The big event of the week will be the Federal Reserve meeting and Chairman Jerome Powell’s commentary since monetary policy is expected to change for the first time in two years. The fed funds rate is expected to rise 25 basis points to a range of 25 to 50 basis points on Wednesday, and this will be the Fed’s first interest rate increase since December 2018. The shift is meaningful, but widely expected and fully priced into stock prices, in our opinion.
But while the Fed may be the media focus on Wednesday, the day is also notable for the fact that Russia has a $117 million payment due on US dollar-denominated Eurobond coupons. This will be the first of several key payments due on Russia’s sovereign debt in coming months and the first since the Fitch rating system downgraded Russian debt to a “C” rating, indicating that a sovereign default is imminent. Most economists now expect Russia to default since it has become the pariah of the Western banking world. Following Russia’s invasion of Ukraine many countries froze Russian reserves of dollars and euros held at banks and this crippled Russian liquidity and will make payment difficult. However, a nonpayment usually initiates a notice of a 30-day grace period to the issuer before defaults are officially triggered. Still, it will be interesting to see how Russia responds to this week’s likely default since it is apt to be the first of many. Several more payments will be coming due in the weeks ahead and we will be watching to see if these defaults have unexpected consequences. Russia’s debt is not large enough to worry about a major banking crisis, but it could result in some unexpected private losses.
To a large extent, the only response to Russia’s invasion of Ukraine have been economic sanctions by the US and other NATO nations. Therefore, a sovereign debt default may be the first of many tests of how well Russia and its economy can weather the sanctions from the West and still continue to wage a costly war in Ukraine.
Oil and Interest Rates
The stock market rose ahead of this week’s FOMC meeting but this rally could have been due to a variety of factors. First, the price of WTI crude oil ($95.15) dropped $28.50 this week after jumping $20 last week. This decline was a welcomed event however, the technical chart of the WTI future shows it still remains above all its key moving averages and remains in an uptrend. Keep in mind that crude oil ended the year at $75 which means it is up 27% year-to-date, despite this pullback. See page 8.
We think the most interesting chart of the week is the 10-year Treasury note yield, which rose from 1.82% to 2.16%. This 34 basis-point jump, ahead of the Fed meeting is somewhat consoling since it reduces the immediate risk of an inverted yield curve, but we are curious about the move since it did not appear to be linked to “economic strength.” The risk of an inverted yield curve in 2022, and of a recession, continues to be significant in our opinion. In short, we believe this week’s equity rally is best for traders. Unfortunately, the problem that inflation brings, its impact on consumers, investors, profit margins, the Fed and PE multiples will not go away any time soon.
There will be a number of key economic releases this week including retail sales as well as industrial production, housing data, and construction spending. However, all this data will be for the month of February and will not include the impact the Russian invasion may have had on the American public. History suggests that wars tend to be good for the economy, but this is mainly true for the industrial sector. The US is a consumer-led economy and wars can have a negative impact on consumer psyche and consumer spending, particularly when the price of gasoline and food is rising rapidly.
Headline inflation rose from 7.5% to 7.9% in February and core CPI rose from 6.0% to 6.5%. These numbers indicate that inflation continues to be a plague on the economy. Energy sector prices are the biggest issue, up 25.6% YOY in February. Nevertheless, inflation has become well-ingrained in the economy and all but 6.4% of the CPI weighting is rising well above the Fed’s target of 2%. See page 3. Transportation costs were up 21% YOY in February, the highest since early 1980.
As we anticipated, housing, which is 42.4% of the weighting of the CPI are now rising. Housing costs did not begin to rise until recently and had been a nice offset to rising fuel cost. But the housing sector saw prices up 5.95% YOY in February, the highest since early 1982. The worrisome issue is that housing costs are now accelerating dramatically and are adding to the inflation problem facing households. See page 4.
Producer price indices were also released this week and they show little signs of decelerating. The PPI for finished goods rose 13.8% YOY in February versus 12.5% YOY a month earlier. The core PPI for finished goods rose 7.7% YOY versus 7.0% in January. Only PPI final demand displayed any sign of stabilizing and was unchanged at a disturbingly high rate of 10.1% YOY. See page 5. The pace of inflation is a big concern, and it is now the steepest jump in prices since the OPEC oil embargo imposed on the US in 1973. The embargo in 1973 was related to the Arab-Israeli War and was imposed by OPEC when the US supplied Israel with military support. Note the US dependence on foreign oil and the impact this has on geopolitics. We find this to be a disturbing parallel in many ways.
The rise in inflation has now created a spread between the fed funds rate and inflation that is even larger than that seen in 1973. As we have often noted, the Fed’s failure to reduce monetary ease early last year to stem the growing tide of inflation, has now created a major problem. Our view of the number of fed funds rate hikes this year is evolving. It is likely that inflation will dampen consumption, weaken profit margins, and slow the US economy in 2022. The Fed must now balance between inflation and the risk of sparking a recession. It is a difficult decision.
This risk is visible in sentiment indicators. The University of Michigan consumer sentiment index fell to 59.7 in March, a new cyclical low. The NFIB Small Business Optimism Index decreased by 1.4 points to 95.7 in March, the second consecutive month below the 48-year average of 98. Twenty-six percent of owners surveyed reported that inflation was their single most important problem in operating their business. This was a four-point increase since December and the highest reading since the third quarter of 1981. Not surprisingly, hiring plans fell from 26 to 19 in March. See page 6.
Little has changed in the technical area although the S&P 500 index has joined all the other indices in confirming a “death cross.” A death cross occurs when the 50-day moving average falls below the 200-day moving average and it is a negative configuration. But since a death cross tends to happen midway or late into a bear cycle, we do not find that meaningful. Still, we do not believe the lows have yet been found. Neither technical nor fundamental guidelines give us comfort this week, and both sets of indicators suggest there is more downside risk in the market. The safest equity sectors in the current environment are energy, staples, defense-related and companies that are insulated from inflation and have dividends greater than 2%. But we do believe a long-term opportunity to buy technology stocks is on the horizon.
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