February 2022 | Equity Commentary
Published on March 8th, 2022
Market volatility continued in February, as uncertainty over the pace of interest rate increases amidst a backdrop of rising inflationary pressures, Russia’s saber rattling, and ultimately, the invasion of Ukraine, weighed on sentiment. The S&P 500 declined about 3% for the month. With about a month’s lag, the market’s peak near year end coincided with the Federal Reserves shift to more hawkish monetary policy—the prospect of higher interest rates lowers what investors are willing to pay for future earnings, which makes many high valuation technology names go from looking attractive to looking expensive.
The ‘twin crises’ of high inflation and the Russian invasion of Ukraine may make it seem like the U.S. and global economy are not on solid footing. But the economic data appears to tell a different story. In February, nonfarm employment jumped by 678,000, which was well above economists’ forecasts, and 200,000 above the January pace.1 November and December jobs numbers were revised higher by 709,000, underscoring that the impact of the Omicron variant on the U.S. labor market was modest.1 The unemployment rate now sits at 3.8%, marking a continued decline even as the labor force participation rate has moved slightly higher. Monthly wage growth was largely flat in February alleviating some concern about a potential wage-price spiral driving inflation even higher.
The Omicron variant did appear to influence consumer spending in January, resulting in yet another month where goods spending outstripped services spending. With many consumers and workers opting to stay home, January’s inflation-adjusted personal spending rose by 1.5% from December, with goods spending jumping by 4.3% and services spending increasing by only 0.1%.2 Spending at restaurants, bars, hotels, and air travel all fell for the month. We believe future months will see a shift back to spending on services, which could help ease inflationary pressures on goods in the second half of the year. Business investment also rose in January. Durable goods orders ticked 1.6% higher month-over-month, while core capital goods orders for things like computer equipment and industrial machinery also went up by 0.7%, which does not include the investments being made in software, research and development, and labor.2
Finally, activity in the U.S. services sector continues to post what we believe to be strong readings, notwithstanding the flat consumer services number. Both the Institute for Supply Management and Markit surveys said the index for non-manufacturing activity was 56.5 in February3, a healthy reading in our opinion. Order backlogs at services businesses also increased in February, which points to persistent issues in supply chains but also to strong demand in the economy. The services sector accounts for roughly two-thirds of U.S. economic activity.
The U.S. economy is expanding at a healthy clip, but inflation persists as a headwind to growth. The Bureau of Economic Analysis’s headline price index rose 6.1% year-over-year in January, which marks the fastest rate of increase since 1982.3 Even with food and energy prices stripped out, the core price index rose by 5.2% y/y, underscoring the breadth of rising prices.3 A key risk to the longevity of the economic expansion is if the Federal Reserve continues to have to fight inflation with higher rates even as the economy begins to slow.
The Russian invasion of Ukraine is an unfortunate development that is weighing on investor sentiment. The response from the West is almost certain to be limited to economic sanctions on Russia, which could have significant impact on the Russian economy but should not cause much disruption to the global economy or financial markets. We believe, the U.S. economy in particular is at low risk—Russia and Ukraine combined make up far less than 1% of total U.S. imports and exports, and U.S. banks have very little direct exposure to Russia. Russia is the world’s third largest oil producer and the world’s largest exporter of natural gas, however, so there is legitimate concern that a supply shock—which could come via a broadening of Western sanctions, Russian curtailment, or supply lines severed in the fog of war—could inflict real economic pain. This outcome is certainly possible and would be bearish if that is ultimately where the escalations land. West Texas Intermediate crude oil is up about 26% in response, and natural gas prices in the EU have also jumped.
For now, sanctions have expressly omitted Russian oil and gas, and even the removal of most Russian banks from the SWIFT global financial transactions network leaves some banks still able to access and process oil and gas transactions. Europe does not appear likely to budge on the issue, as EU countries rely too heavily on Russian oil and gas to ban imports. The United States has less exposure, with roughly 3% of total U.S. crude oil imports coming from Russia. Some U.S. lawmakers are calling for a ban on U.S. imports of Russian fossil fuels, including crude oil, refined petroleum products, and coal, and this drumbeat has been growing louder in recent days. Half of the Russian government’s revenue comes from energy exports, so cutting off the West completely would be economically crippling, at a time when the Russian economy is already hobbled. Beyond oil and gas, the conflict may reduce the supply of other commodities produced in the region, such as wheat, metals, and fertilizers. This has sparked price increases in recent weeks. While they do not play the same critical role as oil and gas, the price increases add to inflationary pressures and may push the Federal Reserve to stay the course regarding its plans to tighten policy, broadly weighing on security prices.
Roosevelt Investments increased the amount of cash in our model equity portfolios in December and again in February, and in the near term we may continue holding higher cash than we usually hold. This is being done in order to try and help cushion the market’s volatility as the conflict runs its course. We continue to believe the U.S. economy is stronger than many appreciate, however, and that the risk of recession in the near term is low, in our view. War is ugly and disheartening, but regional conflicts historically have not derailed global economic activity. Looking back at conflicts since 1925 (when reliable S&P 500 data became available)—the Korean War, Vietnam, the Cuban Missile Crisis, the Iran/Iraq War, two U.S. wars in Iraq—only World War II directly resulted in a bear market, though oil embargoes associated with Arab-Israeli conflicts in the 1970s coincided with equity market turbulence in a way that bears some similarity to the current situation.4 Assuming this regional conflict does not turn global, we believe the fighting and associated sanctions will have only modest impact on the U.S. capital markets, although if high oil prices persist for a longer period of time, our view might change.
As of February 28th 2022