The shocks from soaring inflation, rising interest rates and Russia’s invasion of Ukraine sent markets plunging for weeks. Stocks recouped much of their losses, but both markets have looked shakier in the last few days.
After falling as much as 13.6 percent, the Standard & Poor’s 500 ended the first quarter down a mere 4.9 percent. The rebound may have come from hope for a swift end to the war, one way or another. Or it may stem from a belief that the ramifications of a prolonged conflict would persuade the Federal Reserve to limit the interest rate increases it began in March and said would continue until inflation is under control.
But some strategists suspect the bottom has not been reached for stocks or bonds, and advise approaching both with caution.
“One can make a persuasive case that markets should be down more,” said Chris Brightman, chief investment officer at Research Affiliates, an investment management firm. “Inflation is not going to be as easy to prevent as market pricing implies. There is considerable uncertainty. Risks are elevated.”
Stocks nevertheless rallied strongly after the mid-March quarter-percentage-point rate rise, which is expected to be the first of several moves that take the federal funds rate to a range of 2.25 percent to 2.5 percent this year from essentially zero percent.
Investors seem to expect that the Fed will somehow quell inflation without severe consequences for economic growth, an outcome that Mr. Brightman called an “immaculate tightening.” With so many rate increases on the way and the Fed also reversing the many years and trillions of dollars of asset purchases — overall, a tightening of monetary policy — he finds that benign outcome unlikely.
“You could have a vast and substantial tightening into 2023, and a considerable recession that lowers interest rates again,” he said, “or you could have a period of sustained inflation in the high single digits or low double digits, as in the 1970s.”
James Stack, editor of the InvesTech Research newsletter, found parallels with the economic and political landscape surrounding the 1973 Arab-Israeli war. Inflation had already ticked up, stock prices had peaked, and the war led to an Arab oil embargo that sent inflation and interest rates even higher. One year after the war, the S&P 500 had fallen more than 40 percent.
He was not predicting a similar outcome, but he pointed out that inflation was already rising before the invasion of Ukraine, and the West’s restrictions on importing Russian oil are similar in effect to an embargo by producers. Whatever reflex the Fed might have to maintain less restrictive policies, it has been backed into a corner. The latest reading of the Consumer Price Index showed a 7.9 percent increase in the 12 months through February.
As Russia was moving into Ukraine, Bank of America strategists warned that “the invasion exacerbates and extends bear fundamentals of higher inflation.” This, they said in their report, will require the Fed to tighten until economic growth stalls.
The strategists warned of an increased risk of a “policy mistake” by the Federal Reserve that could cause a recession. Bulls, on the other hand, point out that the stock market often continues to rally after the first rate increase in a tightening cycle.
Inflation and geopolitical risk are up, and so are valuations. At 19 times earnings, “the S&P 500 is still expensive,” said Toby Thompson, co-manager of the T. Rowe Price Global Allocation fund. That valuation “is down from the highs, but clearly is not pricing in a recession,” a distinct possibility with a “very aggressive Fed and moderating growth.”
The rally in stocks in March cut the loss for the average domestic stock fund tracked by Morningstar, a financial research company, to 5.4 percent in the first quarter. Commodity and natural-resource funds had double-digit gains, while almost all other categories lost ground.
International funds fell 8.2 percent, with the 22.7 percent gain for Latin America portfolios a glaring exception.
Bond funds lost 4.2 percent, on average, with long-term funds recording double-digit declines.
Marko Papic, chief strategist at the Clocktower Group, an asset manager, agreed with Mr. Thompson that “the more the stock market ignores Fed hawkishness, the more likely they’re going to go hard early.” But Mr. Papic expects the Fed to choose later in the year to tolerate persistent inflation to try to forestall a recession.
Mr. Papic advises investors to “shift into value now” by buying stocks of commodity producers and in countries, such as Brazil and Chile, that export commodities. The dominance of mining in those countries’ economies could explain much of the recent strong performance that Morningstar noted among Latin America funds.
