Inflation, Invasions, and Interest Rates

By Ben Norris, CFA, Securities Research Analyst, Associate Vice President

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Stocks finished lower once again last week with a strong wave of selling commencing on Friday afternoon. The White House continues to raise concerns about a potential invasion of Ukraine by Russia, and its warnings last week were enough to spook investors, at least temporarily. On top of the Ukraine/Russia situation, many growth-oriented investors saw their portfolios get rocked as more people think that the Federal Reserve will raise rates by 0.50%, rather than the 0.25% hike that they’ve recently hinted at. Strong employment figures combined with continually high inflation (more on this in a moment) is opening up the possibility of a stronger-than-expected move by the central bank at its March meeting. St. Louis Federal Reserve Bank President James Bullard explicitly said last week that he thinks a 0.50% rate hike is the needed move to combat a potentially overheated economy. Some other Regional Fed presidents indicated that they still believe a 0.25% move is the preferred action, but an accelerated pace of rate hikes is squarely in the conversation. In fact, markets are indicating they believe there is a greater than 50% chance that the Fed will raise rates 0.50% in March.

As we’ve discussed in the past, higher rates (or the prospect of higher rates) tend to weigh on growth stocks, especially those in the large- and mega-cap buckets. Last week was no different as the Technology sector saw a 2.95% loss, making it the worst-performing sector. For the year, the sector has lost nearly 11%, putting it firmly in correction territory. Real Estate, Communication Services, Consumer Discretionary, and Utilities stocks also saw steep losses last week with each dropping more than 2%. In contrast, the Energy sector continues its impressive streak, notching a 2.19% gain for the week extending its year-to-date gain to a ridiculous 26.86%. Materials and Financials stocks were the only other positive sectors last week, showing gains of 1.06% and 0.02% respectively.

The S&P 500 (SPX) lost 1.79% last week, while its equally weighted counterpart lost just 0.21%. This disparity indicates that the especially large stocks in the index fared much worse than their small- and middle-sized counterparts. Similarly, the Russell 2000 (RUT), a small-cap index, saw strong relative performance last week, locking in a 1.42% gain. This was a notable reversal from the rut that the index has been in lately – it remains down 9.32% year-to-date even after last week’s rebound. Stronger breadth (a higher proportion of stocks participating in rising market) tends to be good for the market’s health. This recent move in small-cap stocks could be just what the market needs to turn things around after a rough start to 2022. The Dow Jones Industrial Average (DJIA) lost 0.96% last week while the Technology stock-heavy Nasdaq Composite (COMP) lost 2.16%.

It seems like we can’t go a week without mentioning inflation, but last week’s read was particularly notable. On Thursday the Consumer Price Index (CPI) came in higher than consensus expectations last week with a 7.5% readout, compared to the 7.2% rise expected. The core CPI (which doesn’t include food and energy costs due to their relative volatility) also rose more than expected with a 6.0% gain. These are the highest levels of inflation we’ve seen since the early 1980s and we’ve now seen an increase in CPI for each of the last five months. The rise in prices was broad based with most CPI categories (food, housing, energy, clothing) showing an increase. However, the standout in this reading was a 40% increase in the price of used cars year-over-year. This is a direct result of the still tangled global supply chain – especially the shortage in specialized semiconductors that are needed for modern cars. As long as situations such as higher used car prices (something that just doesn’t make sense for an otherwise depreciating asset) are a reality, we’ll be dealing with market-moving levels of inflation.

Consumers are taking notice of higher prices in their everyday lives. Last week’s consumer sentiment reading came in well below expectations and was the lowest reading in over 10 years. I would expect that we see levels of consumer spending level off over time as a result, which may help tamp down certain aspects of inflation. President Bullard seems to be in good company in his urging of faster rate hikes. The market now expects the Fed to raise rates six times in 2022 versus the five expected just last week and three at the beginning of the year, illustrating just how seriously this bout of inflation is being taken. At the same time, bond markets are reacting to the potential shift to a more reactionary stance by the Federal Reserve. The yield on the U.S. 10-year Treasury Note rose above 2% on Thursday for the first time in since 2019 and is up from 1.6% at the beginning of the year.

While inflation data and Fed posturing have been the primary catalysts for the sharp move higher in rates, the possibility that Russia could invade Ukraine in the near future has some investors seeking out the safety of U.S. treasuries and pulled the yield on the 10-year note back below 2%. The Investment Strategy Committee predicted that the yield could exceed 2.25% by the end of the year. If things keep going in their current direction we may be proven right before the first quarter of 2022 is over. Another effect of Russian saber rattling has been a sustained move higher in crude oil prices. The thought is that any conflict may cause supply disruptions and a corresponding increase in prices. Higher crude prices have been the sole reason that the Energy sector is up so strongly in 2022 and it appears that elevated prices are going to stick around for a while. I expect profitability in the Energy sector and, in turn, stock performance to be strong for the remainder of the year.

The upcoming week features the release of the FOMC minutes on Wednesday. Other notable economic releases include the Producer Price Index, Retail Sales, Initial/Continuing Jobless Claims, before rounding out the week with Leading Economic Indicators.

Date Report Previous Consensus
Monday 2/14/2022 None
Tuesday 2/15/2022 Producer Price Index (PPI)

0.2%

0.5%

Wednesday 2/16/2022 Retail Sales

-1.9%

2.0%

Import Price Index

-0.2%

1.4%

Industrial Production

-0.1%

0.4%

Capacity Utilization

76.5%

76.7%

Federal Open Market Committee (FOMC) minutes
Thursday 2/17/2022 Initial Jobless Claims

223,000

222,000

Continuing Jobless Claims

1.61M

Housing Starts

1.70M

1.70M

Friday 2/18/2022 Existing Home Sales (Seasonally Adjusted Annual Rate)

6.18M

6.10M

Leading Economic Indicators

0.8%

0.2%

 

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