An uphill start to 2022: War in Ukraine and Fed rate tightening
The first few months of 2022 have been rough for investors. Going into 2022, I anticipated the first half of the year would be challenging (refer to previous commentaries). That was before Russia invaded Ukraine, causing chaos in the commodity markets. Inflation was surging in the first couple of months of the year. There was every indication the central bankers would raise key rates to combat rising inflation by curtailing demand (by making money borrowed to buy things more expensive).
Global markets were down nearly 10% in Q1 2022, and the S&P 500 Index entered correction territory in February. The S&P 500 ended the quarter at -4.9%, and the MSCI Europe and MSCI EAFE also struggled, with returns of -5.9% and -6.6%, respectively. The S&P/TSX here in Canada fared better, ending with a gain of 3.1%. For more on why the S&P/TSX did better, read on.
On February 24, Russian President Vladimir Putin ordered a military attack on Ukraine. Global stocks fell while bonds increased in value. Oil, measured by West Texas Intermediate (WTI), initially broke through US$100 a barrel, a level not seen since June 2014. It is trading over $100 as I write this commentary after briefly dropping below that price a couple of times in the last several weeks.
When Russia began its invasion, countries in the West and their allies (Japan, Australia, and South Korea to name a few) moved very quickly to place severe sanctions on Russia, its leadership, and its oligarch class. As the war continued, more countries have been supplying lethal weaponry to the Ukrainian military to help them stem the Russian assault.
The impact of the war on global economies is widespread. Ukraine, Russia, and Belarus are significant producers of commodities used by other economies in the world. In many cases, the supply of these commodities has been cut and prices have shot up. This is a watershed moment for some commodities and the countries importing them from these countries. Europe is rapidly looking to cut its reliance on Russian oil and gas which Russia depends heavily on for the revenue to fund its military. African countries that rely on Ukrainian grain exports cannot afford replacement supplies where they can find replacements. European shelves are bare of the cooking oils pressed and exported by Ukraine. Russia and Belarus are significant exporters of potash (used in fertilizer). These represent a shortlist of the resources involved and the potential impacts caused by the war. There are many more products, commodities, and manufactured goods produced and exported by these countries, further upending an already messed up global supply chain.Canada is a country that is benefiting from the hostilities in Eastern Europe. We are a major commodity producer, including agricultural products. We export large amounts of oil and gas, metals and minerals, and lumber. For example, Canada is the largest potash exporter in the world, ahead of Russia and Belarus. Canadian stock markets and the benchmark S&P/TSX stock index) have a heavy weighting to commodity and resource-producing companies. This is why the S&P/TSX index fared so well in the first quarter when the US and most non-North American indexes dropped.
North American inflation and interest rate announcements
Inflation continued to rise in the quarter in North America and in many countries around the world, to levels not seen in more than 20 years. This caused a change in the thinking of central bankers who were largely thinking the pop in the cost of living to be a short-term issue as economies continued opening up after the global COVID pandemic. It now seems they think, left unchecked, it might get out of hand and may not go away for a while. I am no economist but based on my reading in early 2021 when inflation started increasing, there were several factors contributing to what was happening. Yes, economies opening up post-Covid and supply chain challenges were factors, but so were changing demographics and the upheaval in the workplace caused by the great COVID “work from home” experiment. Simply put there are not enough workers to fill positions and those that are, are asking for more money to do the job. This is classic “wage-push” inflation.
After telegraphing its intentions for a couple of months, on March 16, the U.S. Federal Reserve announced a 0.25% increase in interest rates—the first increase since 2018, signaling what looks like the start of a rate tightening cycle. This happened after Canada increased its overnight rate by .25% at the beginning of March. Both central banks also suggested further tightening was sure to follow.
Inflation rates announced in March, for February (7.9% in the U.S. and 5.7% in Canada) justified the actions taken and set the stage for additional increases.
You could compare these tightening cycles to a mountain the U.S. Fed and Bank of Canada must climb, increasing rates to reach its final goal of full employment, stable prices, and moderate long-term interest rates. In the case of the Bank of Canada, it is a more treacherous climb because our economy is pretty tied to what happens in the States. If they can get there, and how soon remains to be seen. If they miss, we could be headed for a recession which will make things more painful for economies and investors.