The Russia-Ukraine War and the Global Economy
Rising concerns. Russia’s invasion on Ukraine has had a ripple effect across the globe, adding to the stock market’s woes. The conflict has already caused dizzying spikes in energy prices and is causing Europe to raise its military spending.
The cost of energy. Oil prices already were the highest since 2014, and they have continued to rise since the invasion. Russia is the third-largest producer of oil, so more price increases are inevitable.
Gas supplies. Europe gets nearly 40 percent of its natural gas from Russia, and it is likely to be walloped with higher heating bills. Natural gas reserves are running low, and European leaders worry that Moscow could cut flows in response to the region’s support of Ukraine.
Food prices. Russia is the world’s largest supplier of wheat; together, it and Ukraine account for nearly a quarter of total global exports. Countries like Egypt, which relies heavily on Russian wheat imports, are already looking for alternative suppliers.
Shortages of essential metals. The price of palladium, used in automotive exhaust systems and mobile phones, has been soaring amid fears that Russia, the world’s largest exporter of the metal, could be cut off from global markets. The price of nickel, another key Russian export, has also been rising.
Financial turmoil. Global banks are bracing for the effects of sanctions intended to restrict Russia’s access to foreign capital and limit its ability to process payments in dollars, euros and other currencies crucial for trade. Banks are also on alert for retaliatory cyberattacks by Russia.
If the Fed does not go ahead with an aggressive approach, inflation-adjusted bond yields “are going to be very low, so commodities will go higher,” he said. He acknowledged, though, that putting money into commodities is risky, and added, “If I’m wrong and there’s a recession, they’ll get killed.”
In the current environment, he continued, growth stocks, especially large and expensive technology blue chips like Microsoft and Apple, may be dangerous to own. They started to fall from favor before the pandemic, “and then Covid allowed tech companies to bring forward a decade of customer growth,” Mr. Papic said. “We’re at the limits of that outperformance.”
The outlook for tech stocks may hinge on the outlook for interest rates. Tech stocks tend to react badly to higher rates because these companies are more expensive than others to start with, and higher interest rates tend to depress stock valuations generally. Also, higher rates often come when the economy is strong and the ability of tech companies to grow when other sectors cannot matters less.
A more aggressive Fed, even if just for several months, means higher rates, and Mr. Brightman highlighted a trend, driven by heightened geopolitical risk, that may keep rates higher for far longer: “slowbalization,” as he put it, a decline, or even reversal, of the system of freer trade that has created enormous wealth for investors.
A new urgency to ensure stable, secure supply chains could compel companies to shift production closer to home, he said. Building manufacturing capacity will require capital, pushing up interest rates and, because it costs more to make a widget in Secaucus than Shenzhen, inflation, too.
“That’s bad for growth stocks and bonds,” Mr. Brightman said. “Over the last couple of decades, profits were created with little investment — a couple of guys doing things with software, not building factories and doing things with real resources. To create more secure supply chains, for chips, pharma, mining and metals, you need large infrastructure investment. Then, if we get serious about climate change, we have to replace the grid.”
Mr. Brightman is negative about most asset categories right now.
“The tactical move is to reduce risk and move to safer investments,” such as inflation-protected Treasury securities or cash, he said. “Wait for better opportunities. Take risk off the table and get defensive.”
General wariness has led Mr. Thompson to reduce exposure to stocks and bonds alike. He says he is preparing for possible stagflation, an insidious condition last seen in the 1970s in which slow economic growth coexists with elevated inflation.
“If we do have the stag part of it and we’re tipping over into recession, long Treasury bonds is a good hedge,” he said, “and we’re adding real-asset-related equities for the ‘flation’ side,” including energy stocks and real estate investment trusts.
But because he anticipates stronger growth eventually, Mr. Thompson’s portfolio also includes economically sensitive segments like smaller companies and value stocks.
A volatile start to 2022 left few places to hide in the markets. As the fighting in Ukraine and the Fed’s effort to subdue inflation continue, it’s unwise to assume that the rest of the year will be easier on investors’ nerves or their portfolios.