According to Reuters, as soon as Wednesday, President Joe Biden’s administration could announce it is extending another $750 million in military assistance for Ukraine’s fight against the Russian invasion. Separately, the Pentagon is hosting leaders from eight weapons and defense manufacturers to discuss the industry’s capacity to meet Ukraine’s needs in case the war with Russia lasts for years.
These announcements are just one indication of how the world, the financial markets, and potentially, our futures have changed in the last two months. There is no denying that energy prices were trending higher well before Russia invaded Ukraine in late February. However, energy, grains, metals, Russia, Ukraine, inflation, financial markets, and politics are now irrefutably intertwined in an inflationary quagmire. This war-induced combination is not really something the Fed has the tools to fix. And in our opinion, this is why the consensus has flipped from optimism to pessimism about the US economy and is worried about a Fed-induced recession. We are too.
Other headlines are also disconcerting: the possibility of Russia using chemical weapons in Ukraine, eurozone banks becoming risk averse and tightening corporate credit, and China shutting down Shanghai due to the spread of a COVID variant. It is a mixed collection of news, but individually and together, it points to substantially weaker growth or potentially a global recession.
We contemplated raising cash this week, however, we still believe select stocks can do well despite these challenges. In fact, some companies will benefit. Therefore, we remain overweight the energy sector, industrials (with an emphasis on defense stocks), consumer staples, and utilities. Each of these sectors is a direct, or indirect, beneficiary of the current world condition. Utilities are not a direct beneficiary, but they are defensive, can pass on costs to consumers and are preferable to bonds in an era of rising interest rates.
Inflation continues to Roar
The March CPI report was filled with bad news. Headline inflation exceeded expectations showing prices rising 8.5% YOY with core inflation up 6.5% YOY. Both series displayed the highest inflation in 40 years. Energy rose 32.2% YOY, up from 25.7% in February. Food prices rose 8.8% YOY, up from 7.9% in February. Services rose 4.7% YOY, up from 4.4% YOY. Goods inflation “moderated” to 11.7% YOY, down from 12.4% YOY in February. See page 3. The March CPI report indicates why the average household is struggling to keep up with normal expenses even though average weekly earnings rose 4.6% YOY in March. After inflation, the purchasing power of consumers fell nearly 4% YOY in March.
All the large segments of the CPI – housing, food & beverages, medical care, and transportation – have been experiencing escalating price increases over the last six months. See page 4. Many economists, like Larry Summers, are voicing concerns about the probability of a recession in the next two years; and not surprisingly, most strategists fear the Fed will trigger a recession by raising interest rates too much or too fast.
A History Lesson
However, history suggests that today’s inflation rate has reached a level that may make a recession inevitable. On page 4, we show a long-term chart of the S&P 500, various inflation benchmarks, and recessions. It shows that the last time inflation began to soar at this pace was during the oil embargo of 1973. That inflation was followed by three recessions in the subsequent ten years.
This era was called the “great inflation” and it began in late 1972 and did not end until the early 1980s. In his book “Stocks for the Long Run: A Guide for Long-Term Growth“ (1994), our friend Wharton Professor Jeremy Siegel, called it “the greatest failure of American macroeconomic policy in the postwar period.” This decade-long inflation era has been blamed on many things: oil prices, the end of the gold standard in 1973, funding of The Great Society legislation, greedy businessmen, food shortages due to bad weather, and avaricious union leaders. But, according to Professor Siegel, the root cause of the great inflation was monetary policies that financed massive budget deficits driven by political leaders and their legislation. This should sound familiar.
The great inflation ended with Paul Volcker, Chair of the Federal Reserve from 1979 to 1987. Volker made financial history in March 1980 when he raised the fed funds rate from 14% to 20%, its highest level on record. It was tough love but needed in order to end years of crippling double-digit inflation. Volker also moved the fed funds rate back to 20% in May 1981 when inflation began to creep higher. Although widely criticized at the time, the March 1980 “Volker Shock” is now seen as a courageous and wise act. Both rate hikes to 20% were followed by recessions, but in the end, it finally broke the back of a dangerous inflationary cycle.
Perhaps this was the history lesson discussed at the March FOMC meeting. If so, it would explain why dovish Fed governors like Lael Brainard suddenly become monetary hawks. The current Fed seems determined to enforce tough love on the economy in 2022 by raising interest rates and contracting its balance sheet. We believe both are needed. Unfortunately, it also raises the risk of recession.
This week kicks off first quarter earnings season, and while all earnings seasons are important, this time analysts will be listening carefully to hear what corporate leaders have to say about revenues and margins. As we show on page 6, inflation is apt to pressure margins this year and we already discussed how inflation will decrease the purchasing power of households. IBES currently is forecasting earnings growth in the first quarter of 6.1% YOY but excluding energy growth falls to 0.6%. Clearly, any disappointments this quarter could tip the balance to negative for the quarter. Again, we would emphasize companies that benefit from the current environment, have predictable earnings streams, and safe dividend yields.
In our view, the most meaningful technical event of the last week was the inability of the DJIA to better the resistance found at 35,000. A convergence of three key moving averages made this a critical point for the index, and the DJIA not only failed to break through but has been noticeably weak in recent sessions. All the popular indices have a similar pattern, but it was most clearly seen in the DJIA. In short, all major indices continue to trade below their 200-day moving averages in a classic bearish pattern. AAII sentiment has been unusually volatile. Last week, bullish sentiment fell 7.2 points to 24.7% while bearish sentiment jumped 13.9 points to 41.4%. Pessimism has been above 40% for nine of the last 12 weeks. Optimism has been below 27.9% for 10 of the last 13 weeks. Neutral has been above average for the third consecutive week. Overall, the AAII bull/bear spread remains positive.
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