02.22.22

Geopolitical risk and Fed concerns deliver a 1-2 punch

The last week’s market highlights:

  • Last week, markets continued to toss and turn based on developments in Ukraine and hints from the Federal Reserve about its plans to tighten monetary policy. Amid ongoing high levels of daily volatility, the S&P 500 fell 1.6% for the week, while the 10-year U.S. Treasury yield was little changed.1
  • Minutes from the Fed’s January meeting showed that policymakers have not become concerned enough about high inflation to announce an “emergency” (i.e., between meeting) interest-rate increase or to consider a 50 basis point (bp) hike at its next meeting in March. We expect the Fed to begin rate normalization with a more modest 25 bp “liftoff,” while offering more information about its plans to begin shrinking its balance sheet later in the year.
  • U.S. and U.K. retail sales growth in January topped forecasts, led by online sales. Evidence of consumer strength even during a month of acute concern about COVID-19 continued to surprise economists.
  • This week will provide more January data on U.S. consumer behavior. Friday’s the big day, with personal income, consumer spending and PCE inflation all scheduled for release. We’ll be looking closely at whether the Omicron variant interrupted the shift in consumer preferences from goods to services and whether outsized goods purchases continued to push prices higher.

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook:  

  • U.S. economy: Slower growth and inflation compared to 2021, but still pretty fast.
  • Global economy: Showing signs of heating up thanks to accelerating vaccination rates.
  • Policy watch: No more stimulus, but the Fed isn’t likely to raise rates too quickly.
  • Fixed income: Expect further challenges for rate-sensitive assets; consider assuming more credit risk.
  • Equities: Our cyclical tilt includes U.S. small caps and non-U.S. developed market shares.
  • Asset allocation: Although valuations appear relatively full across many segments, we’re leaning toward risk-on positioning.

Quote of the week:

“If there is no struggle, there is no progress.” – Frederick Douglass

What’s got investors down?

One of the most popular gauges of equity investor sentiment is the weekly survey from the American Association of Individual Investors (AAII), which asks its members where they think stock prices will be in six months. According to the latest results, 43% say stock prices will be lower, while just 19% believe they’ll be higher, and 38% are neutral. The 43% figure representing pessimists is well above the survey’s 30% historical average.2​ 

Why the gloomy outlook? Consider the following culprits:

1. A sweeping transition to tighter monetary policy

The world’s most important central banks have pivoted away from the extraordinarily dovish, pandemic-driven monetary policy of the past two years and toward tightening. As recently as the end of the third quarter of 2021, federal funds futures — used by traders to bet on the direction of U.S. interest rates — were pricing in just over one Federal Reserve rate increase in 2022. Today, amid decades-high levels of inflation, markets expect between six and seven Fed hikes this year, beginning in March. Against this backdrop, the S&P 500 Index is down 8.8% year to date.3

Outside the U.S., the Bank of England (BoE) has already raised its benchmark rate in consecutive meetings (December and February) and is expected to do so again next month. As for the European Central Bank (ECB), markets aren’t quite sure of its next move. In early February, ECB President Christine Lagarde signaled that the ECB would be open to the possibility of a rate hike if inflation continued to run hot. Since then, she and her colleagues have awkwardly walked that assessment back, leaving central bank watchers guessing. 

Despite the hawks circling overhead, financial conditions remain loose. Indeed, both the Fed and the ECB are still holding rates at zero and continuing their monthly quantitative easing (QE) purchases, albeit at reduced levels. (The Fed plans to conclude its current round of QE in March.) 

But looser financial conditions haven’t been enough to keep investor sentiment afloat. Global stocks have improved modestly from their January lows, but their sensitivity to changes in interest rates and central bank communications remains elevated, as has their daily volatility. Moreover, the shift from easy to tighter monetary policy entails two primary risks. First, central banks could raise rates too quickly, thus choking off the global economic recovery. Second (and in contrast), they might not increase rates fast enough. That would allow inflation to heat up further, thereby requiring additional (and perhaps larger) hikes down the road — potentially triggering a recession. 

Even if central banks manage to calibrate their interest-rate normalization perfectly, global growth is set to slow significantly this year. In the U.S., for example, while January’s strong retail sales report confirmed that consumers shopped with authority, in doing so many households not only wound down some of their accumulated pandemic savings but also saved less of their monthly incomes than they did a year ago. 

In our view, this suggests that the burst of consumer spending growth we saw in 2021 won’t be replicated in 2022. Consequently, corporate profits, which drive equity prices, should rise more modestly than they did last year, when bottom lines boomed amid the U.S. economy’s reopening. This slower pace of earnings growth, combined with Fed uncertainty, could throw a wrench into many firms’ plans to hire and expand this year, potentially limiting the scope of gains for major indexes like the S&P 500.

2. Russia/Ukraine tensions 

Geopolitical risk is always a tricky thing for investors. At any given point in time, there are dozens if not hundreds of potential flashpoints around the world that could affect financial markets in some way: trade disruptions, negative commodity supply shocks or just general risk aversion. It verges on impossible for investors to individually or collectively assess (a) the likelihood of any of these geopolitical risks becoming more severe and (b) the impact that any of these risks is likely to have on the global economy and financial markets. 

For lack of a better strategy, the way markets tend to deal with this problem is to ignore it. Geopolitical risks simply aren’t routinely incorporated into global equity market prices, interest rates or in real estate property values. Economists generally ignore these risks when compiling quarterly and annual forecasts. When geopolitics become worth worrying about — as the situation in Ukraine clearly has — the impact can be swift and substantial but typically doesn’t last long. 

Although the ultimate outcome in Ukraine is unknowable, we see two clear impacts, one specific and one more general:

  1. A boost to the energy sector. Much of this year’s 21% spike in the Brent crude oil price (the main benchmark for oil prices outside the U.S.) reflects concerns about supply disruptions that could result from a military conflict between Russia and Ukraine.4 The rise in oil prices has lifted the performance of energy stocks in both the S&P 500 and European indexes like the Stoxx 600.
  2. General risk aversion. The prospect of hostile action in Ukraine has spurred “flights to safety” and better performance from “risk-off” assets like U.S. Treasuries and defensive equity market sectors than would have been the case otherwise.

For most of 2022, monetary policy concerns have been the dominant driver of financial asset prices, but that began to change last week as the tensions in Eastern Europe appeared to worsen. On the other hand, a durable drawdown of troop levels and general de-escalation would likely allow equity markets to recoup more of their losses (with energy being the sector most at risk), and would likely push interest rates higher. 

Although the twin culprits of monetary tightening and geopolitical risk have certainly contributed to some miserable performance in the early days of 2022, we don’t expect either of them to turn an otherwise solid year of economic growth into a disappointing one for investors. Given our generally positive outlook for the balance of 2022, investors may want to take advantage of opportunities to rebalance their portfolios by putting new cash to work at what are now more attractive prices.

Sources:

1 Marketwatch

2 AAII

3 Marketwatch

4 Bloomberg

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff. 

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