The Fog of War

By Crest Capital Advisors on March 4, 2022

Dow: (1.30%) to 33,614.80
S&P 500: (1.27%) to 4,328.87
Nasdaq: (2.78%) to 13,313.44
Russell 2000: (1.96%) to 2,000.90
10 Year Yield: 1.73%
Outperformers: Energy 9.25%, Utilities 4.78%, REITs 2.09%
Underperformers: Financials (4.87%), Technology (3.01%)

Russia’s invasion of Ukraine dominated the news cycle and weighed heavily on risk sentiment this week, thus dragging the markets lower across the board. While Russia’s purported hope for a quick takeover of major cities was dented by fierce resistance from Ukrainian troops and logistical headwinds, the attacks intensified as the week progressed and fueled concerns the most destructive part of the offensive may still be to come. There were no meaningful breakthroughs in two rounds of ceasefire talks, though a third round is expected next week. Investors desperately want to see Putin take an “offramp” to dial down escalations but that has been frustratingly elusive as of the close of this week.

From a financial point of view, the severity of the sanctions imposed by the US, EU, UK, and others last weekend has fueled a record surge in commodities, most notably energy, which exacerbated concerns about more persistent inflation pressures. Inflation concerns had already been the key driver of the hawkish Fed policy repricing that had put the path of least resistance for stocks lower before geopolitical concerns even came into play.

The market received some near-term clarity on the Fed as Chairman Powell largely blessed a 25 bp liftoff at the March FOMC meeting, thus throwing cold water on those that were fearful of a full ½ point increase in the face of the current uncertainty.

The February employment report was another bright spot on the economic calendar as nonfarm payrolls surprised to the upside while average hourly earnings missed, alleviating some of the concerns about wage inflation.

The Ukraine crisis remains in the fog of war. For all the volatility, risk-off behavior in markets thus far has been relatively modest, unless you are a growth stock investor in which case it has been more severe. Spot WTI oil is over $100, but the futures curve is at $85 one year out and $70 beyond that. Market-implied inflation expectations have not budged. This appears to confirm expectations for resolution, which we think is the right bet, but leaves markets vulnerable to shocks. Higher oil prices will computationally feed into short-term inflation statistics, but the Fed will worry more about their effect on maximum employment than on stable prices.

From a trade and finance perspective, Russia is not significant enough to derail the world economy. However, the links through commodity prices are key and Russian aggression looks set to keep energy and food costs elevated. The fall in asset prices if sustained will also dampen global activity as will higher uncertainty. In this respect events in Ukraine add a further stagflationary twist to the market outlook by pushing up inflation and weakening growth.

Front Running

Just because one situation has similarities to another, doesn’t mean the market must follow the same path. And yet, despite the myriad of differences, we still find there are lots of 2018 analog’s out there, attempting to explain the ‘why’ behind the recent market performance. For those that aren’t following our reference, it was late in 2018, a full year and a half into the Fed’s then tightening cycle, where markets threw a fit and forced the Fed to reverse course. It was an example of a period where ‘over tightening’ on the part of the Fed had us on a path to disaster, only to be averted by a Fed about-face in early 2019. And this period is similar to today’s market in that we are once again ‘having difficulty’ around a shift in Fed policy towards higher interest rates and restrictive monetary policy. The fear is the Fed will once again overtighten and cause an economic accident.

With that as the backdrop, it’s interesting to take a look at an actual comparison of the two periods. The complicated chart below shows the stock market in the top panel and overlays the price moves of the market around the direction of the Fed’s balance sheet and the fed funds rate. As you can see on the left side, in 2018, the market had already endured 8 rate hikes and a sizable -6% decline in the balance sheet BEFORE the market broke and started on the path of a significant correction. (The horizontal red line shows the peak in the market in relation to the balance sheet and fed funds rate. On the right side of the chart, we have 2022….and you’ll note the balance sheet is STILL expanding (even now) and the Fed funds rate remains UNCHANGED! And yet, the market has pre-priced all the panic that took 8 full rate hikes and nearly 18 months to incubate back in 2018. So, yes, there are similarities in that both circumstances are based on fear around Fed policy, but the markets have completely front-run the Fed in 2022, at a speed and severity we have not seen before.

