Russia/Ukraine and the Fed Knock Raise Uncertainty
There are three major themes that have been uppermost in the minds of investors since the start of the year.
- Russia/Ukraine,
- The swift pivot by Federal Reserve, and
- Strong corporate profits
The first two have been significant headwinds for equities: the Russia/Ukraine crisis and subsequent invasion, and the Fed’s hawkish rhetoric.
But the downside since the beginning of the year has been cushioned by the expanding economy, which has fueled the rise in corporate profits.
Nevertheless, the story we have all been following has been the brewing crisis and eventual invasion of Ukraine by Russia.
Short-term investors usually step back when uncertainty rises because increased uncertainty can lead to additional outcomes for the U.S. and global economy. Many of those outcomes, even if remote, are to the downside.
Therefore, short-term investors recalibrate and attempt to discount the uncertainty. Over time, the new reality gets incorporated into the outlook and the focus returns to the domestic economy. That has been the historical pattern.
Ultimately, how the crisis affects the U.S. economy will play a significant role for markets. In the case of Russia and Ukraine, the direct exposure of the U.S. economy is limited. It includes a few commodities, including oil. The U.S. receives very little oil from Russia, according to the Energy Information Admin., but higher oil prices will translate into higher energy prices.
Nevertheless, a February 28th headline in the Wall Street Journal seems to sum it up well: U.S. positioned to withstand economic shock from Ukraine crisis, effects could push inflation higher from already elevated levels, but economic expansion appears to be on solid ground.
A more aggressive turn by the Fed has also created headwinds. As 2021 unfolded, Fed Chief Powell assured us that the surge in inflation was tied to the reopening of the economy and short-term supply disruptions. The uptick in inflation, he said, would be “transitory.”
But inflation has proved to be a much trickier problem than Powell and the Fed expected, and a more hawkish monetary policy has been openly discussed by Fed officials.
The first rate hike is expected to occur at the March meeting—probably a 0.25% increase in the fed funds rate to 0.25—0.50%. Additionally, a key gauge from the CME Group suggests that the current fed funds rate could rise to 1.25—1.50% by the end of the year.
That’s a far cry from a year ago when Powell strongly suggested no rate hikes through at least 2023.
But let me caution that any projection on rates is highly dependent on the economy and inflation.
Key question: can the Fed bring inflation back to its 2% target without throwing the economy into a recession? It may need some help from the supply chain and outside factors. In addition, Russia’s war against Ukraine may complicate matters.
But corporate profits have been strong, with S&P 500 earnings up 32% from one year ago, per Refinitiv. On January 1, analysts were forecasting a still sizable gain of 22%. It has helped act like a shock absorber against today’s headwinds.
Final thoughts
The S&P 500 Index registered its first 10% drop since the bull market began in late March 2020. Through careful planning, diversification, and managing behavior we have navigated crises in the past and will continue to do so into the future. Through diversification and various measures, we take steps to help manage risk.
But keep this in mind, too. In the 32 times the S&P 500 Index has shed at least 10% since 1980, one year after hitting a bottom, the index was up 25% on average. It was higher 90% of the time, according to LPL Research.
We won’t try to pinpoint a bottom, and we know that past performance is no guarantee of future results, but the historical data are encouraging.
Since WWII, LPL Research compiled the market reaction to 22 “market shock events.” On average, the total drawdown was just 4.6% for the S&P 500 Index.
During the Cuban missile crisis, the S&P 500 lost 6.6% over eight-trading days. For those of us who are old enough to remember, the world appeared to be on the brink of nuclear annihilation.
The biggest decline in LPL’s survey occurred after the surprise attack on Pearl Harbor. The index shed nearly 20% in 143 days but managed to erase losses within one year of the attack.
Historically, geopolitical challenges have had only a short-term impact on the broader market. Whether the U.S. economy enters a recession has been the biggest factor for stocks.
We are bracing for more volatility, but we do not think the U.S. economy will wither under the war Russia has brought to Ukraine.
If you have any questions or want to discuss any other matters, please feel free to reach out to your advisor.
1 The Dow Jones Industrials Average is an unmanaged index of 30 major companies which cannot be invested into directly. Past performance does not guarantee future results.
2 The NASDAQ Composite is an unmanaged index of companies which cannot be invested into directly. Past performance does not guarantee future results.
3 The S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly. Past performance does not guarantee future results.
4 The Global Dow is an unmanaged index composed of stocks of 150 top companies. It cannot be invested into directly. Past performance does not guarantee future results.
5 CME Group front-month contract; Prices can and do vary; past performance does not guarantee future results.
6 CME Group continuous contract; Prices can and do vary; past performance does not guarantee future results.
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