What this means for investors
"There’s no previous rate-tightening cycle that mimics the current environment, with geopolitical risk, supply chain issues, pandemic-driven inflation, and economic growth levels all factoring into the Fed’s decision-making process. Historically, on an individual basis, some of the factors we are experiencing tend to play out in the markets as follows:
- geopolitical conflicts typically are top of mind to investors for a short period of time. Market fundamentals tend to take over after some initial upheaval.
- the U.S. Federal Reserve is usually cautious during the early stages of a tightening cycle and when markets correct (a sell-off of 10% from the peak).
- the dismal performance to start the year many times does not continue moving forward during the year.
As I pointed out at the outset here, in my time in the business, we have not had a set of market influences come together quite like we are experiencing now. So, in some regard, we are in new territory.
As we start the second quarter of 2022, things are getting messier. Both the U.S. Fed and the Bank of Canada announced .5% increases in their respective key rates here in April, spurred by significant year-over-year inflation rate increases in both countries (8.5% in the U.S. and 6.7% in Canada).”
As the year progresses, we think that the Fed and Bank of Canada will raise interest rates less than the six times that’s currently being priced in BUT they might administer economic shock treatment in the form of rate increases in June, with a possible rate increase above the .5% announced in April. Central banks generally increase their benchmark rates by .25% at a time. The .5% increase we just witnessed by each was largely telegraphed and anticipated but that doesn’t take away from the significance of the size of the move, both in the message it sends and the immediate impact it will have on borrowers. A steep rise in rates with higher increases per occasion may accelerate the anticipated slowdown in spending activity sooner allowing the banks to ease rates to a neutral state sooner. The trick is not triggering a recession… We’ll see how much central banks and economists learned from history here soon.
The war in Ukraine is at a crucial stage. Russia has pivoted on its stated objectives to “securing the Donbas region and its two sponsored breakaway republics, Donetsk and Luhansk”. It is also looking to secure a land bridge between Crimea and the Donbas “republics”. Another somewhat transparent objective might be stretching the territorial bridge to Transnistria, a breakaway Russian-speaking enclave in Moldova. These are all territorial expansions for Russia. The area involved contains a significant portion of Ukraine’s industrial capacity. If the Russians do make a push towards Moldova, it could include Odesa and the remaining Ukrainian Black Sea access, effectively making Ukraine a landlocked country.
The stakes for both countries are very, very high. For Ukraine, it is all about their territory and independence. For Russia, it is an existential challenge. To fail would challenge their own image of themselves as a “super-power”. If they are stopped or pushed back in their quest, what might they do to turn the tide of the war? It’s not like the Russians have demonstrated a lot of success so far… That said, the battlefield is changing in this next phase of the war to one that favours large troop and equipment numbers. We will know soon enough…
In the meantime, at least in the short run, the war will be a backdrop to events in the market and likely will increase volatility depending on who is “winning” the battles to come. The fact is that the economic connections formed over the last 30 years between the West and Russia are broken and there is little prospect for a fix unless the current regime in the country is changed. We think a good part of the economic impact of the break has been factored into markets already. While Europe and some other EAFE (Europe, Australasia, and the far East) countries will be affected by the decline in Ukrainian exports, North America is largely insulated from the actual loss of access to Ukrainian and Russian products. The issue is that the prices for products they would normally be supplying to the global marketplace will go up and that will translate into higher prices for these goods here as manufacturers choose who they will sell to (the highest bidder rule might kick in???).
We think that regardless of which way the war goes, Russia cannot continue this “misadventure” indefinitely. They are spending a lot of cash and military resources for little in the way of meaningful results. While that may change in the near future with a breakthrough in the Donbas, they are limited to what they can conquer AND hold. Sooner (hopefully) or later, they will be forced to the table to negotiate some sort of cease-fire and “peace”, which may allow Ukraine to stabilize and rebuild (and perhaps to fight another day???).
When this happens, financial markets will likely stabilize leading to a pivot in the negative narrative that has unfolded since the start of the year, and even bounce on the emotional relief. The geopolitical premium built into oil prices today will likely go away, but supply-and-demand dynamics will continue to support oil prices above US$90 a barrel as global economies continue to fully reopen leading into the summer
Investment market moves are largely driven by geopolitical, economic, and market news along with shifts in company and market fundamentals. These drivers affect the collective emotions of investors, sometimes referred to as the “mood of the markets” or “market sentiment”, which is shaped by the news and recent market trends. This mix of factors is what drives markets, both up and down. It’s wise to understand that as long as one is investing, they and their portfolios are affected by larger forces. Just because their portfolios are going up it doesn’t mean they are doing anything extraordinarily right. Nor does it mean that in periods where their portfolios are going down that they are doing anything extraordinarily wrong. To get the good (returns) over the long term, most investors accept that you have to accept the bad (market drawdowns/declines) in the short term.
