by William Henderson, Chief Investment Officer
All major market indexes fell last week adding to an already poor start of the year in equity markets. Even a wild upward rally on Wednesday was not enough to thwart negative returns across the board. The Dow Jones Industrial Average fell -2.0%, the S&P 500 Index fell -2.9% and the NASDAQ lost -3.5%. Year-to-date returns have stayed well into negative territory for all three major market indexes. Year-to-date, the Dow Jones Industrial Average is down -8.9%, the S&P 500 Index is down -11.5% and the NASDAQ has moved into technical “Bear Market” territory being down -17.8%. The Russia / Ukraine war has taken a triple toll on the markets: pushing oil higher, further impacting overall inflation, and finally impacting U.S. Consumer Sentiment. Inflation fears and this week’s FOMC (Federal Open Market Committee) meeting, where markets are expecting the Fed to raise interest rates for the first time in three years, negatively impacted U.S. Treasury bonds leaving us with a very volatile week in fixed income markets. After finishing the previous week at 1.73%, the yield on the 10-Year U.S. Treasury bond jumped last week by 27 basis points to close at 2.00%. (See the chart below from the Federal Reserve Bank of St. Louis).  

The yield on the 10-Year U.S. Treasury is now well off the dramatic all-time low of 0.50% hit during the peak of the COVID-19 outbreak and is working its way back to pre-pandemic levels. However, even as market participants are seeing higher yields, remember that if fear and uncertainty exist investors will need the risk management provided by fixed income securities. 

As mentioned, inflation, as measured by the U.S. CPI (Consumer Price Index), for February 2022 came in at 7.9% versus 2021, a 40-year high. All sectors, led by higher energy prices, showed increases including food and rent. See the chart below from FactSet showing oil prices (WTI Crude – left scale) and Inflation (U.S. CPI – right scale) and their close correlation. 

Critically, understand that the inflation data is backward looking information from February 2022 and therefore has not even considered the recent run up in oil prices during the month of March. This gives us a lot more confidence around the Fed’s plan for higher interest rates soon. 

Another data point that has us worried was last week’s release of the March preliminary University of Michigan Consumer Sentiment Index (previously called Consumer Confidence Index), which came in lower than expected at 59.7, versus a Bloomberg estimate of 61.0. At that level, the measure of consumer sentiment is the lowest since 2011 and well off the highs hit at the beginning of 2021 when COVID-19 was waning, and the geopolitical climate was a lot calmer. Throw in significantly higher oil prices and you get a worried consumer. (See the chart below from YCharts and Valley National Financial Advisors showing U.S. Consumer Sentiment since April 2021). 

We always talk about the efficiency of the markets, and we believe this to be the case today as always. Last week’s wild ride in the markets saw a 650-point (+2%) swing in the Dow Jones Industrial Average on Tuesday based on rumors of positive comments from Russian leader Vladmir Putin and hints of a ceasefire. This upward move was quickly reversed when peace talks fell apart and instead Russian invasions efforts into Ukraine intensified. As we write this report, ceasefire whispers are again underway, and markets are rallying. The international pressure on Russia and by decree on Vladmir Putin are enormous. Aside from blocking monetary transactions on SWIFT, an oil embargo by the west and severe sanctions elsewhere, the U.S. Department of Justice announced an intense “hunt” for assets held in the U.S. belonging to Russian Oligarchs. Putin was desperate enough to ask China for military and economic aid for its Ukraine war. This action was met swiftly with rebuke from Washington strongly advising China against any assistance whatsoever with Russia. In fact, this week, Washington officials are scheduled to meet with Chinese counterparts in Rome to discuss the war.  

It is difficult to see any outcome for Russia that ends well. The only plausible endgame is for a negotiated solution between Ukraine and Russia that gives Putin something yet allows Ukraine to remain and independent state. Unfortunately, if the war drags on, uncertainty and fear will persist, and the markets will react accordingly. Beyond the humanitarian impact the war is having, prices of such commodities as oil, natural gas and palladium are skyrocketing and inflation is the result which further impacts consumers and eventually economic growth. Expect inflation to continue for longer but the Fed will be on the move this week and their new objective will be to combat inflation. This week’s FOMC meeting will be important for reasons beyond the expected 25 basis point rate hike. The markets will be watching for language around the pace of future hikes and the scope of balance sheet reduction. This may add some calm and clarity to the markets, but it could be overshadowed by any breakdown in peace talks or unwelcomed involvement from China.  

