Rarely do we see the confluence of so many factors in such a short timespan to affect the market either positively or negatively as we have seen in Q1. As 2021 was coming to a close essentially with every market index at or near record highs, the expectation was that it would be difficult continue the torrid upward trend, even if the economy and the world were to make the transition from COVID dominated concerns to a broader reopening of the economy. Four factors, however, became far more powerful than almost anyone predicted at the beginning of 2022: inflation, upwardly interest rates, oil prices and hence gas prices spiking at the pump, and finally, the Russian invasion of Ukraine. Apart from the upward pressure on interest rates, the other factors were all exacerbated by the anticipated disruption from the Ukraine issue. Let’s look at each of these factors separately and then as a whole.
For almost 40 years inflation in the U.S. economy was almost non-existent, however, slightly above or below two percent. Inflation is a little like red wine – a little might actually be good for you. Low inflation around two percent generally provides a type of lubricant in the economy that makes everything from currencies to transactions flow smoothly. When it escalates to 8% to 10%, problems quickly begin to emerge, especially around the basics of everyday life like a rent or mortgage payment, food, gasoline and bigger ticket items like appliances or automobiles. The effect of inflation disproportionately affects different segments of the population. Individuals at the lower end of the economic spectrum spend most of their income on the basics, hence, inflation can have a devastating effect on life and lifestyle. Those individuals at the upper end of the spectrum are affected very little because the basics account for a very small proportion of their income. In fact, because the stock market and the housing market respond very well to inflation, those at the upper end, actually benefit through increasing asset values.
The key tool to control inflation was first used in the early 1980’s when Federal Reserve Chairman Paul Volcker raised interest rates to almost 20%, which reduced double-digit inflation to 2% overnight and plunged the economy into a brief recession. Since then, there has been a balancing act between inflation and interest rates that has kept inflation around 2% and interest rates in the 4% to 5% range. This stable environment created all the right conditions for the economy in general and the stock market to grow at relatively steady and constant rates for four decades – until 2020 – and the shutdown of the economy due to government action in response to COVID. The shutdown was so drastic that many segments of the economy halted almost completely. In order to support the dead economy, the Federal Reserve lowered interest rates to zero (some countries even went negative) and also started to flood the economy with cash through a complex process called quantitative easing (QE). In addition, Congress and two presidential administrations pumped almost $5T into the economy through relief legislation. With interest rates at zero and a virtual flood cash, inflation took off like a rocket!
Compared to inflation, interest rates are easy. They are going up because inflation is going up. The plan of the Federal Reserve was to gradually raise rates and gradually bring down inflation to acceptable levels without plunging the economy into another recession, right on the heels of the brief recession brought about by the shutdown. The market waits for each Fed meeting and especially the comments by Chairman Jerome Powell. In normal circumstances in the past, the market would already know the position of the Fed and that position would already be “baked in”. This time, however, given the confluence of factors noted here, the market was not so certain about the future. Whenever, the market is uncertain it does one thing and one thing only – sell. It’s a fear response. Consequently, the market within a few weeks fell by more than 20% from its highs and was clearly in correction territory. Uncertainty is selling and selling is uncertainty.
Oil and The Russian Invasion of Ukraine
However, a competing fear entered the world stage. This bad actor of course needs no introduction – Putin. Wouldn’t you agree, growing up with a name like “Put-in” might make for an angry boy who became a tyrant! All kidding aside, the maniacal vision of the past certainly informed the present. The brazen Russian attack prompted disruption throughout the world, but especially the oil markets. Russia is essentially a one-commodity economy and oil is that commodity. Putin’s disruption created an instantaneous bonus as Russia continued to sell oil at a premium to the watching world, until the West finally came together to impose sanctions that are now diminishing the premium and the profits. At one point oil hit $148/barrel before settling slightly above $100/barrel. Before the invasion crisis oil traded in the $80/barrel range. The spike in oil prices immediately translates to the higher prices at the gas pump, so everybody feels the impact of Ukraine in the gas tank. It also causes almost all goods to go up also because transportation costs are built into everything we buy.
So here is the confluence – extraordinary amounts of cash sloshing through the economy, mostly in the hands of the very wealthy, very low interest rates, surging inflation and surging oil prices produced a very uncertain environment, so the market sells off sharply, waiting for some good news. It’s hard to tell when good news is going to come, but the success of Ukraine in fending off the Russian army is a bit of good news that can’t be underestimated. It was assumed at the early stages of Russia’s military advance that they would simply overrun the country and perhaps move into other Soviet-era countries, Ukraine being the first. The realty is quite to the contrary. A few years ago, I made a visit to Lviv, Ukraine, along with a few of my colleagues at Slavic401k. Lviv is essentially the intellectual hub of the country and even perhaps the former Soviet Union. For the few days I was there, the hatred of Russia was palpable. Consequently, it comes as no surprise that these resourceful people would resist Russia so successfully. The country’s charismatic leader has helped galvanize the West and the world against Russian aggression. Hence, the worst fears of the market are being laid to rest – Russia will not simply invade one country after another. For now, they have been stopped in their tracks in small portions of Ukraine.
Good news can slowly creep in other ways and prompt the market to recover. Remember, despite interest rates heading higher, they are still relatively low by historical standards. Money is still plentiful in our overly stimulated economy and gas prices may begin to fall as production increases. So, despite significant headwinds and in some instances hurricane-force winds, the market could recover its lost ground. That’s why the long-term investor must resist the fear, be committed to the long-term and eventually win. It is far too early to declare an “all clear” for the markets, but it is important to see the good as well as the bad news. The next window of market uncertainty I think will come from U.S. domestic politics and the mid-term elections, which of course sets the stage for the 2024 presidential election. It is frequently said that the current election is the most important, but it might well fit the next two election cycles, only because of the unprecedented intervention in the economy by all levels of government in recent years.
The commentary and market insights provided by John Slavic are for informational purposes only and do not guarantee future results