War? What is it Good For? Absolutely Nothing.

by Liz Ann Sonders and Kevin Gordon, Charles Schwab & Company Ltd.

The titles of these reports are always courtesy of well known (and often more obscure) rock songs; but today, a few of the lyrics resonate emotionally from the song War by Edwin Starr:

It ain’t nothing but a heart breaker
War, friend only to the undertaker
Oh, war, it’s an enemy to all mankind
The thought of war blows my mind
War has caused unrest
Within the younger generation
Induction then destruction
Who wants to die? Oh

It’s been an overwhelming two years; with Russia invading Ukraine just as it looked like we might be putting the COVID-19 virus in the rearview mirror. The immediate impact of the war on the U.S. and international economies is via energy markets; but sanctions placed on Russian banking and payment systems have led to significant volatility in currency markets as well. The significant flattening of the U.S. yield curve and plunging GDP forecasts for this year’s first quarter already pointed to rising recession risk … a war clearly ups that ante.

What the sentiment tea leaves say

U.S. stock market volatility has exploded over the past couple weeks; yet investors’ positioning—as shown by the Chicago Board Options Exchange (CBOE) equity put/call ratio in the chart below—isn’t reflecting full-blown panic yet. As you can see, despite the uptick this year (reflecting more put purchases relative to call purchases), the current ratio isn’t near alarming levels seen in prior crises—including the 9/11 terrorist attacks, subprime housing bubble, or eruption of the COVID-19 pandemic.

No panic (yet)

Source: Charles Schwab, Bloomberg, as of 3/4/2022.

The picture looks different within attitudinal measures of sentiment, however. Bearish sentiment—measured by the weekly American Association of Individual Investors (AAII) survey—spiked in January as global equities sold off and again recently (to its highest since 2013) as geopolitical tensions erupted. The latest reading shows a pullback in bearishness, but the bulls (understandably) remain outnumbered for now (the survey is conducted on Wednesdays, so the readings shown don’t reflect the latter part of last week’s market action; or the war news over the weekend).

Bears outnumber bulls

Source: Charles Schwab, Bloomberg, as of 3/3/2022.

As stress has continued to wade into the stock market and several sentiment metrics have turned sour, there has been no shortage of pundits and analysts positing that equities may be poised for a contrarian move to the upside. While it may indeed be true that pessimism has historically been consistent with stronger gains for equities, we’d emphasize that a positive catalyst is typically needed to provide a lift. Obviously, this could come via a cease fire and/or quick retreat in energy prices; but betting on that in the near-term seems a fool’s errand.

War exacerbating prior trend

Market weakness is not a new Russia/Ukraine-related phenomenon. Keen observers know that breadth among traditional indexes had been deteriorating well before Russia invaded Ukraine. No matter how you slice and dice it, as shown in the table below, weakness has been widespread and the violent churn under the surface made its way to the index level this year.

A stealth bear market within the NASDAQ and Russell 2000 has taken shape, as the average member’s year-to-date drawdown has amounted to 26% and 25%, respectively. The share of members that have experienced at least a 20% drawdown over the past year (52 weeks) has grown to 58% for the S&P 500, 77% for the NASDAQ, and 85% for the Russell 2000.

Stealth bear market rolls on

Source: Charles Schwab, Bloomberg, as of 3/4/2022. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results. Some members excluded from year-to-date return columns given additions to indices were after January 2022.

Is past prologue?

We’re often asked about historical comparisons to the current environment. Two that come to mind are late 2018, when the market went into a tailspin courtesy of a Fed that was tightening monetary policy; and 1998, when Russia defaulted on its debt, leading to the collapse of the Long-Term Capital Management (LTCM) hedge fund.

The chart below compares the current drawdown from the S&P 500’s January peak to those in September 2018 and July 1998, both of which turned into near-bear markets for the index (drops of 19.8% and 19.3%, respectively). Ultimately, in both instances, stocks escaped “official” bear territory (using the simplistic -20% peak-to-trough index-level decline). While the current fall from January’s all-time high has followed a somewhat similar pattern to 2018 and 1998, we’d caution against assuming a similar pattern looking ahead.

A near-bear resemblance

Source: Charles Schwab, Bloomberg, as of 3/4/2022. Data is indexed to 100 at 1/3/2022, 9/20/2018, and 7/17/1998. An index number is a figure reflecting price or quantity compared with a base value. The base value always has an index number of 100. The index number is then expressed as 100 times the ratio to the base value. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

There are myriad differences in today’s market and economic backdrops. Perhaps most notably, the Fed was cutting interest rates in 1998 and it wasn’t until June 1999 that it embarked on a tightening cycle. In 2018, the economy was embroiled in a trade war with China and the Fed was nearing the end of its tightening cycle. In fact, the Fed stopped hiking rates in 2019 and started cutting rates later that year. Both instances are in direct contrast with where the Fed is today: intent on sticking to its plans to hike rates, not to mention an unwinding of its balance sheet.

From a geopolitical perspective, 1998 does indeed provide a stronger comparison to today. With western sanctions currently crippling Russia’s economic and financial systems, and the Russian ruble in freefall, probability of a Russian debt default is rising. That last occurred in 1998, as Russia was reeling from the impact of the Asian Financial Crisis in 1997. Contagion made its way throughout global markets, including the collapse of LTCM, which had ripple effects within the financial markets.