by William Henderson, Chief Investment Officer
While domestic resiliency was present last week with strong jobs and earnings numbers, volatility related to the war in Ukraine won the week over and all three major market indexes closed lower. The Dow Jones Industrial Average fell -1.3%, the S&P 500 Index also fell -1.3% and the NASDAQ fell by -2.8%. Year-to-date returns continue to be unfavorable across all sectors and indexes. Year-to-date, the Dow Jones Industrial Average is down -7.2%, the S&P 500 Index is down -8.9% and the NASDAQ is down -14.8%. As a result of the uncertainty, fear, and volatility the “risk-off” trade occurred in the bond market and the prices of U.S. Treasury bonds moved dramatically higher sending yields sharply lower. The yield on the 10-Year U.S. Treasury fell 23 basis points from last week to close the week at 1.74% – a stunning move considering the path the Fed has laid out this year for interest rates. What this move tells us is that the safety and liquidity of U.S. Treasury bonds currently trumps everything else, including the Fed’s well-telegraphed plan of raising short-term interest rates. 

The move in U.S. Treasury yields further “flattened” the yield curve. If the yield curve (the measure of 10-year yields minus two-year yields) is flattening, it indicates the yield spread between long-term and short-term bonds is decreasing. The yield curve is often a reliable indicator of economic and monetary policy conditions. The recent yield curve flattening is a result of two-year Treasury bond rates rising in anticipation of Fed policy rate hikes; while 10-year rates declined, due to the flight to safety trade resulting from increased concerns over the war in Ukraine. (See the chart below from the Federal Reserve Bank of St. Louis showing the 10s – 2s spread and the dramatic decline since mid-year 2021). 

While a downward movement in the 10s – 2s spread has historically preceded an impending recession, we do not believe this to be the case now due to the sound underlying fundamentals of the U.S. economy including strong continued employment gains and near-record profits by corporations. According to FactSet, with the recent fourth quarter 2021 earnings season concluding last week, companies in the S&P 500 recorded average earnings gains of 31% over the fourth quarter of 2020. With such solid underlying economic fundamentals, why are the markets exhibiting such volatility and negative returns year-to-date? Fear and uncertainty!  These are and will always be the worst thing for markets. When you cannot measure the risk, the risk-off trade prevails, and investors sell stocks and buy bonds. Additionally, the Ukraine war and resulting severe sanctions on Russia are impacting many commodity prices, further exacerbating already hot-running inflation. This reaction again may be more than necessary, while oil spikes occurring are understood as Russia is a large supplier of oil to the world, their impact on the global economy is much less than one would think. See the chart below from Haver Analytics and Goldman Sachs showing Russia’s contribution to the global economy and Russia’s production percent of important commodities.   

Presently, oil is the biggest shock to the market and the price of WTI Crude has spiked to $130/barrel. Oil, as we have stated many times, is a key component in many household and industrial goods way beyond refined fuels for planes, trains, and automobiles. Oil is used in clothing (nylon & polyester), plastics, agriculture (pesticides & fertilizers), tools and toys – frankly – it is everywhere and when the price of oil rises, inflation is the result. These events – global slowdown in activity due to sanctions on Russia and the resulting inflationary impacts – puts the Fed in a quandary. Fed Chairman Jay Powell must raise rates to combat inflation but now he also risks slowing the economy at a time when things are precarious as the Russia/Ukraine war evolves. And thus, we have the uncertainty that the markets hate. 

Western nations are united in sanctioning Russia for starting the war with Ukraine. China, a strategic and economic partner of Russia, has not officially condemned the incursion but has stated succinctly that “all sides exercise restraint and avoid escalation.” While not a stern rebuke like the west, it may be the best we can expect from China, who selfishly understands any global economic slowdown will directly hurt their pocketbook. The obvious question is which side yields first – Russia led by Vladimir Putin, a former KGB Officer or Ukraine led by Volodymyr Zelenskyy, a former TV actor and his western “allies.” Again – uncertainty, and again – volatility in the markets.    Balanced portfolios with risk management tools like bonds help in times like this. What helps best is a level head and a long-term outlook on investments.