Between late February and mid-Match, the world drastically changed. And financial markets reacted by becoming much more volatile as unknowns emerged in the Brave New World. Markets displayed about 60% more volatility in the week just ended (March 11) than they did in the February 18 week before the Russian invasion (referred to as R/U in this blog). These three major risks have dominated the news, and impacted most Americans’ lives:
- Geopolitical risk as the world divides and reacts over R/U;
- The spike in energy and food prices due to R/U, sure to push inflation higher and acting as a regressive tax on low and middle income earners;
- A looming Fed tightening cycle with a high probability of a policy mistake leading to recession.
Those “risks” have caused volatility in the financial markets, i.e., a “bear” market in both stocks and bonds, as the latest news, especially surrounding R/U, inflation, and the Fed gets “priced in.”
The fact that Russia and Ukraine are significant exporters of energy (oil, natural gas), grains (wheat, corn), and metals (palladium, titanium, neon gas) has caused commodity prices to spike to record levels. Nickel is the poster child here, with its price spiking to such an extent that the London Metals Exchange (LME) stopped trading in the commodity and even broke some of the trades as a significant short-seller couldn’t meet margin calls. It now appears that there will be a Russian default on the payment of coupons due this week (week of March 13) on their sovereign debt. Thus, more volatility ahead!!
The CPI rose +0.8% in February, half of which was due to rising food and fuel prices (+0.4%) and bringing Y/Y inflation to 7.9%. Without the food/fuel increases, February’s inflation would have remained at 7.5% where it was in January, and that likely would have been the peak.
But, the world changed that day in late February. As indicated above, rising food and fuel prices are a regressive tax. Every $10/bbl. increase in the price of oil translates into U.S. households spending and extra $35 billion/year, equivalent to 0.2% of GDP. Thus, the rise from $90/bbl. to $110/bbl. reduces GDP by -0.4 pct. points. If the price of oil should reach $150/bbl., GDP will be reduced by -1.2 pct. points. And, the rise in food prices isn’t included in that analysis. The NY Times recently reported that at mid-week prices (March 9) for gasoline and food, American families will have to shell out an extra $3,000/year; $2000 for gas and $1,000 for food. That means spending on something else must be foregone. For an economy already having trouble growing (the latest Atlanta Fed GDP estimate for Q1 is +0.5%), this spells trouble.
The economy cannot handle surging oil and food prices for long. Demand destruction soon sets in. This happened in the 1970s with the OPEC oil embargos, and again in 2007 when oil hit $150/bbl. The chart shows that gasoline prices fell early in the COVID lockdown period., but as the economy re-opened, they rose to levels last seen in the 2011-13 period, before falling as the U.S. became energy independent with the development of fracking. You can see the spike up at the very right hand side caused by R/U. Perhaps the economy could handle $90 /bbl. oil; but we doubt a recession can be avoided at $130/bbl. The University of Michigan Consumer Sentiment Index (see chart at the top of this blog) shows that consumers are downbeat to levels normally only seen in recessions, and that was before the rapid rise in gasoline prices over the week ended March 12.
Will “Normal” Return?
An interesting question is, “if the R/U issue gets settled, will oil/food/commodity prices return to their pre-conflict levels? We doubt it! What we have learned, as globalization unwinds, is that the world has under-invested in the natural resource sector. And, now, every country will aggressively pursue “resource independence,” or at least availability of resources from allies.
Businesses, which until COVID practiced “just-in-time” inventory management, have now begun to stockpile, just to insure that they can meet delivery commitments to their customers. (Note that inventory growth was more than 70% of Q4’s GDP growth.) As we noted in our last blog, China is already doing this and they are likely to continue to do so for the reasons mentioned above and, perhaps, to insulate themselves in case there is any blowback if they assert their sovereignty claims regarding Taiwan. So, no, we don’t think the commodity price run-up is temporary. While there might be some price reduction when the R/U conflict ends (i.e., if sanctions are lifted), we don’t see prices reverting to their pre-conflict levels.
Inflation Was Moderating
As we saw in last week’s employment report, the first signs of moderating inflation appeared with median wage rates actually falling -0.1% and two-thirds of the economic sectors reporting negative wage growth. That was due to the return of the unskilled to the labor market in droves. Further proof of an easing labor market was in the latest JOLTS (Job Openings and Labor Turnover Survey). The number of job openings in January was -185K lower than in December. In the leisure/hospitality sector, openings were down -314K, while they fell -58K in education/health and -16k in state/local government employment. Layoffs increased +152K (to 1.414 million). And voluntary quits (i.e., the “Great Resignation”)? They fell -157K!
No blog of ours would be complete without a discussion of Fed policy or prospective policy. Powell has told us that they are entering a tightening cycle with a rate rise in March locked in along with a cessation of QE (Quantitative Easing – something, we think they should have halted several months ago). We, and others, have observed, that they are entering this tightening cycle with a weakening economy and with a yield curve on the precipice of inverting (the 10-2 yield spread is 25 basis points (10-Yr Treasury = 1.99%; 2-Yr = 1.74%); it is normally 150 when the Fed embarks upon a tightening cycle, and most of those tightening cycles have resulted in recession!).
[Note: In his Congressional testimony, Powell lauded Paul Volcker as a hero and savior for his inflation fighting tactics in the early 1980s. One of us was a practicing economist then and has a very different perspective – Volcker was reviled at the time as his inflation fighting tactics resulted in back-to-back recessions. Some hero!! Wonder if that’s what Powell sees as his role? Certainly, recession will follow if the FOMC follows Bullard’s advice (raise the Fed Funds Rate to 1% by June!).]
Our hope is that the Fed resists the temptation to tighten more aggressively due to inflation‘s uptick caused by the R/U spike in oil/food prices, as much of the price spikes are expected to be temporary (“transient” to use an out of favor word) and will fall because 1) the R/U conflict ends, or 2) OPEC opens its spigots, and/or 3) U.S. production rises as falling rig counts are reversed (i.e., high prices are a cure for high prices). Today’s oil/food price spikes are not the same kind of inflation that occurs on the demand side when there is a broadening of wage pressures (the Fed has the proper tools to fight that kind of inflation, but not the supply side inflation issues we see today).
Despite the fact that it has a very low correlation with what actually happens in the future, the dot-plot (the FOMC individual participant forecast of the Fed Fund Rate for the next several quarters), which will be released on Wednesday after the Fed meeting, is the markets’ clue to how many rate hikes the FOMC is contemplating. Four or fewer in 2022 will be “good news; while five or more is “bad.” Expect market reaction either way.
We see four near-term issues that will impact the financial markets – we call them our “For Better” or “For Worse” scenarios:
|For Better||For Worse|
|R/U Truce||No R/U Truce|
|Oil Prices Fall||Oil Prices Rise|
|Fed: Dot Plots Show 4 Rate Hikes 2022||Fed: Dot Plots Show 5+ Hikes 2022|
|Inflation: Moderates After R/U Settles||Inflation: Still Hot After R/U Settles|
Robert Barone, Ph.D
(Joshua Barone contributed to this blog)