February 2022 Market Commentary
March 3, 2022
February bore witness to historic events that few could imagine and many thought were near impossible. At the outset, markets were focused on US monetary policy and how it might unfold in the face of sustained upward pressure on inflation. Comments by Fed members were scrutinized closely in an effort to ascertain the Fed’s most likely course of action. Each additional inflation reading added to market expectations that the Fed would act decisively to prevent higher inflation from becoming entrenched. By mid-month, markets were pricing in a nearly 50% chance for a 0.50% rate increase following the Fed’s March meeting, and a total of seven rate hikes before year end. That, however, was before Russia’s invasion of Ukraine; before the vast majority of developed nations responded to Russia’s unprovoked attack with crippling sanctions; and before the specter of a larger conflagration on the European continent became a distinct, if still remote, possibility.
At the conclusion of World War II, an uneasy peace settled over Europe. However, even before the fighting ceased, tensions were building between the Soviet Union and the Allied powers of western Europe and the US. In the years following the War, the USSR expanded its “Iron Curtain” to cover much of Eastern Europe. Following the fall of the Berlin Wall in 1989, and the subsequent collapse of the Soviet Union in 1991, numerous Soviet satellites, including Ukraine, declared their independence. Current Russian President Vladimir Putin has referred to the breakup of the Soviet Union as a “catastrophe” and during his time in power has sought to re-exert influence, if not control, over certain countries and regions, including Chechnya, Georgia, Belarus, and Ukraine. Putin has long been particularly focused on Ukraine given its strategic importance. In addition, he has refuted the idea that Ukraine ever achieved “real statehood” and declared that it is an integral part of Russia’s “own history, culture, spiritual space.” Those historical views and Ukraine’s desire to join NATO ostensibly drove Putin to attack Ukraine.
In response, the US, UK, European Union, Japan, Australia, and others, enacted numerous sanctions against Russia. The speed with the which the sanctions were implemented and their overall severity have few modern precedents. The closest analogy in terms of severity may be the sanctions applied against South Africa in response to its system of apartheid. Thus far, the sanctions have targeted a wide range of industry’s including Russia’s technology, finance, energy, aerospace, and military sectors. In addition, the foreign assets of many Russian oligarchs, and even Putin himself, have been frozen. In response, Russia’s central bank has been forced to increase interest rates from 9.5% to 20%, while restricting capital outflows from the country. In addition, the ruble has fallen to an all-time low against the dollar, and trading on the Russian stock market has been halted until March 5.
As a result of the uncertainty created by the fighting between Russia and Ukraine, and how longer-term geopolitical relations will be reshaped as a result, financial markets have been understandably volatile. Interestingly, however, market loses thus far have been far more muted than one might have imagined given the current state of affairs. While the S&P 500 did fall 5.6% in the four days preceding Russia’s invasion, it actually gained 3.7% in the two days afterthe invasion, thereby providing another vivid example of how difficult it is to time market events and why trying to do so is often fruitless. One explanation for the market’s gains was the idea that the Fed will now take a more cautious approach with monetary policy than previously anticipated. That has been reflected in part by market expectations that now anticipate a 0% chance of a 0.50% rate increase in March and a total of five rate hike before year end.
For the month, large caps (S&P 500) fell 3.1%. Small caps (Russell 2000), on the other hand ended up 1.0%. Some of that was likely due to investors rebalancing back into small caps after they briefly entered bear market territory in late January. Performance was also likely aided by the perception that small caps tend to be more domestically oriented, and thus less susceptible to geopolitical concerns. International markets finished down for the month with developed markets (MSCI EAFE) losing 2.0%, while emerging markets (MSCI EM) fell 3.1%. Commodities were one of the few bright spots, gaining 6.2% thanks to an 8.6% increase in oil prices. Even before the fighting in Ukraine, oil prices were facing upward pressure due to increasing demand and constrained supply. Concerns about how recent sanctions might affect exports of Russian oil and natural gas helped push prices even higher.
US economic data released during the month pointed to continued growth. January’s employment report saw 467K new nonfarm payroll jobs added, well in excess of the expected 150K. Household survey data, upon which the unemployment rate is calculated, showed 1.2M individuals found work in January. Encouragingly, another 1.4M individuals joined the labor force in search of work, increasing the participation rate by 0.3% to 62.2%, the highest level since March 2020. That bodes well for employers desperately seeking to fill open positions. Inflation continued to move higher, with headline consumer prices (CPI) and core personal consumption expenditures (PCE), rising to 7.5% and 5.2%, respectively, their highest levels since 1982 and 1983. On the consumer front, despite sentiment falling to its lowest level since 2011, spending remained robust, increasing 2.1% in January to its highest level since March 2021. Spending on durable goods, including automobiles helped drive the gain.
Fixed income returns for the month were negative, as measured by the Bloomberg US Aggregate Bond index which dropped 1.1%. Despite wild swings in the markets, primarily caused by the evolving Russia-Ukraine conflict, the 10-year Treasury yield finished the month up just five basis points (0.05%). Mid-month saw the 10-year Treasury yield move to highs last seen prior to the coronavirus pandemic, but the escalation of events in Ukraine started a risk-off rally to close out the month, pulling yields back down to nearly no change. Yields had risen on continued concerns over high inflation data and subsequent expectations that the Fed would respond more aggressively to contain it. Some Fed members have indicated a willingness to consider 50 basis point rate hikes, or undertaking a rare intra-meeting hike in hopes of accelerating the process. By month end, however, fears over Fed hikes had taken a back seat to the risk-off market sentiment and yields were drawn lower. Longer municipal bonds showed a similar, though less volatile pattern, with the 10-year AAA muni yield rising just three basis points on the month.
Shorter Treasury bonds saw even more volatility due to shifting Fed rate-hike expectations. Affected more by Fed sentiment, the 2-year bond saw a rise of over forty basis points within the month before dropping in the final week, as rate hike expectations subsided. Despite the month-end drop, 2-year Treasury yields still finished about 25bps higher, reflecting the continued need for the Fed to combat inflation despite the market disruption caused by the Russian invasion, which could bring further inflationary pressures in its own right.