Wild Range

Friday was the 43rd trading day of the year, and it was also the 43rd straight day where the intraday range of the Nasdaq 100 ETF (Ticker: QQQ) was more than 1%. Seems like a lot, right? Looking back over the last ten years, 43 straight trading days of 1% range on an intraday basis ranks as one of the longer streaks we have seen. The longest streak during this period was 46 trading days coinciding with the COVID crash, and besides that, the only one that was longer was the 41 trading days ending 1/10/19. (Note: the chart below is only updated thru Monday so you may notice it reflects 39. The streak just keeps on going at this point.)

Goods Inflation

According to Goldman Sachs, which we agree with as well, goods inflation is about to drop significantly. Commodities are a different matter, however. The chart below shows the expected slowdown with the right side (of the dashed line) representing the forecast.

Pendulums Gonna Swing

One of the top investor concerns regarding growth stocks has been valuations. Since the early days of 2021, traders and investors have been aggressively rotating out of growth and towards more pro-cyclical value themes. The initial rationale was around the “re-opening” of the economy and buying beaten-down names. This rotation picked up even more momentum in late 2021 and we saw growth stocks come under significant pressure. Well, we think valuations are no longer a headwind for quality growth stocks as the COVID premium that growth stocks enjoyed has been completely erased. The spread in style valuations has declined to more reasonable levels, and we think growth stocks are once again ready to.

Russia/Ukraine uncertainty and war may speed up the transition to the Growth phase of the market cycle. We’d argue 2021 was all about phase 3, quality rather than simply growth v. value. That may be about to change as we get deeper into 2022. For the time being, markets are still grappling with the headline risk around Russia-Ukraine. Eventually, investors will be seeking safe havens in times of uncertain growth, and that likely means secular growers will once again be rewarded.

Crazy Stats of the Week

Here are this week’s crazy stats, all of which are related to Russia’s economy:
Western nations have responded to Russia’s invasion of Ukraine with a raft of sanctions intended to cripple the country’s economy, and economists suggest it could work.

• The rouble is down 30% on where it was pre-crisis – an all-time low against the dollar.
• Russia’s central bank has doubled interest rates from 9.5% to 20% in a bid to curtail the fallout.
• Goldman Sachs has raised its end-of-year forecast for Russian inflation to 17% – the previous projection was 5%.
• The worst effects of most depressions aren’t felt for months – this all happened in the past 72 hours.

Quote of the Week

“I’m inclined to propose and support a 25 basis point hike [at the March meeting].”
– Jerome Powell, Chairman of the Federal Reserve

Calendar of Events to Watch for the Week of March 7th

Q4 reporting season has basically wound down with over 99% of the S&P 500 having reported earnings, yet we still have a number of notable names left to report in retail, cyber security, and software. We’ll also get a fair amount of guidance updates this week from Shareholder and Analyst Day events from headliners like Disney, AT&T, Qualcomm, GE, eBay, Applied Materials, and others. On the economic front, the main event will be the Consumer Price Index (CPI) for February due out on Thursday. Will this finally be the report that shows a rollover in the inflationary data (as we are expecting) or will the data continue to confound?

Monday 3/7 – US Consumer Credit for January is expected to come in at $22b, up from $18.9b in the prior month’s report.

Tuesday 3/8 – Not much on the calendar domestically. Investors will be paying attention to overseas data with Chinese inflation data for February (CPI and PPI) as well as in the Eurozone where we’ll get final Q4 GDP and Household consumption data.

Wednesday 3/9 – The JOLTS jobs openings for January are expected to come in at 11.1m, up from 10.925m in the prior report.

Thursday 3/10 – The main event for the week will be the release of the February Consumer Price Index (CPI). Economists are predicting a fairly hot 0.7% month-over-month increase and 0.6% in the core (ex-food & energy).

Friday 3/11 – Consumer Sentiment for March is not expected to show much in the way of optimism. Last month’s 62.8 reading was below levels we saw during the pandemic.

Source: FactSet