Overcoming this Bear
The coronavirus pandemic has dominated the investment landscape the past two years. As the U.S. economy rebounded and corporate profits recovered, stock prices surged while interest rates stayed very low. Entering 2022, the focus shifted to the potential threat of inflation and how Federal Reserve policy could hamper growth. Then came Russia’s unconscionable behavior in Ukraine.
Cold War 2.0
Vladimir Putin has long referred to the breakup of the Soviet Union as the greatest geopolitical catastrophe of the 20th century. Over the years, he has maneuvered to try to restore Russia’s global power and sphere of influence while bringing former Soviet-bloc states back into Moscow’s fold. As Robert Gates (former director of central intelligence, former secretary of defense, and Russian scholar) warned eight years ago in a Wall Street Journal column, Putin has “no grand plan or strategy to do this, just opportunistic and ruthless aspiration. And patience.” He has been playing the long game. Gates’ words certainly resonate today.
Since the collapse of the Berlin Wall, the West has sought ways to engage with Russia. However, Putin’s ambitions and worldview differ dramatically from the West’s. His regime clearly does not respect the rule of law nor the sanctity of borders; he displays no concern for human or political rights. For Putin, geopolitics represents a zero-sum game, every transaction having a winner and a loser, as he aims to amass power.
Bear not hibernating
For Western leaders and their allies, Russia’s state-sanctioned carnage in Ukraine seems to have finally marked a wakeup call to this simmering, existential threat. Their response following the 2014 annexation of Crimea had been fairly anemic, a mere hand-slap for the Russian aggressors. In contrast, Russia’s invasion of Ukraine and the resulting humanitarian crisis has sparked tough financial and economic countermeasures (not to mention military aid and intelligence to the Ukrainians as they fight a proxy war).
The broad-based sanctions are intended to hinder the functioning of the Russian economy while imposing significant burdens on Russian elites and businesses. Absent direct military intervention, such channels are the main levers that the United States and its allies possess. Yet it remains to be seen whether these efforts will induce an end to the war, particularly if Europe keeps importing Russian oil and natural gas — the chief source of that government’s revenues, amounting to $1 billion/day.
In the meantime, the economic impact from the conflict in central Europe will continue to ripple beyond the war-torn region. Russia and Ukraine only comprise 3.5% of the world’s gross domestic product so the direct effect on global growth should be modest. However, the indirect effects could prove sizable — primarily through changes to the prices and availability of fuel, food, and raw materials.
Russia is the second largest commodities exporter (after the U.S.) and a key player in global energy and metals markets as well as some agricultural sectors. Most notably, it is among the top three producers of both oil and natural gas. Prices for many commodities spiked in late February on fears of supply disruptions, immediately after the invasion commenced.
Europe has become increasingly dependent on Russia to address the continent’s energy needs. In total, Russian supplies more than one-third of Europe’s natural gas consumption and one-quarter of its crude oil. Germany, the largest European economy, receives more than half of its natural gas from Russia. While the U.S. and U.K. have banned oil imports and the European Union is drafting plans for an embargo, natural gas seems to be off the table.
As for industrial metals, Russia is an important producer of aluminum, nickel, copper, and steel. The country also supplies more than one-third of global palladium (that metal is most commonly used for catalytic converters). Russian metals shipments have dropped as some foreign commodity buyers and financiers have felt pressure to disengage.
Basket is bare
Russia and Ukraine together account for one-fourth of global wheat exports, much of it going to developing countries in Africa and Asia. Besides wheat, Ukraine produces substantial amounts of barley, corn, soybeans, and potatoes. In fact, Ukraine has been known as the “breadbasket of Europe” due to its fertile soil and abundance of arable land. The war will dampen Ukraine’s agricultural output as well as its ability to ship crops to other countries.
More broadly, the global agricultural sector will also be impacted by a scarcity of fertilizer. Russia and its ally Belarus provide 40% of global potash, a key ingredient for potassium-based fertilizers. Russia also produces about two-thirds of the world’s ammonium nitrate, the main source of nitrogen-based fertilizers. The country has announced a “temporary” ban on their export. Farmers around the world are scrambling; higher fertilizer prices and inadequate supply could lead to lower crop yields and increased food costs.
The spot prices of many commodities were already at historically high levels before the first Russian tank crossed over Ukraine’s borders. Prices had been elevated from persistent supply shortages and logistics challenges induced by the pandemic. The war has aggravated these disruptions, leading to additional price pressures for raw materials and intermediate goods. Currently, futures markets generally expect commodity prices to come back down later this year.
Since mid-2021, consumer inflation has also been running hot. In March, the Consumer Price Index (CPI) rose at an 8.5% annual rate, the fourth consecutive month with an increase of 7% or more. The Core rate (all items less food and energy) jumped 6.5%. While propelled by pandemic-impacted categories, the upward trend has become more widespread. But not surprisingly, rising food and energy costs have had the biggest bite overall.
How much fuel?
The Federal Reserve began to change its tune late last year, no longer viewing the recent inflationary spike as entirely “transitory”. Imbalances from the war are only adding fuel to the fire, causing challenges for the Fed as it seeks to walk the fine line between tightening too slowly (causing inflation expectations to jump) and too aggressively (throwing the economy into recession).
In mid-March, the central bank raised its short-term target rate to 0.25%, the first increase since 2018. Policymakers expect to raise rates six more times in 2022, implying a fed funds rate of 1.75% at year end. Not as sanguine, the bond market anticipates the need for nine more rate hikes this year. In either case, the policy rate would return to a level at or below that which prevailed just prior to the pandemic.
Meanwhile, longer-term rates have also shifted up. The benchmark 10-year Treasury yield stands at almost 3%, the highest in three years. Mortgage rates have followed suit, with the interest rate on the average 30-year fixed rate loan now 5%. From an historical context, these rates would not be viewed as particularly high — for instance, the 30-year mortgage rate is still below the levels seen during the last housing boom. Nevertheless, the speed at which yields have increased has led to some consternation.
So far, the bond market has given the Fed the benefit of the doubt: Expectations for longer-term inflation have moved up but remain fairly muted. Prior to the war, one could make a strong case that headline inflation would turn back down in the back half of the year as disruptions caused by the pandemic continued to recede. The situation in Ukraine obviously clouds the issue.
Against this backdrop, equities in recent months have struggled to gain traction. In the prior four Fed tightening cycles, stocks came under pressure at the outset, but generally rebounded as long as rates did not become too restrictive. The current cycle began with short-term rates near zero and the 10-year Treasury trading at 2%. Yields should therefore have room to reset before significantly hampering economic growth. And absent a recession, stocks should grind higher.
Christopher J. Singleton, CFA, Managing Director
April 18, 2022