Before the Russian invasion in Ukraine dominated the headlines, we were worried about the following:
- Inflation increasing
- Growth slowing down
- Federal Reserve action on interest rates
While Russian action may exacerbate inflation and result in some short-term drag on growth, the effect on our economy is likely to be somewhat limited. Of course, any escalation into greater Europe is a different story. Many may not recognize that Russia is the largest supplier of Europe’s natural gas (30%: down from over 40% in 2019) and oil, which is likely to drive up energy costs and lower European growth dramatically. Russia is also the largest exporter of wheat in the world.
Over the last six days, markets have sold off, accelerated by Russian actions. The NASDAQ, at one point, fell 20% from its previous high. The S&P 500 fell over 10%, and the Dow reached a 10% loss today at one point. But what is missing from all of the noise is that earnings for the S&P 500 rose 22% in the latest quarter. Russia’s economy is commodity-based. It is not otherwise a significant player in the global supply chain.
Unless there is a significant conflagration of hostilities, the invasion is likely to have a short-term negative effect on U.S. markets. Today’s reversal of most asset classes starting the day sharply negative then recovering losses or moving into positive territory was quite remarkable.
While the geopolitical risk has increased, we are still first and foremost worried about inflation, growth, and Federal Reserve policy.
While we feel this is not the time to panic, we are looking to reduce some exposure to Europe. We think inflation will continue to express itself in commodity prices. Therefore we are looking to increase our exposure to commodities and energy as an alternative. Recognizing that energy, particularly in carbon-based fuels, is not popular with all clients, please contact us if you want to discuss it further. Energy is very attractive given the economics of the highest projected 5-year growth and the highest dividend yields in the S&P 500 industry groups. Financials have not done very well the past couple of weeks but represent another sector with relatively high yields, and we are watching to increase exposure to this sector as well.
Fixed Income Sector
Even though we have been somewhat defensive in fixed income (and have avoided junk bonds and other higher-risk fixed-income categories), our choices are not immune to interest rate increases. Most core fixed-income investments are down over 3%, with the iShares Core U.S. Aggregate Bond ETF (which reflects the U.S. investment-grade fixed income market) down 4.1% as of February 23. Bonds are not stocks, and while the decline is bothersome, we worry less about it. As bonds in the funds mature, the proceeds buy new bonds with higher current yields. While rising rates can cause a temporary loss of principal, the bondholder gets paid the total value at maturity. Eventually, and in much shorter time frames than stocks, this leads to price recovery. And the income stream ends up being higher.
In sum, markets are unstable with much bad news. But companies and the economy are doing well. At this point, we are experiencing a correction and are taking some reasonable steps to adjust to new conditions.