3 Keys in Changing Markets

The Russia-Ukraine war, accelerating inflation, and rising interest rates dominated headlines during the first quarter of 2022, which witnessed stocks and bonds uncharacteristically declining at the same time.  It’s no surprise to see stocks occasionally post losses given the average intra-year decline in the S&P 500 since 1980 is about 14%.  However, broad investment grade bonds – typically viewed as a ballast in a diversified portfolio – experienced their worst quarterly performance since 1980.  Bond prices tend to move in the opposite direction of interest rates, which spiked during the quarter.  For most investors, this atypical environment created a situation where there were very few places to hide.

Entering the year, the overall tenor of the financial markets had already begun shifting, with investors particularly concerned about increasing inflation and how the Fed was going to manage it. As we noted last quarter:

“Does the Fed actually have the stomach to tighten monetary policy and rein in inflation, even if that puts the economy and financial markets in jeopardy? The answer to that question will likely determine the fate of stocks and bonds in 2022.”

While markets were grappling with that important question, a serious geopolitical situation arose in late-February when Russia invaded Ukraine.  As if investors didn’t already have enough to contend with, they now had to consider the potential ramifications of a major conflict.

From a humanitarian perspective, the Russia-Ukraine war is unquestionably hugely tragic.  The last thing anyone wanted to see after two years of dealing with a devastating global pandemic was a catastrophic war.  However, from an investment standpoint, some historical perspective is warranted.  When looking back at 37 major geopolitical and historical events since World War II – including events such as Pearl Harbor, the 1987 stock market crash, and 9/11 – there are two key data points to keep in mind:  1) If the US wasn’t in a recession at the time of the event (as is currently the case), the S&P 500 was up an average of nearly 11% a year after the event.  2) If the U.S. was in a recession at the time of the event, the S&P 500 was down a little over 11% a year later.  But even in the latter situation, recall our earlier comment that the average intra-year decline in the S&P 500 over the past 40+ years is around 14%.  An 11% decline if we were to enter a recession would not at all be unusual for stocks.

Geopolitical Events
Source: Ryan Detrick, Chief Market Strategist at LPL Financial

The takeaway from all of this?  While events such as what we are witnessing in Ukraine can be highly emotional, successful investors would do well to separate “personal” from “portfolio”.  It’s also important to remember that not even Russia or Ukraine have any idea what to expect from one day to the next.  If these two countries don’t know what’s going to happen, how can investors make sound investment decisions based on this situation?  As the above data indicates, it’s usually best to tune out the geopolitical noise, the investment impact of which is usually short lived.

What About Inflation and Rising Rates?

Now, all of that said, this doesn’t mean the Russia-Ukraine war isn’t having any impact.  Both Russia and Ukraine are meaningful suppliers of a variety of important commodities, covering energy, metals, and agriculture.  For example, the two countries account for a combined nearly 30% of the global trade in wheat.  This is problematic given that inflation was already running at 40-year highs prior to the invasion.  If the supply of commodities is constrained longer-term, that could exacerbate the post-pandemic shortages which have already driven up the prices of everything from gas to food to cars.  Anyone who’s been to the gas pump, grocery store, or car shopping can quickly attest to the sticker shock.

The Consumer Price Index (CPI), a key measure of inflation, rose 7.9% from February 2021 to February 2022.  Increases were across the board.

Inflation
Source: J.P. Morgan Asset Management

We’ve previously explained the inflation dilemma:

“While some inflation should be expected in a healthy economy – which is why the Federal Reserve targets 2% annual inflation – too much inflation can be a negative. If consumers start balking at higher price tags on goods and services, they’ll stop buying. Corporate earnings will be negatively impacted. A reduction in corporate earnings could lead to layoffs, less business spending, and reduced investment – all negatives for the economy. Which brings us to the aforementioned Fed.”

Ah, yes, the Fed.  There’s no question the Federal Reserve had a very difficult task in navigating the various impacts of the pandemic.  In a nutshell, the Fed made the decision to support the economy and financial markets at all costs and deal with any negative ramifications later.  Well, “later” is now.  The Fed’s actions have clearly contributed to rising inflation and they now find themselves in the difficult spot of attempting to rein in surging prices without throwing the economy into recession.  In summary, if the Fed fails to bring inflation under control, the economy could buckle. However, if they’re too aggressive in stamping out inflation… well, the economy could still buckle.

In March, the Fed raised interest rates for the first time since 2018.  Six additional rate hikes are expected the remainder of this year.  Higher interest rates impact everything from mortgages to auto loans to credit cards.  Increased rates also make financing more expensive for businesses, who borrow money to finance daily operations and invest in longer-term projects.  All of this can have the effect of slowing the economy since consumers and businesses spend less when faced with higher rates.  A reduction in consumer and business spending theoretically helps reduce inflation, since there is less demand for goods and services.  Less demand puts downward pressure on prices.  The Fed’s dilemma should now be apparent:  they have to strike the right balance between bringing inflation under control, while not crashing the economy.

Investors aren’t so sure the Fed will find that proper balance, which can be seen in the yield curve.  The yield curve is simply a plot of interest rates on similar quality bonds of different maturity dates.  The yield curve is usually upward sloping, with longer-dated bonds yielding more than shorter-dated bonds.  That makes sense because investors typically demand higher interest rates if they’re lending money for a longer period of time.  A longer period of time means more potential for something to go wrong, such as not getting paid back in full.  Recently, the yield curve inverted, meaning that shorter-term yields are higher than longer-term yields.  For example, the 10-year U.S. Treasury recently yielded less than the 2-year U.S. Treasury.  Notably, an inverted yield curve has preceded every economic recession since the 1970s (though it’s important to note that not every yield curve inversion has preceded a recession).

An inverted yield curve signals that the market anticipates slower growth ahead, possibly the result of a Fed policy error.  In other words, one interpretation of the current yield curve is that the Fed is already getting too aggressive with raising rates, which could throw the economy into recession and result in lower future interest rates.  This all comes back to the question of, “does the Fed have the stomach to tighten monetary policy and rein in inflation, even if that puts the economy and financial markets in jeopardy?”.

Further complicating matters is the upcoming mid-term elections.  Which is the lesser of two evils for politicians in power?  Is it rampant inflation or potentially volatile and declining financial markets?  While the Fed is apolitical, Washington has a way of exerting pressure when needed.

So, What Should Investors Do?

Many investors, and certainly investors born after say 1970, have never had to contend with an inflationary environment and a prolonged period of rising rates (which may or may not come to fruition).  The Fed themselves haven’t had to contend with this level of inflation in four decades.  Toss in the Russia-Ukraine war and there’s no question financial markets are facing some headwinds at the moment.  The Fed is currently messaging that they do, in fact, have the stomach to tighten monetary policy and rein in inflation.  The question is whether their approach will put the economy and financial markets in jeopardy.

We continue to believe that we’re now in an environment where diversification, discipline, and patience are more critical than ever.  The favorable monetary policies of the past decade-plus appear over.  That doesn’t necessarily mean stocks and bonds will decline, but the strong market tailwinds have dissipated.  We know there is a higher level of change and complexity in the financial markets right now, hence, this commentary is much “deeper in the weeds” than we would like it to be.  Markets have become more difficult to navigate, which is why we at the ETF Store are here for you.