Weekly Summary: February 28 – March 4, 2022

Key Observations:

1. The Russia-Ukraine war has led to many “hard day[s] on the planet” – especially for the Ukrainian people. Increasing levels of uncertainty have exacerbated financial market volatility.
2. As we indicated in last week’s commentary, these increased levels of uncertainty, which encompass an increasing number of variables, have led us to consider stock selection across ALL sectors. It has become too difficult to foresee the outcome and timing of the war and its repercussions.
3. The quicker the resolution of this war, the more likely our prior forecasts might be realized.
4. Given incoming economic data, inflation movements and war developments, we suppose that the Federal Reserve (Fed) will remain as hawkish as possible. We understand that it would take very severe and unexpected developments to dissuade the Fed from its projected path of tightening its monetary policies.

The Upshot: We remain encouraged by the resiliency of the U.S. economy and we remain hopeful for a somewhat “quick” resolution to the war. However, almost no development or outcome would surprise us at this point. A well-diversified portfolio especially is important at times of great uncertainty, such as now. We would continue to focus on selecting attractively-priced stocks on a risk/reward basis with underlying strong balance sheets and sustainable cash generation. Additionally, we would maintain a relatively broad-based exposure to commodities in a diversified portfolio. Once the Russia-Ukraine war is resolved – and it is resolved in a manner to allow the prior economic trends to resurface – we would be more confident that our pre-war forecasts could be realized in the intermediate-to-long term. These forecasts included a weaker U.S. Dollar (USD), higher interest rates, robust global economic growth, relative outperformance of many international equities relative to U.S. equities, and generally rising but volatile commodity prices. In the meantime, Fed chair Powell’s Wednesday’s testimony left little doubt that the Fed will raise the federal funds rate by 25 bps at its mid-March meeting.

What’s so “Hard?”

The sentiment expressed in the song “Hard Day on the Planet” by Loudon Wainwright III has been shared by many of us over the past two weeks. “It’s been a hard day on the planet; It’s getting harder to understand it; Things are tough all over on earth.” At this point, it remains very unclear how many more “hard days” the world will have to endure due to Russia’s invasion of Ukraine. Of course, Ukrainian people continue to suffer the hardest days. The end result and the ultimate consequences of this war remain uncertain as well. As we noted in our last week’s commentary: “It is our position that once the shooting and/or war begins it is almost inevitable that unforeseen developments and consequences follow.” Such an unforeseen development occurred at the end of this week with Russia’s attack on and gaining control of Ukraine’s largest nuclear facility. According to CNBC’s account on March 4, a fire at the facility was extinguished and radiation levels were described as normal. The European Union’s top diplomat Josep Borrell said that the shelling and resulting fire at this facility could “endanger the whole of Europe.” The six reactors at this site produce about half of Ukraine’s electricity. We speculate that the Russian president Vladimir Putin must be now asking himself: “How much is it all worth?”

Financial Market Volatility

The financial markets also are experiencing rather “hard” days due to extreme volatility and “dislocation” in certain market pricings. The drop in the 10-year Treasury yield of 25 basis points (bps) over the first two days of this week before rebounding somewhat on the next day is such an example. Similarly, J.P. Morgan observed on March 2, that the 10-year real Treasury yields fell from -43 bps on February 16 to -91 bps on March 1. We continue to view such decreases in yields as temporary and mostly due to uncertainties about the Russian-Ukrainian war. We also agree with Goldman Sachs’ contention on March 1 that the “thinning” of liquidity in fixed income markets over the past week increased the risks of disorderly price action. We imagine the possibilities of “disorderly” price action in many other assets and markets due to liquidity issues, one-sided positioning, surprising developments and news items.

Focus of Financial Markets

As long as the war is ongoing, we suspect that the focus will be on war-related developments most days. Key drivers of financial markets could center mostly around the duration and dislocation of commodity supply disruptions. However, on days when there are no new war developments, the focus could shift perhaps to more general economic growth considerations or a consideration of Fed policies. We presume that such a day occurred midweek. Many analysts interpreted Fed chair Powell’s comments in the U.S. House of Representatives as more dovish than many market participants were expecting. The February ADP report of better-than-expected increases in private payrolls and the very substantial positive revisions for January helped create a relatively more positive atmosphere under which equities could rally and yields could rise even as many commodity prices extended their ascent.