Where are we at, here at 360 Private Wealth Management, in the face of inflation, interest rates, and the Russo-Ukraine war (Please read!)
We take a broadly diversified approach to building client investment portfolios. This said we will experience volatility in this environment. We believe, given the current economic and geo-political situations we are dealing with, that we need to be prepared for short-term volatility of as much as 20% in portfolio values before things stabilize and trend higher. Timing is not a strategy as appealing as it might be looking at statements. In theory, the time to sell is at the absolute top of the markets, which now are some weeks and months behind us. Selling now locks in losses. Then, you must determine when to buy back in. Let me tell you that it is a far more difficult decision because after witnessing a downdraft, very, very few investors, retail or professional are at all good at it. In my 40 years of experience investing money, I may have seen a few pros get it right once, or maybe even twice, only to blow up the next time around. Market events might “rhyme” (have some similarities to each other) but they never, in my humble experience, look or “feel” the same. Each situation has its own look and outcome. The investment landscape is littered with reputational and actual financial casualties who thought they could consistently guess the future. In the end, they could not. In scientific and math circles the phenomenon I am discussing is known as “correlation not implying causation”! Thinking otherwise leads down some dangerous rabbit holes.
The best strategy is to make sure you have enough cash equivalent assets (i.e., savings account balances and short-term GICs) to weather a year or so of cash flow needs, or sometimes more, at the end of each review encounter we have. If they get run down and portfolios are still down, the strategy is to sell as little of the managed portfolio assets as we must from your managed portfolios (i.e., 1-3 months) and then repeat as necessary until things improve.
On the other hand, if you are still focused on growing wealth, be prepared to take advantage of a significant equity market pullback. Let us know if you have the ability to invest additional money into your managed portfolios beyond the cash equivalents we may already be strategically holding for you.
Investment wealth is made and lost in volatile markets. The key to not losing is not to get emotional when watching and reading the news. Some of the greatest investors I have studied over the last 40-plus years I have been blessed to be an advisor, including my hero, Warren Buffett, are quite simply some of the most rational individuals you will EVER encounter. My favorite story about Warren Buffett involves his move to buy the remaining 77% stake of Burlington Northern Santa Fe (BNSF) Railroad he did not already own in the depths of the Great Financial Crisis of 2007-2009. Here is a link to the Reuters story the day the deal was announced:
I highly recommend everyone reading this commentary read the article! The investment Berkshire Hathaway made in BNSF stock in 2009 is now worth multiples of what was paid for it back then.
Rational thought combined with resources (personal and financial), a well-thought-out financial life plan, foresight, time, and patience are the keys to building and sustaining family wealth. These are the “controllables” in wealth creation and preservation and the things we can help you and your family with. Global events, economics, and investment market movement are not normally controllable by investors, whether individuals or professionals.
The thing you learn from sailing, whether sailing on the open ocean or on a lake, is you need a destination (“It really doesn’t matter where the winds are coming from if don’t have a destination!”) You need to have confidence in your boat and crew (a good boat and a skilled crew are very important contributors to confidence!). Then, you need a sail plan (a map of how you are going to get to your destination). Once you have this in place, you need to actually leave the harbour (many sailors avoid leaving the harbour unless conditions are most favorable; Tip: They rarely are!). Once out, you will set, then adjust, your sails; less sail when the winds are blowing hard and more sail when they are light. Then, steer the boat confidently along the course you have set, as the boat and winds allow, in the direction of your destination. Stuff will happen to be sure, but if your route is well planned, you, your boat, and your crew will handle it. As the saying goes, “Stay calm and carry on.”
Why I became so passionate about sailing is the incredible similarities the pastime has with the work we do as financial advisors, helping clients invest and build and preserve their wealth and live the best lives they can! Typing these thoughts brings a smile to my face! I can’t wait to get back out on my sailboat! Looking outside as I type this; we are some weeks away from that happening!
Call or email us if you have questions or want to discuss anything in this commentary or about your portfolios. We look forward to talking with you.
If someone in your circle might benefit from this commentary, feel free to pass it along.
Thank you for your continuing confidence!
David J. Luke, CFP, CLU, CH.F.C., RFP, CIM, RIAC | Financial Advisor
360 Private Wealth Management/ Manulife Securities Incorporated