflation occurs when there is an imbalance between supply and demand, specifically, too much demand or too little supply. The pandemic gave us a little of both (fiscal stimulus increased the demand for certain goods), but most of the imbalance has stemmed from the supply side. According to the US Federal Reserve Bank of San Francisco, the bulk of the current surge in inflation can still be attributed to COVID and supply chain issues, given their COVID Sensitive inflation index has moved significantly higher. In contrast, their COVID insensitive basket has only recently returned to early 2018 levels.
The belief that inflationary pressures should be transitory and normalized once supply chains ease is reasonable, though a return to 2% or lower is questionable. The longer that inflation remains elevated, the more likely inflationary expectations will permanently ratchet higher. Goldman Sachs highlights that inflationary pressures are broadening, with inflation on two-thirds of the consumption basket above 4% and almost 20% above 10%.
The key to settling the transitory versus permanent inflation debate will be wage growth. According to the Washington Post, over 1.5 million more people retired than expected during the pandemic, leaving companies scrambling for workers. Moreover, according to Goldman Sachs, higher wages lead to higher short-term inflationary expectations and increase concerns about a wage-price spiral. This is primarily a risk given that current wage gains have not kept up with inflation, resulting in workers falling even further behind.
Russia’s attack on Ukraine could push up already sky-high inflation.
If markets were concerned about inflation before Russia invaded Ukraine, the war will only raise anxiety levels even higher. Historically wars are inflationary, and this one looks to be no exception. While the US doesn’t have significant trade exposure to Russia or Ukraine directly, both countries export several essential commodities. As a result, the price of food, particularly wheat (the Financial Times estimates Russian and Ukraine represent 25% of global production), has moved materially higher. According to Bloomberg, Russian and Ukrainian exports of food commodities such as corn, wheat, and sunflower oil total more than 10% of all calories traded globally. Even semiconductor supply could come under renewed pressure. According to Reuters, 45% to 54% of the world’s semiconductor-grade neon gas comes from two Ukrainian companies. Both ceased operations in early March as Russian troops escalated their attacks.
Of course, Russia is also a significant exporter of oil and gas, mainly to Europe. According to Bridgewater, Russia is responsible for 11.4% of global oil production and 17.3% of global natural gas production. However, as the WSJ points out, Russia is the source for 30% of the EU’s oil and 40% of its Natural gas demand. For Europe, there are no easy alternatives to Russian gas imports in the short term.
The inevitable rise in oil and gas prices has increased the risk of an economic slowdown or even recession. As a percentage of GDP, the world is paying more for extractive materials than at any time in the last 50 years, shows Bernstein Research. For just energy, recessions have typically followed whenever fossil fuel costs have historically risen rapidly and approached 7-8% of GDP. Bernstein Research indicates that we are at that level. Oxford Economics sees the impact of the Ukraine crisis hurting Europe more than the US, but the pain will be felt globally and likely last beyond 2022.
Even before the fighting started in Ukraine, consumer confidence had begun to turn lower in the US.
Consumer spending has still been strong, but higher prices seem to have taken a toll on consumer sentiment. Even with strong job growth, Americans appeared gloomy, with consumer confidence approaching levels last seen during the financial crisis. Wages are going up, but prices are going up more.
Central banks need to tighten financial conditions to control inflation, yet most price increases are still a result of supply issues. Higher interest rates can help reduce demand but will not fix supply chains.
The crisis in Ukraine only makes inflation worse and puts additional pressure on central banks to act. In addition, higher prices inevitably lead to more demand destruction, which is the goal of tightening monetary conditions. Supply and demand need to fall back into balance, and constraining demand is a more likely outcome in the short term than increasing supply. However, constrain demand too much, and we have a recession, or even worse, stagflation. We do not see this as the most likely scenario yet, but the Fed has not started raising rates yet.
As the pandemic eases and workers get back to work, positive economic momentum should be good for corporate earnings, even if interest rates move higher. However, if inflation stays high and interest rates have to rise too much too fast, humanity and markets might come under pressure. In this scenario, a market correction likely turns into a bear market.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.