In the article that follows, I hope to cover a lot of ground, addressing a multitude of factors shaping markets and providing an outlook on where things are likely to go from here.
These have been days of superlatives: unprecedentedly low interest rates, record-breaking inflation, equity indices breaking record after record, heightened volatility, post-WW2 record high unemployment followed by record job availability and, now, an unprovoked invasion of a sovereign state by the world’s second strongest military showcasing for the first time the horrors of modern warfare and raising the risk of nuclear war to an all-time high. These factors all point to global financial markets that ought to be more volatile than they’ve been in years past. After all, it wasn't since 2008 that oil prices were higher than $130/barrel; it wasn’t since 1980 that inflation was higher than 8%; and it wasn’t since 1962, during the Cuban Missile Crisis, when the risk of nuclear conflict was as high as it is today.
As I write this, tech stocks remain about 20% below their November highs, pushing them ever so slightly into bear market territory. The S&P 500 is in correction territory, down about 10% from its highs. The 10Y yield trades at 1.98%, near its recent highs of 2.05% and significantly off of its flight-to-safety lows of 1.7%. Oil trades at $105/barrel, significantly lower than $130/barrel high reached earlier this week.
Ukraine:
The most important factor shaping markets right now is the war in Ukraine, where the United States estimates that up to 6,000 Russians and 6,000 Ukrainians, including at least 550 civilians (including at least 41 children) have been killed. The unprovoked, unwarranted and reckless Russian invasion of Ukraine has been an utter disaster for the Russian Federation, which has now become an international pariah, a status that has sent its currency reeling. The impending embargo of Russian oil and natural gas, as well as the sanctioning of Russia’s financial sector, including its central bank, has caused the Russian ruble to fall in value by 50%. With the consensus being that Russia is now looking down the barrel of an imminent default, a further collapse of the Russian ruble is probable at best and inescapable at worst.
The conflict in Ukraine is unlikely to end anytime soon, as Russian forces meet steep resistance from Ukrainian forces. Without the imposition of a NATO-imposed no-fly zone or the supplication of fighter jets to Ukraine by NATO nations, the most probable outcome from here is continued shelling of Ukrainian civilians by Russian forces, leading to the slow takeover of Kyiv and other key cities. A Russian occupation of Ukraine will not succeed, as the Ukrainian people will never sit idly by while the Russian government attempts to control them. Ukraine will not ultimately become part of Russia. The best possible outcome for Russia is the acquisition of the Donbas region of Ukraine following the ratification of a peace treaty. Russian has failed miserably in its mission to prevent the spread of NATO and has instead provided the strongest catalyst for the strengthening and re-arming of NATO in the strategic alliance’s history. Russia's sovereign debt will default.
Oil:
Before I begin my brief on oil, I want to quote from Barron’s inimitable Jack Hough, who wrote about the relative irrelevance of Russia to capital markets and global economics; even oil, its economic crutch, pales in comparison to total US oil consumption. “I took breaks this past week between rage-scrolling Russian convoy pics on Twitter and hollering questionable takes on NATO at the television to ask around about energy, because it’s pivotal for investors now. Russia is a capital markets featherweight that previously had a smaller stock weighting in emerging markets than Thailand. And its imports to the U.S. are near squat. But one of them has outsize importance for price-setting: sour crude.” What a relatable quote. I find myself more drawn to Twitter than ever these days, scouring the platform for news and commentary before it enters the mainstream media, if it ever does. Regardless, oil could go higher this year, as reserves remain low and promises to expand supply remain basically non-existent. Oil producers are hesitant to increase supply since any investment in new oil production would take several months, at which point oil is supposed to trade for less than it does today, a phenomenon known as backwardation in the futures markets.