Prospects for another default have surfaced and, while the last episode was followed by a rebound in the stock market, it’s worth noting that Russia benefited in 1998 from a rescue package organized by the IMF and was not under duress from widescale sanctions. Given the highly different circumstances today, a reprieve for the market cannot be predicated on a late-1990s replay, especially as severe debt and currency risks abound.

Hot commodities

Though sanctions on Russia have thus far excluded the energy sector, that hasn’t arrested the buyer’s strike for Russian oil. Given the country’s dominance in the energy export space—Russia is the world’s third largest oil producer (second largest natural gas producer), accounting for 11% of global oil supply in 2021 (per the Energy Information Administration)—the heightened risk of a significant cut to global oil supply has sent crude prices sharply higher, as shown below.

A crude rise

Source: Charles Schwab, Bloomberg, as of 3/4/2022.

The United States is the 13th largest importer of Russian oil (representing 1.3% of Russian oil exports); with China a dominant #1 (representing nearly 24%) and the Netherlands #2 (at 13%). A possible U.S.-European Union ban on Russian oil imports could remove as much as 50% of Russia’s trade value from oil exports according to UN Comtrade data.

The parabolic move up hasn’t been confined to just oil. Given Russia and Ukraine account for more than a quarter of the world’s wheat exports and 12% of calories traded globally (per the International Grains Council), food and commodity prices have surged as well. As shown below, even though the Bloomberg Commodity Spot Index is off its recent peak, it is still increasing at a 33% annual rate. Historically, most recessions occurred after, or in the midst of, double-digit percentage increases in commodity prices.

All together now

Source: Charles Schwab, Bloomberg, as of 2/28/2022.

The unnerving surge in food and energy prices has played a role in reducing the market’s expectations of more aggressive action from the Fed. As shown in the chart below, consistent with when Russia invaded Ukraine and commodity prices surged, traders have lowered their expectations for the total number of rate hikes this year.

A less steep hike

Source: Charles Schwab, Bloomberg, as of 3/4/2022.

Working hard or hardly working?

The global geopolitical crisis has made the Fed’s job even more difficult. Higher energy and food prices add upside pressure to headline inflation, which may in turn keep the heat on the Fed to stand firm in raising rates. However, there is a building risk that economic growth is dealt a larger blow if the current surge in energy prices continues unabated and destroys demand.

As noted, the risk is coming into sharper focus at a time when GDP growth is expected to be precisely nil in the current quarter. As shown below, the Atlanta Fed’s GDPNow estimate for first-quarter growth is currently sitting at 0% (after dipping into negative territory recently). For now, the Blue Chip Consensus range is in positive territory; but the path of least resistance is lower.

Growth looking scarce

Source: Federal Reserve Bank of Atlanta, as of 3/1/2022.

While a March rate hike is all but guaranteed at this point, the pace at which the Fed will hike thereafter is still unknown, especially as economic growth is slowing and financial conditions are tightening. While conditions are nowhere near levels seen during the initial phases of the pandemic-induced recession, the pace of tightening is accelerating (effectively doing some of the Fed’s tightening work already), as shown below.

Tighter conditions, faster

Source: Charles Schwab, Bloomberg, as of 3/3/2022. Goldman Sachs (GS) Financial Conditions Index (FCI) is defined as a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.

What say you, yield curve?

The latest mix of imminently tighter monetary policy, surging oil prices, and slowing growth warrants a dusting off of some recession checklist items. Among those most consistently relied upon is the Treasury yield curve. As shown in the chart below, the spread between U.S. 10-year and 2-year yields has fallen sharply, with only 25 basis points separating the two. An inverted yield curve (when the spread turns negative) has preceded every one of the past six recessions. It hasn’t yet reached inversion territory but is steadfastly approaching it.

2s10s spread is collapsing

Source: Charles Schwab, Bloomberg, as of 3/4/2022.

In addition, the fall in consumer confidence started flashing a warning even before Russia invaded Ukraine. Per The Conference Board’s Consumer Confidence measure, the spread between consumers’ expectations for the future and consumers’ confidence about their present situation has plunged. As shown below, this spread has never been this low in history without a recession occurring in relatively short order.

Consumers eyeing a cloudy future

Source: Charles Schwab, Bloomberg, as of 3/4/2022.

In sum

The world is in turmoil; with spiking energy and food prices the dominant non-human casualty. Russia’s invasion of Ukraine arrived during a period when inflation was already surging, energy crises were already brewing, and economic growth was already waning. Given the limited additional energy and/or food supplies that can be brought on quickly, and the reticence of monetary policy makers (read: Fed) to stall rate hikes, a distinct possibility is that the spike in energy and food prices will lead to recessions in various countries. In other words, energy crises get “solved” via the demand destruction that comes via recessions.

We continue to believe the U.S. equity market, like international markets, will be at the mercy of Russia/Ukraine headlines; with volatility likely remaining high. This is likely to continue to be a risk-off market environment—notwithstanding counter-trend rallies that can pop up any time. This is a time for discipline; including diversification across and within asset classes and periodic rebalancing. For investors overweight equities, we recommend using counter-trend rallies to trim exposure back to strategic weights. For stock pickers, we continue to recommend a factor-based approach, with an over-arching emphasis on high quality—including factors like strong free cash flow yield, high earnings yield, positive earnings revisions and low volatility.

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