BLS February U.S. Employment Report

The “official” employment report was released by the U.S. Bureau of Labor Statistics (BLS) on Friday. It more than confirmed the robust ADP report from midweek. Total nonfarm payroll increased by 678,000 in February, which included 654,000 private sector jobs compared to expectations in the roughly 500,000 range. The leisure and hospitality sector accounted for 179,000 of these jobs. The prior two months of jobs data was revised higher by a total of 92,000. The unemployment rate dropped to 3.8% from 4.0% in January. The basically flat (+0.03% increase) average hourly earnings on a month-to-month comparison was also a surprise compared to expectations of an increase of 0.5%. The year-over-year increase was 5.1%.

Powell’s House of Representatives Testimony

Our interpretation of Powell’s testimony in the House of Representatives was somewhat different than the “market’s” interpretation. We perceived some elements of Powell’s testimony as dovish and other parts as more hawkish. In his prepared testimony, Powell reiterated perhaps his guiding principle in assessing the trade-off between economic growth and inflation. “We know that the best thing we can do to support a strong labor market is to promote a long expansion, and that is only possible in an environment of price stability.” A key part of this strategy is to prevent higher inflation expectations from becoming “entrenched.” Powell then acknowledged that the war’s effects and sanctions-related developments in regard to Russia remain “highly uncertain”, and that under such circumstances the economy can evolve in “unexpected ways.” “We will need to be nimble in responding to incoming data and the evolving outlook,” Powell concluded.

Dovish Interpretation

In much of his actual testimony, Powell repeatedly noted that the Fed would proceed “carefully” as it learned more about the war and its effects. He stated that he was “inclined” to propose and support a 25 bps hike at the Fed’s upcoming March 15-16 meeting as the “appropriate” increase. Although we never expected that the March hike would be 50 bps, the “market” was relieved that it would be only 25 bps. We have little doubt that Powell’s consideration of the war and his assurances that the Fed would proceed “carefully” in implementing its tightening and less accommodative policies was also interpreted as dovish. Powell stated that the Fed did not want to add to “uncertainty” and that monetary policy is “never on autopilot.”

Hawkish Interpretation

But there was a hawkish side to Powell’s testimony as well. Powell all but admitted that the Fed was behind the curve in implementing a less-accommodative set of tightening monetary policies. He acknowledged that supply side constraints were more “persistent” than the Fed had imagined. Powell emphasized that the Fed needs to move away now from its highly accommodative monetary policies. Furthermore, Powell made it very clear that monetary policy mostly affects demand and has very little influence on the supply side of the equation. As we have noted previously, the “excess” demand for goods in lieu of services has been a big part of the inflation story, along with supply disruptions and constraints. Chair Powell even characterized elevated inflation as the “collision of supply issues and excess demand.” Powell then intimated that the Federal Open Market Committee (FOMC) “would be prepared to move more aggressively by raising the federal funds rate more than 25 bps at a meeting or meetings,” if inflation was stronger than FOMC participants expect. Moreover, Powell referred to the consecutive Fed hiking pace of the early 2000’s as an example of the possible pace of rate increases – “rate hikes at every meeting.” Powell noted also that higher energy prices, in part due to the war and sanctions against Russia could “push up headline inflation and … [would] weigh on spending.”

We doubt that a Fed which acknowledges its readiness to hike the federal funds rate in increments of more than 25 bps when “appropriate” should be characterized as dovish. Powell knows that the Fed is behind the curve and that he needs to “anchor” inflation expectations. We surmise that the Fed’s job will become increasingly difficult if the Russia-Ukraine war persists. Furthermore, we remain convinced that peak or near-peak inflation could be pushed out further along with an extended war. A higher-than-otherwise pace of inflation would then most likely be accompanied by slowing global economic growth. Given the Fed’s belief that the best way to prolong economic growth is through an environment of “price stability,” we postulate that the Fed will remain on a more aggressive tightening path than is expected now by the consensus of investors and analysts.

