So much has happened since my last quarterly update that it is hard to know where to start! I’ll apologize in advance for the lengthy read, but hopefully it will be worth your time.
The War
Recent indications from Russia is that a ceasefire is unlikely, despite embarrassing losses to the Ukrainian army. Whatever rhetoric comes from Russia in the near term could be a ruse, giving them time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality. For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.
The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP. Most corporations have little direct exposure to Russia. In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output, and it is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa. They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers.
Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit.
Inflation
Most of the increase in consumer prices has been concentrated in goods rather than services. This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. The pandemic caused spending to shift from services to goods. This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.
If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023.
The recent headline grabbing Inflation (over 8%!) should temporarily come down later this year as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. As inflation starts to pick up again, the Fed will likely resume hiking rates in 2024. This second round of Fed tightening is not anticipated by the markets, and so if it happens, it could be quite disruptive for stocks and other risk assets.
Pandemic
Just when we thought we could put the pandemic behind us, the latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America. This adds another risk to the global economy by exacerbating supply chain issues.
Bonds
The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates.
Markets are clearly worried about the latter scenario, evidenced by the 2/10 yield curve inverting earlier this month. However, with the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along. Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the (current record low) unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring.
The neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable.
Consumption
Household balance sheets are in good shape and consumers will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments. Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP.
The US Dollar
Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar. Note that the dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening. The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US. As we have been arguing in the past, the Dollar is probably overvalued by more than 20% on a Purchasing Power Parity (PPP) basis. Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply. Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record.
Earnings
Equity market moves mainly boil down to one thing: what is going to happen to company earnings in the near and long term. So all eyes will be watching Q1 2022 earnings results which will start rolling in during April, as well the “guidance” that companies give to future earnings. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year. Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.
Valuations are more attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment that might prevail in the second half of the year. US small caps also perform best when growth is strengthening and the dollar is weakening. In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 (small caps) currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul.
Globally, growth stocks have outperformed value stocks by 60% since 2017. This has left value trading nearly two standard deviations cheap relative to growth.
We will continue to carefully monitor market developments and welcome the opportunity to speak with clients in more detail about portfolio strategies.