A Russian Invasion of Ukraine, Inflation, and Supply Chain Issues Spook the Market

There were plenty of concerns to go around as we finished out the week including:

  • The imminent risk of war between Russia and Ukraine continues to build. The NY Times on February 11th reported US officials have picked up intelligence suggesting Russia may invade Ukraine as early as Wednesday.
  • Further chip shortages may result from a conflict with Russia. The White House warned the US Chip Industry on February 11th that Russia may retaliate against US sanctions by blocking access to key materials like neon and palladium.
  • The ongoing Covid-19 disruptions include staff shortages because employees are out with Covid and supply chain disruptions due to protests like what is taking place in Canada now. Further complicating the issues around the protests is the fact that officials and law enforcement speculate that by removing peaceful protestors by force they may in fact encourage more protestors to join the cause. They have also acknowledged if they use too much “force,” what have largely been peaceful protests may become much less peaceful. It appears government leaders are looking at alternatives to the land bridges that are now blocked, including the use of air and sea corridors to resume the successful shipment of goods. However this plays out, the end result to the economy is that the flow of goods is again restricted, potentially leading to the shortage of more goods and higher prices.
  • The steady grind higher for energy prices. And as with the protests going on in Canada, government officials are caught between a rock and hard place. There is talk of taking the Russian pipelines offline, but Russia is one of the largest suppliers of energy to Europe, and losing Russia’s supply would likely cause immediate shortages of natural gas and a sharp increase in its price. There are solutions to the energy shortages that could be implemented, but they would come with the loss of political capital.
  • The issue of rising inflation here in the US. The Fed has issued statements acknowledging that inflationary pressures did not subside during December or January. This has caused a rapid shift in the Fed’s outlook. Six months ago it was uncertain if the Fed would begin raising rates in 2022; some believed that would not take place until 2023. Now there are reasonable estimates that the Fed may do as many as 7 interest rate increases in 2022. A month ago, most thought there might be 3 or 4 rate hikes in 2022. Adding to the concern, one of the Fed Governors (Bullard) now believes it may be necessary to increase the size of the rate hikes. Up until now, it has largely been assumed that when the Fed began raising rates it would do so 0.25% at a time. Bullard believes the rate hikes may need to be more like 0.5% at a time.

After reviewing all the "bad news" out there, it’s easy to see why the market has seen an increased level of volatility. What seems to be getting less attention is how quickly the market has been snapping back from the bout of selloffs that have accompanied the bad news. The catalyst behind the sharp rebounds has been strong earnings. Even as we confront a litany of negative headlines about all that “may” go wrong, there is a persistent flow of good earnings and economic news.

Reuters reported on February 11th that for the week ahead we are likely to see a 1.8% increase in retail sales. We are also likely to see a 0.4% growth in industrial production. Business inventories are expected to have increased 2.1% in December (and this is important - rising inventories will help stabilize supply and demand - and then inflation). Home sales are likely to have dropped 1% in January after having fallen 4.6% in December (this could be good and welcome news too - softer demand means inflation may begin to taper off).

It has also been reported that Wall Street expects to see a rise in fourth quarter revenue for Nvidia Corp, which is scheduled to report next week. They also expect to see a rise in first quarter revenue for Applied Materials (also in the semiconductor space). Marriott International is expected to see a rise in fourth quarter revenue as travel continues to pick up, as are AirBnB and Hilton. Deere & Co is expected to see a rise in revenue on the back of strong demand for its farming and construction machines. In summary, earnings growth has been persistent and is widely spread throughout the economy.

Adding to this good news, we know that during much of 2020 and 2021 US consumers became prodigious savers. During this period, we saw the highest savings rates in our history, and it makes sense. The government flooded the economy with money that was hard to spend in some regards because of the lockdowns. Beyond being harder to spend, Covid brought with it a type of uncertainty many of us have not felt before, and fear of the “unknown” likely contributed to consumers ramping up their savings.

We can look to Federal Reserve Data to see that "saving more" is not a new trend. Even before Covid, consumers had begun to save. The Federal Reserve periodically conducts a survey of the median account balance for US households. In 2016, the median account balance was $3,400. By 2019 (before we heard of Covid), the median account balance had increased to $5,300, and this was during a period of very low inflation, so inflation cannot account for the increase. We can only guess what the median account balance increased to during 2020 and 2021 (the data has not yet been made available), but we have reasons to believe it is much higher now than it was in 2019.

Putting all of this together, the sharp increase in inflation and all the other issues are causing market turmoil because they “might” lead to falling economic activity (i.e. if the cost of living is up 9%, and wages are up 5%, then there must be a “real” drop of 4% in economic activity). A drop in economic activity would then lead to a drop in “real” (i.e. inflation adjusted) earnings, and thus the price of stocks would need to fall too. This however does not take into account the impact of savings. If the average consumer has increased his/her savings by 25%, then the loss of purchasing power caused by inflation outpacing wages could be absorbed by reducing savings. If reducing savings alone were not enough to offset inflation, then consumers could begin drawing down savings. If inflation outpaces wage growth by 4%, then the combined efforts of reducing savings and drawing down savings could potentially offset inflation for years. In other words, the expected drop in economic activity may not come, at least for a while.

This does not mean that we don't acknowledge that eventually, wages will need to catch up to inflation; we know that they must eventually or economic activity will suffer, but it does not have to be immediately, or even soon. Another interesting thought that most economic models seem to ignore is how the “Gig” economy has opened new doors. Traditionally a worker had a full time job, and from the full time job the worker derived all of his or her income. If wage inflation did not keep up with cost inflation, then difficult decisions and adjustments had to be made, often leading to a slowing economy (i.e. a recession). However, in the “Gig” economy, a great number of flexible options have presented themselves. The traditional worker in the “Gig” economy often derives a considerable amount of his or her total take home income from side gigs, i.e. driving for Uber or Amazon, or working on something online from home (i.e. etsy, ebay, "virtual call centers," etc.).

In today’s economy, workers have more flexibility to choose “Gig” employment opportunities to bolster their income, thus allowing their take home income to keep up with inflation. It is true they will have to work more hours to accomplish this, but the efficiencies that modern life affords may also provide more time in the day for these endeavors. We live in a time when people can work while they commute (thanks to high speed cellular connections). At home, the floor can clean itself with a robot, the electric car needs less time at the shop, and prepared foods are easier to come by than ever (just to name a few areas where consumers can get back more time in the day). The reduced demand on consumers' time for "personal needs" allows for more time to be spent on increasing one's earnings.

In summary, the current inflation level is concerning, and it does merit our attention. This, however, does not mean that the battle is already lost. Following the logic that high inflation should destroy earnings growth, we must stop and acknowledge that over the last year high inflation was met with higher earnings growth. This of course does not mean that if high inflation persists it will continue to drive higher earnings. We are in fact quite certain that at some point, high inflation must negatively affect real earnings. Where the uncertainty persists is how long will it be before this happens, because we have reasons to believe that it could be some time before inflation causes earnings growth to stall out. This means that there is a real possibility inflation could be tamed allowing for an orderly resolution to our current inflation problems without a recession.

Lastly, we believe it is worth mentioning that equity (i.e. stocks) has always been one of the best ways to hedge against inflation. Some stocks will tend to perform better in an inflationary environment, and others will struggle more. Because of this, we believe it is prudent to increase one's exposure to equities that typically perform better in an inflationary environment, and we have been focused on this transition for some time.


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