Russia-Ukraine War Equals More Uncertainty

We agree with Powell that the war has heightened the level of uncertainty in regard to inflation and global economic growth projections. The last two weeks have highlighted possible scenarios in financial markets. Based on the markets’ reactions during this time frame and to the extent the war and/or sanctions persist, we anticipate movements in several key market indicators. Although most likely delivering lower-than-anticipated growth in an erratic fashion, we expect that the USD will strengthen and that U.S. equities will outperform European and emerging market (EM) equities on a relative basis. Furthermore, we suppose that interest rates will be volatile with a downward trajectory and with a flattening yield curve and that commodities will exhibit volatility as well – but with a continuing upward bias. We foresee that this scenario could include higher and more-prolonged rates of inflation and slowing global economic growth.

Quantifying Increasing Escalation of Ukraine War

Russia is the world’s second largest producer of oil and the biggest supplier of natural gas to Europe, accounting for about 40% of Europe’s natural gas supplies shipped through pipelines. The Ukraine war and Russian sanctions have had a dramatic effect on these energy prices already. On March 3, Goldman Sachs attempted to quantify more specifically the effects from further escalations in the war or from longer supply disruptions. Even though crude oil prices have risen about 20% to just below $115 per barrel (bbl) recently, Goldman Sachs considered the possibility of $150/bbl levels. At those levels, Goldman calculated a further rise of more than 23 bps in core PCE levels of inflation and an increase of over 130 bps to headline PCE inflation. “Such an increase would further increase the risk of entering a wage-price spiral, because near-term consumer and business inflation expectations are already very high and particularly tend to be sensitive to energy prices.” Goldman estimated that $150/bbl crude oil prices would reduce U.S. GDP growth by 0.5%.

Source: Goldman Sachs US Daily: Quantifying the US Growth and Inflation Risks from the War in Ukraine (Briggs) (3/3/2022)

Commodities Exported from Russia and Ukraine

As we have highlighted in our previous commentaries, Russia and Ukraine are also exporters of many other materials besides oil and gas. These include many base metals like copper, aluminum and lead, as well as agricultural products, such as wheat and corn. The prices of many of these commodities have risen dramatically this year, and especially over the past two weeks. Supply disruptions in key materials needed for auto production could lead to continued elevated auto prices. Possible disruptions to shipping routes could increase delivery times and raise transportation costs. We suppose that consumer sentiment should diminish under this scenario as many recent surveys have shown a lowering of consumer confidence as inflation rates have increased.

Source: Goldman Sachs US Daily: Quantifying the US Growth and Inflation Risks from the War in Ukraine (Briggs) (3/3/2022)

Continued Positive U.S. Economic Data

Virtually all of the recently released economic data has continued to indicate robust global economic growth, elevated inflation rates, tight labor markets and increasing wages – particularly in the U.S. Further data includes easing but still constrained supply disruptions and/or constraints, as well as commodity shortages in general – relative to recent levels of demand. The generally acknowledged underinvestment in many commodities over approximately the last ten years could make it difficult for the commodity suppliers to respond to shortfalls in a timely manner. To the extent that the war will not be very prolonged, we conjecture that our pre-war forecasts will be able to be reinstated given the resiliency that many economies have shown – rebounding from relatively short-lived infections and negative effects due to the COVID-19 Omicron variant. Although most European and EM economies may take longer to recover from the war and its related effects when compared to the U.S., we assume that global economic growth will increase relative to U.S. economic growth rates at some point. We maintain our faith in generally higher, but volatile, commodity prices over the intermediate-to-long term.

USD, International Equities, Interest Rates

In its report of February 28, JPM calculated that a “broad-based” USD has strengthened about 2% for every 1% downgrade in global economic growth rates. We still suppose that USD will show a downward trajectory sometime this year when the pick-up in global economic growth becomes more evident. At that time, we presume that the relative outperformances of many international equities will be able to reassert themselves as they outperformed earlier this year. We assume interest rates will resume an upward trajectory at some point as well.

U.S. Yield Curve

Our notion that the yield curve could flatten in the near term when economic growth fears surfaced in investors’ perceptions was illustrated by the spread between the two-year and the 10-year Treasury yields shrinking from the closing level of 42 bps on February 25, to 33 bps at the close of March 3. We continue to conjecture that the shape of the yield curve will continue to fluctuate depending on the latest market perception of economic growth rates. In the current environment, the war seems to be of paramount importance in this regard.

