Stock and bond markets around the world have had a rough start to 2022. We’ve remained optimistic and have maintained that the worst for the market is happening now. We do not believe current market performance is a prelude for a significantly deeper fall on the horizon. With that said, investors should always be prudent and objective in assessing the broader environment. So let’s discuss what’s changed since the beginning of the year and what hasn’t. Further, what needs to change from here to allow markets to perform better?
What’s changed? Oil prices
Inflation was a known problem coming into the year, and it’s the main reason the market quickly started to price in a more aggressive fed. Rising energy prices have been a core driver of increased inflation. Even still, the recent rise in oil prices has been historically fast. Since Russia invaded Ukraine on February 24th, the price of oil has risen 16%. Other inflationary commodities like wheat and corn have risen 25% and 7%, respectively, over the same time. Palladium, a widely used industrial metal, of which Russia is one of the world’s biggest producers, is up 20%.
These are just handful of the drastic moves higher that have occurred recently in the commodities market. In our view, the biggest problem these moves present for markets goes beyond the pragmatic ones (which is mainly higher inflation), but rather that they caught the market off guard. The market has been repricing itself for higher inflation and higher rates with known information for months. The Ukraine/Russia war presented a major unknown that has only made the market’s outlook on inflation worse.
While some may have initially thought the war could lead to a less aggressive Fed, the resulting surge in commodity prices basically takes the possibility of that off the table.
What hasn’t changed? The Fed’s path
Because inflation continues to come in hot, and is likely to get worse as a result of the war, the market still expects the fed to be aggressive in raising interest rates. Remember, in November of last year the debate was over if the Fed would raise rates for the first time by June. By December, the market was starting to anticipate that the first hike might actually occur by March of this year.
Those December expectations have proven to be pretty sticky and it’s now expected that the Fed will announce their first rate hike on March 16th. Even though the war is likely to slow down the economy a little bit (more so in Europe), the Fed is sticking to their plan. One month ago, before the war officially started, the market was expecting 6-7 hikes this year. Today, the market still expects 6-7 hikes:
In other words, the war in Ukraine has not impacted the Fed’s path.
What needs to change?
There’s a few factors in the short-term that would likely provide immediate relief to the market:
- A cease fire in the war, or at least an agreement to avoid nuclear zones
- Lower oil prices
- Different rhetoric from the Biden administration
We can’t assign odds of a cease fire being reached, but if there was an agreement, we’re 100% sure the market would rally off of that. On that same point, an agreement to avoid the use of nuclear weapons, or fighting near nuclear zones, even without a full cease fire, would likely be celebrated by markets.
Ironically, in the two days following Russia’s invasion of Ukraine, the S&P 500 rose 3.50%, and oil prices fell 0.50%. Since after those two days, however, oil prices have risen 16% and the S&P 500 has fallen 3%. This suggests the market is nervous about the impact higher oil prices are going to have on inflation and the economy, and thus, the stock market.
“Putin Price Hike”
The Biden administration has attempted to brand the surge in inflation and oil prices as the “Putin price hike” while at the same time casting blame on “inaction” by the US oil industry to tame prices. Aside from the political calculation Biden is making by blaming rising inflation on Putin, its damaging rhetoric for the market.
The market would prefer if the President tried to talk down oil prices. If Biden said, “We are going to work with the US oil industry to lower gas prices for all Americans” the market would probably rally. In other words, it might not even require a change in policy to moderate oil prices, simply a change in rhetoric.
It’s hard to know if any of the three factors we outlined will change, but if they do, expect the market to rally. It’s also possible that we soon reach a point of “no news is good news” for the market. Meaning, that in the absence of further bad news, the market starts rallying even without any obvious positive catalyst. For what it’s worth, the S&P 500 is still above its lows from January, even with new negative information being introduced (war, more inflation, etc).
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