“It is appallingly obvious that our technology exceeds our humanity.” – Albert Einstein
First Quarter Recap
Almost all financial market indices fell during the first quarter. Equities were generally lower: The S&P 500 dropped 4.6% while the Nasdaq 100 dipped 20% into bear market territory before rebounding in March.
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Foreign markets were also down, with the UK and Australian markets bucking the trend and closing higher.
The big surprise were the bond markets. Both longer maturity Treasuries and corporate bonds suffered their worst quarter in almost four decades. However, commodities provided a diversifier with metals such as copper moving higher and the energy complex (oil, natural gas and the like) spiking due to the Ukrainian war. Meanwhile, the U.S. dollar and gold proved to be safe havens once more.
Overshadowing all is the Covid-19 pandemic which has receded in most countries, China being a notable exception. Although variants of the Omicron strain are still proliferating, they appear to be milder than earlier strains. This supports the argument that the disease is evolving much like the influenza viruses a century ago with annual vaccinations likely becoming the norm.
Inflation and the War in Ukraine
The year started with the December Federal Open Market Committee (FOMC) meeting proving even more hawkish than Chairman Powell’s press conference. Investors began to price in more tightening by the Fed, and reports continued to show an increase in inflation. Supply chain issues, as well as labor shortages and the rising price of housing persisted. Higher valuation stocks such as technology sold off as higher interest rates discounted the earnings stream from future years.
By mid-quarter, the markets recalibrated to the new reality, only to sell off again after Russia invaded Ukraine. So far, the war has demonstrated the stiff resistance by the more nimble and opportunistic Ukrainian defenders, as well as numerous strategic errors by the larger but lumbering Russian army. It appears that most of the country, including the capital Kyiv, are now safe from a takeover, though Russian leader Putin is now concentrating his forces on the eastern provinces where supply lines are shorter and his chances for success are higher.
Western nations have responded to the attack by sanctioning the Kremlin economically. This has driven up the price of oil and natural gas, of which Russia is a leading exporter. Also, prices are spiking because Ukraine, a leading supplier of wheat and corn, has not been able to plow its fields nor transport grain from its ports because of Russian attacks. Recently, peace talks have also been derailed due to reports of civilian atrocities committed by invading Russian forces.
Although inflation may soon see a peak, it still appears that the descent will be slow and “sticky”, due to rising wages and housing prices. Any new negative surprises from the Ukraine war will also push the peak out further.
The Effect on Economic Growth
All this has caused growth in the Eurozone (minus the UK due to Brexit) to slow significantly. Countries such as Germany and Italy have imported a substantial portion of their energy from Moscow and now must quickly find other suppliers. Economic growth in China has also been problematic because of Covid-19 outbreaks, especially in Shanghai, the most populous city in the country. The U.S. has not been impacted as hard, at least not yet. We are fortunate to be largely self-sufficient in energy resources, consumers are still flush with $2.5 trillion unspent stimulus money, and the labor market remains strong.
There has been much attention devoted lately to the yield curve. Various maturities have been showing an inversion, or a negative slope where shorter maturities have higher yields than longer ones. In the past, inverted yield curves have often preceded recessions (with a lag time up to two years), although it is debatable whether this is causation – the inverted curve actually causes the recession — or merely a correlation between the two. The curve with the best predictive record is that of the 90-day Treasury Bill to the 10-year Treasury Note, which currently has a steeply positive slope.
The Outlook
Because of these factors, we do not foresee a recession this year or next, although the probability of one occurring by late 2023 has increased about 30%. We will continue to monitor the situation since much can happen between now and then. In the meantime:
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- We have reduced our U.S. core equity exposure slightly but still favor equities over bonds and other asset classes
- We favor stocks with reasonable valuations and good pricing power to counter higher input prices
- We have initiated positions in domestic natural gas, defense and agricultural oriented companies, in recognition of the longer-term changes caused by the war in Eastern Europe
- With interest rates rising to more attractive levels, we have once again started buying municipal bonds for our Hawaii-based clients in high tax