U.S. ISM Manufacturing PMI

Nevertheless, the ISM Manufacturing PMI February U.S. survey released early this week was better than expected as U.S. manufacturing activity continued to expand. New orders and backlogs of orders grew substantially as production lagged somewhat. Prices remained very elevated. The release of this survey was accompanied by its official statement that the “U.S. manufacturing sector remains in a demand driven, supply-constrained environment.”

Source: J.P. Morgan US: ISM manufacturing survey moves up to 58.6 (3/1/2022)

U.S. ISM Services PMI

Although the ISM Services PMI February U.S. survey released later in this week was below expectations, the results appeared “…to be impacted by supply chain disruptions, capacity constraints, inflation, logistical challenges and labor shortages. These conditions have affected the ability of panelists’ business to meet demand, leading to a cooling in business activity and economic growth.” Perhaps the difficulty of finding workers in the services sector is more acute than in the manufacturing sector. This might explain why the rate of growth in the services sector slowed for the third consecutive month in February and showed the slowest rate of growth since February of 2021. But the slowing rate of expansion was still robust and above the long-run average of expansion. Supply constraints were also evident by the prices paid index rising 0.8% over January’s level to 83.1. Even as new orders declined, the backlog of orders rose by the largest monthly increase since February of 2020. However, it should be noted that about 40% of respondents indicated that they do not “measure” backlog of orders.

Source: J.P. Morgan US: ISM services report disappoints (3/3/2022)

Fed’s Beige Book

The Fed’s Beige Book for February was released midweek. This compilation of anecdotes compiled by the twelve Regional Banks of the Federal Reserve in their own surveys of business executives denoted an overall U.S. economy that was expanding at a “modest to moderate pace.” All twelve districts reported that supply chain issues and lower-than-needed business inventories continued to restrain growth – especially in construction activity. The economic outlook over the next six months was stable to generally optimistic. It was notable that most reports highlighted an elevated degree of uncertainty in regard to future business activity.

Resilient U.S. Economy

After reviewing many U.S. economic reports released this week, we feel comfortable characterizing the U.S. economy as resilient and growing at a robust rate. Supply constraints – including a very tight labor market – appear to be restraining an even stronger rate of economic growth. Strong demand relative to “weak” supply apparently continues leading to elevated levels of inflation as output is curtailed. Elevated inflation rates and supply issues seem to be increasing uncertainty about future business activity. We suppose that the war could add substantially to uncertainty levels.

Bottom Line

Given the myriad of uncertainties at present, we assume continued volatility across virtually all financial markets. These increased uncertainties as of last week have led us to consider ALL sectors in our search for the most-attractively-priced stocks on a risk/reward basis. We contemplate a more difficult period in investing in commodity-linked equities relative to their underlying commodity prices.

In the intermediate-to-long term, we continue to favor diversified portfolios that include selected European and EM equities for long-term investors. Companies with strong balance sheets and strong cash-generating attributes could become increasingly attractive. Eventually, we continue to foresee higher interest rates, higher-than-consensus inflation rates, robust global economic growth and weaker USD, as well as strong, but volatile commodity prices. Our forecast of robust global economic growth, a weaker USD and relative outperformance of European and EM equities relative to U.S. equities would be most at risk if the Ukrainian war persists for an extended length of time and/or results in potentially unforeseen consequences. In general, interest rates could then be lower as well, relative to our pre-war forecasts.

Source: Factset Earnings Insight (2/25/2022)

Source: J.P. Morgan US Market Intelligence: Morning Briefing (3/2/2022)

Definitions

Real Interest Rate (Real Yield) – A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate reflects the rate of time-preference for current goods over future goods. The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate.

Positioning – Investors taking a position in a security. This could be a long position where investors expect price appreciation, or a short position where investor expect prices to fall.

ADP – The ADP National Employment Report is a monthly report of economic data that tracks the level of nonfarm private employment in the U.S.

ISM Services PMI – The ISM Services PMI, also known as he ISM Non-Manufacturing Index, is an economic index based on surveys of more than 400 non-manufacturing firms’ purchasing and supply executives.

ISM Manufacturing Index (ISM) – The ISM manufacturing index, also known as the purchasing managers’ index (PMI), is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is considered to be a key indicator of the state of the U.S. economy.

