Escalation, Inflation, and Interest Rates
Ongoing inflation, escalation of the Russia-Ukraine conflict, and concerns about central banks tightening roiled the markets in February. All three major U.S. averages posted monthly losses, with the S&P 500 down 3%. The Dow Jones Industrial Average dropped 3.3%, while the tech-heavy Nasdaq Composite lost 3.4%. On a sector basis, technology, telecommunication, and consumer discretionary underperformed, while the energy sector gained 7.1% to outperform the market.
Russia’s invasion of Ukraine on February 24 represented a dramatic escalation of long-standing tensions. The conflict has sparked historical volatility in the global financial markets, with major equity and fixed-income indexes experiencing huge swings and oil and gas prices surging. While the Russia-Ukraine conflict could have economic effects on various channels ranging from consumer confidence, trade, and financial systems, we believe the most important channel affected is likely to be energy prices. As the European Union relies on Russia for about 50% of its natural gas and about 25% of its petroleum, it would be challenging to substitute alternate sources for such large quantities, intensifying risks of even higher energy prices and more persistent inflation.
In addition to higher inflation, we believe that the more immediate economic impact would be felt in Russia and Europe. Although Russia's economy now is much more robust as compared to 2014 to weather sanctions from Western countries, strong sanctions could trigger the Russian stock market to tumble further, deflating the Ruble's value, undermining confidence in the country's banking system, and making doing business in Russia increasingly difficult. Current sanctions could reduce Russian GDP by about 1% as a plausible estimate. However, the direct impact of the Russian equity market meltdown on the global market is likely to be limited as the Russian equity market only represents about 0.16% of the ACWI (MSCI All Country World Index) index. For Europe, higher energy costs there can weigh on demand, and losing Russia as a trade partner might negatively affect European GDP growth to some extent. However, the impact on European GDP growth should not be significant given Russia's limited contribution to trade beyond the energy market.
Although central banks usually look through fluctuations in energy prices when reviewing monetary policy, the current geopolitical risks make their approaches more challenging to assess at this moment. Policymakers need to weigh the upside risks to inflation against the downside risks to the economy. The conflict makes a 50-basis points rate hike at the Federal Reserve’s March meeting less likely, though we believe that the Fed is still on a path to raise rates at the next three to four FOMC meetings. According to CME Group data, market participants have now adjusted their expectations on the Fed after the recent bout of turbulence in equity and bond markets, with the probability of a 50bps interest rate hike in March down to 13%. However, the balance of risks could change later in the year if the threat to the economy diminishes, and US equity markets recover.
Despite considerable uncertainty regarding the outcome of the Russia-Ukraine clash and the ultimate response from Western governments, one point worth emphasizing is that major geopolitical events have tended to have a limited negative impact on business confidence and growth in the months that follow. While there is no exact historical analogy to the current crisis, a study of previous major military and geopolitical events shows that these events have often had limited discernible impact on key macroeconomic variables such as inflation, interest rate, and GDP growth in the G7 countries over the following six months.
By the Numbers (Year-to-Date)*
U.S. Equities (S&P 500 Index) | -8.1%
International Equities (MSCI ACWI ex-U.S.) | -5.6%
U.S. Bonds (Barclays U.S. Aggregate Bond Index) | -3.3%
Global Bonds (JP Morgan Global Aggregate Bond Index) | -3.2%
The NorthCoast Navigator is a market "barometer" displaying NorthCoast's current U.S. equity outlook. This aggregate metric is determined by multiple data points across four broad market-moving dimensions: Technical, Sentiment, Macroeconomic, and Valuation. The daily result determines equity exposure in our tactical strategies.
As of 2/28/2022. Data provided by Bloomberg, NorthCoast Asset Management.
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Valuation S&P posted a monthly loss of 3%; valuation for equity improved with the market pull-back but remained negative. P/E: decreased from 22.45 to 23.18; Forward P/E: fell from 20.4 to 19.6; Inflation-adjusted valuation metrics continued to be negative with inflation rising.
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Sentiment U.S. manufacturing conditions continued to soften as the ISM manufacturing index fell from 58.8 in December to 57.6 in January. However, the drop in supplier deliveries index (from 64.9 to 64.6) indicated slightly faster deliveries. Consumer confidence remained depressed, with University of Michigan consumer confidence dropping sharply in February, hitting a new cyclical low to 62.8. High inflation was likely the major driver, although the continuing COVID infections, a volatile stock market, and geopolitical risks may also contribute to the weaker confidence. Homebuilder confidence continued to inch down to 82, but still well above the 50-point threshold. Despite robust housing demand, material bottlenecks and higher construction costs caused sentiment to fall this month.
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Technical Technical indicators were positive as the fear index outweighed momentum indicators. The S&P 500 was 2% below its 200-day moving average, 4% below the 100-day average, and 4% below the 50-day average. VIX: settled at 30.2 at the end of February compared with 24.8 at the end of January. Volatility spiked as investors assessed the risks of escalated Russia-Ukraine conflict and series of sanctions against Russia. The reversal signals became positive with the market sell-off.
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Macroeconomic The labor market remained tight, with January payroll increasing 467,000 on a seasonally adjusted basis and an unemployment rate at 4%. Inflation remained elevated in January, with the headline and core CPI up by 7.5% and 6%, respectively. Meanwhile, The PPI for final demand was up 1% in January after rising a revised 0.4% in December. Consumer demand data was encouraging. U.S. retail sales posted a robust 3.8% monthly increase in January after a soft patch in December, while real consumer spending rose 1.5% in January.
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1 Source: Bloomberg, WSJ, NorthCoast Asset Management.
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