What I do know is this: buying oil stocks while oil prices are skyrocketing hasn’t been a good idea historically, although energy stocks like Chevron and Exxon have offered healthy levels of operating cash flow, free cash flow, and EBITDA over the past five years, excluding 2020, when oil prices were unexpectedly low. Here’s my take: if and only if you think oil prices could go tremendously higher, take a position in one of the oil giants as a hedge to the stagflation that higher energy prices could cause. After all, each of the last three energy price spikes have been followed by recessions. If you’re unsure of where oil is heading, my recommendation is to sell your energy holdings at a gain now and leave that cash on the sidelines. If markets recover, that’s likely because oil has come down, meaning energy stocks will have fallen in price. Conversely, if oil prices continue to rise, other more attractive stocks should become even cheaper, and you’ll have the option to buy those cheap shares. My advice, frankly, is to avoid energy stocks right now. Utilities stocks would be a better purchase, as the utilities sector experiences far less volatility than the energy sector and tends to increase in value when fears of an economic slowdown abound, given the sector’s defensive nature.
Below are some particularly relevant direct quotes from CNBC's talented Tim Mullaney, who makes sense of oil's dramatic rise.
Oil company capital spending has been dropping since the mid-2010s, making it hard to ramp up new production quickly as economy rebounds.
Wall Street has pressed oil and gas producers to cut capex, and shift their cash to financial goals like paying down debt and boosting dividends, as well as de-carbonization, after investment in fracking led to billions in negative cash flow.
About half of last year’s lost production has returned, but prices will stay high until domestic producers pump more, or OPEC nations make a change in their production quotas.
Interest Rates and the Fed:
The forecast for the 10Y yield at EOY 2022 is around 200bps, which is the yield currently offered on the 10-year Treasury; thus the market has fully priced in the worst case scenario expected by investment banks such as Credit Suisse, JP Morgan and Goldman Sachs. The Fed is hiking rates rates in an attempt to reverse post-pandemic easy money and to slow the impact of inflation. Should the Federal Reserve hike at all seven remaining FOMC meetings, which is expected by Goldman and JPMorgan, the market reaction should be mild at worst, as such an expectation has already been built into the yield curve and discounted in the equity markets.
The Federal Reserve will need to hike more than 25bps at one of their upcoming meetings, namely next week's 3/16 meeting, for the equity markets to have a further negative reaction to the Fed's tightening. I find a 50bps hike from the Fed unlikely given the dramatic rising global energy prices and the associated war in Ukraine. Nevertheless, Japanese investment bank Nomura is among a rare group of financial market participants, including Citi and Grant-Thornton, that thinks the Fed will indeed hike 50bps (something that has not happened since 2000) at next week's meeting. In 2006, the Fed conducted its 17th continuous rate hike, raising rates to 5.25% to tame what was then much, much milder inflation. Since the 10Y currently trades at 2.01%, I think it is now best to position as if the Fed will not hike 50bps next week. We are now encountering a scarier situation in which significantly elevated levels of inflation are becoming systemic. The notion that inflation is transitory is completely out-the-window.
"The greater risk is that we under-tighten and that we end up with an economy with underlying inflation above 4% -- and then there is no alternative at some point to do the kind of thing that Paul Volcker had to do at the end of the 1970s,” said Summers. “An error of allowing inflation to become entrenched would be a very real and grave error.” - Larry Summer, former Treasury Secretary and President of Harvard University
Equity Indices:
Despite elevated levels of inflation and the headwinds of rising rates, equity markets are supposed to move higher this year on growing corporate earnings backed by growing consumer demand. The unemployment rate remains low and jobs are in fresh supply; this should drive demand and spending that will likely lead to higher earnings for the index as a whole. Higher energy prices and input costs should suppress earnings, ceteris paribus, as higher prices at the pump take a toll of consumers' discretionary spending. Additionally, companies will be unlikely to pass on the entire price of input costs to price-sensitive consumers. Between this phenomenon and inflation's ability to force the Fed's hand, inflationary developments should be viewed as significantly negative for equity markets. Nevertheless, I am still of the belief that negative real yields and the fixed-rate nature of bonds make equity indices a better short and long-term investment than fixed income. The 10Y breakeven inflation rate now stands at almost 3%, a multi-decade high but still reasonable given 7.5% headline inflation.
Ultimately, I believe the equity markets will bounce back from their current lows to end the year flat, making right now a fantastic buying opportunity. I think that this year will be a year of multiple contraction, with many stocks seeing large jumps in earnings but mild to no growth in stock price from the start of the year. Some of my favorite stocks include FB, DELL, INTC, BIIB, TROW, DKS, BBY, CVS, MU, HD, and CIEN.
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