The Purchasing Managers’ Index (PMI) – The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting. The purpose of the PMI is to provide information about current and future business conditions to company decision makers, analysts, and investors.

Federal Funds Rate – The term federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

Yield Curve – A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.

Dove (Dovish) – A Dove is an economic policy advisor who promotes monetary policies that usually involve low-interest rates. Doves tend to support low-interest rates and an expansionary monetary policy because they value indicators like low unemployment over keeping inflation low. If an economic suggest that inflation has few negative effects or calls for quantitative easing, then they are called a dove or labeled as dovish.

Inflation Hawk (Hawkish) – An inflation hawk, also known in monetary jargon as a hawk, is a policymaker or advisor who is predominantly concerned with the potential impact of interest rates as they relate to fiscal policy. Hawks are seen as willing to allow interest rates to rise in order to keep inflation under control.

“Behind the Curve” – slower about doing something than other people, companies, etc.

Federal Open Market Committee (FOMC) – The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines the direction of monetary policy specifically by directing open market operations. The committee is made up of 12 members: the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve Bank presidents on a rotating basis.

bbl – An abbreviation for oilfield barrel, a volume of 42 galUS [0.16 m3].

Tightening Monetary Policy – Tight monetary policy is an action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth. Central banks engage in tight monetary policy when an economy is accelerating too quickly, or inflation is rising too fast. Central banks often use the federal funds rate as a leading tool for regulating market factors. The Fed may also raise reserve requirements for member banks or performance open-market operations by selling U.S. Treasuries to large investors.

Core Inflation – Core inflation is the change in the costs of goods and services but does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI), which is a measure of prices for goods and services.

Headline Inflation – Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics. The CPI calculates the cost to purchase a fixed basket of goods, as a way of determining how much inflation is occurring in the broad economy. The CPI uses a base year and indexes the current year’s prices according to the base year’s values.

Personal Consumption Expenditures (PCE) – Personal Consumption Expenditures (PCE) refers to a measure of imputed household expenditures defined for a period of time.

Beige Book – The Beige Book is a report produced and published by the U.S. Federal Reserve. The report, referred to formally as the Summary of Commentary on Current Economic Conditions, is a qualitative review of economic conditions. The Beige Book is published eight times each year before meetings held by the Federal Open Market Committee (FOMC) and is considered one of the most valuable tools at the committee’s disposal for making key decisions about the economy.

Brent Crude – Brent Crude may refer to any or all of the components of the Brent Complex, a physically and financially traded oil market based around the North Sea of Northwest Europe; colloquially, Brent Crude usually refers to the price of the ICE Brent Crude Oil futures contract or the contract itself.

West Texas Intermediate (WTI) Crude – West Texas Intermediate can refer to a grade or a mix of crude oil, and/or the spot price, the futures price, or the assessed price for that oil; colloquially WTI usually refers to the price of the New York Mercantile Exchange WTI Crude Oil futures contract or the contract itself.

The Energy Select Sector SPDR Fund (XLE) – XLE seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Energy Select Sector Index (the “Index”). The Index seeks to provide an effective representation of the energy sector of the S&P 500 Index.

OIH – VanEck Oil Services ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the MVIS® US Listed Oil Services 25 Index (MVOIHTR), which is intended to track the overall performance of U.S.-listed companies involved in oil services to the upstream oil sector, which include oil equipment, oil services, or oil drilling.

XOP – The SPDR® S&P® Oil & Gas Exploration & Production ETF seeks to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P® Oil & Gas Exploration & Production Select Industry® Index (the “Index”). The S&P Oil & Gas Exploration & Production Select Industry Index (the “Index”) represents the oil and gas exploration and production segment of the S&P Total Market Index (“S&P TMI”)

IHS Markit PMI – Purchasing Managers’ Index™ (PMI™) data are compiled by IHS Markit for more than 40 economies worldwide. The monthly data are derived from surveys of senior executives at private sector companies and are available only via subscription. The PMI dataset features a headline number, which indicates the overall health of an economy, and sub-indices, which provide insights into other key economic drivers such as GDP, inflation, exports, capacity utilization, employment and inventories. The PMI data are used by financial and corporate professionals to better understand where economies and markets are headed, and to uncover opportunities.