March Outlook: Interest Rate & Inflation Risks Heightened by Russian Invasion

Investors are likely to get their first rate hike in March, but how big will it be? Rising commodity prices are making it harder for companies to get ahead of rising inflation. Russia’s occupation and bombing of Ukraine territories is causing volatility. However, the Nasdaq Composite is doing its best to avoid bear market territory. Omicron cases are falling. Can the economy live with what comes next?

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5 min read
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Key Takeaways

  • Interest Rates and Geopolitical Strife Are Causing Volatility in Stocks and Commodities
  • Projecting President Putin’s Possibilities 

  • Will Omicron Finally Allow Companies to Grow Earnings?  

JJ Kinahan, Chief Market Strategist, TD Ameritrade

Investors have been facing tough times, and when you consider that according to a Charles Schwab survey, 15% of investors began trading stocks in 2020. That means there’s a lot of people who are experiencing their first bear market. While 2020 did see a bear market, it was very quick as stocks sold off in March, causing the S&P 500 (SPX) to fall nearly 35%, but then recovered nearly half of its losses by April.

The obstacles stocks are facing in 2022 are broad and widespread and don’t have any quick fixes. These problems include residual effects from the COVID-19 pandemic, skyrocketing inflation, rising interest rates, oil prices reaching $100 per barrel, and geopolitical turmoil with Russia invading Ukraine. These issues have caused sell-offs in stocks, taking the Nasdaq Composite ($COMP) and the Russell 2000 (RUT) nearly 20% off their highs and flirting with bear market territory. The S&P 500 is down about 14%, while the Dow Jones Industrial Average ($DJI) is down about 12% drop from its highs.

If history is any guide, there may be some investors who choose to step back from the market. Data from Statista shows the share of adults investing money in the stock market in the year 2000 was 62%. After the dot-com bubble popped, it fell to 60%. However, investors did not stay out for long, and by 2007, 65% of adults were investing. And then came the credit crisis. The credit crisis bear market was the last straw for many. By 2013, only 52% of adults were investing in the stock market. Since then, the number of adults in the stock market has fluctuated between 52% and 55%. If new investors leave and take their money with them, it could hurt stocks even more.

Companies looking to go public are also showing concern as many withdrew their initial public offerings (IPOs) at the highest pace in history. January set a new record for IPO withdrawals, with 22 potential IPOs deciding against going public. Uncertainty around the current business environment appears to have scared off these companies, which are likely afraid they may not raise the capital they want.

With that said, experienced investors understand that over the long term, stocks have historically bounced back. Additionally, there’s often opportunities for investors are who are willing to look for them. Investors may find it difficult to search for these opportunities while trying to keep one eye on Russia and the other eye on the Federal Reserve.

Interest Rate Outlook

The Federal Reserve is scheduled to meet March 15 and 16 to discuss interest rate policy. As of the end of February, the CME FedWatch Tool reported that the market is giving an 84.7% probability that the Fed will raise the overnight rate to 0.25% and a 15.3% probability it will raise the rate to 0.50%. The probabilities have been all over the place in February, and at one time, there was a 93% probability of a half-point hike. So, there’s a good chance that these probabilities could change by the March meeting.

Investors should keep their eyes on the March Employment Situation Report and the Consumer Price Index (CPI) because they carry important information for Fed members trying to make a decision. The January CPI that was reported in February showed inflation grew 0.6% month over month, which was above the expected 0.5%. It also grew at 7.5% year over year, which was also above the forecasted 7.3%. Economists were hoping for some easing in inflation with the holidays well behind us, but these were the hottest numbers since February 1982.

The S&P 500 (SPX) fell in reaction to the CPI news, but it really sold off after St. Louis Federal Reserve President James Bullard told Bloomberg News in an interview just a couple hours into the trading day that he wanted to see the federal funds rate at 1% by July 1. In another interview with CNBC the following Monday, Mr. Bullard defended his comments that the Fed needs to be more aggressive in attacking inflation, citing that each CPI report from October 2021 to January 2022 has been worse-than-expected. He also expressed concern that the situation could create a systemic problem of rising inflation that the Fed may not be able to manage in the future.

However, when the Federal Open Market Committee (FOMC) meeting minutes for January were released later in February, it revealed that many other Fed members were far more dovish than Mr. Bullard. Many committee members were pushing for a measured approach, but they did acknowledge that inflation was spreading beyond pandemic-affected sectors and into the broader economy.

Despite the pullback in expectations for the March rate hike, the market appears to expect back-to-back rate hikes. At the end of February, the market was pricing in a 100% probability of quarter-point hikes in March, May, and June. And an 80% probability of a hike in July.  

Until Russia started bombing Ukraine on February 24, rising interest rates appeared to be biggest fear for investors. Russia’s aggressions are now adding another area of concern for investors.  

Russian Outlook

Over the last few months, NATO and Russia have squared off over Ukraine potentially joining the North Atlantic Treaty Organization, or NATO. On February 23, 2022 the situation escalated when Russian President Vladimir Putin ordered troops into the Donetsk and Luhansk regions after each one decided to claim their independence from Ukraine.

The next day Russia launched missiles and moved troops further into Ukraine. In response, the United States and the European Union announced sanctions on Russian banks and elites. Until that point, stock and oil investors seemed to be unconcerned about the events in Ukraine. However, due to the conflict escalating beyond a “minor incursion”, concerns over more severe sanctions caused commodity prices to skyrocket, and stocks experienced heavy selling pressure.

However, stocks made a surprisingly strong rebound, and oil prices retreated as the increased sanctions didn’t go as far as many investors expected particularly with respect to the SWIFT system. The SWIFT, or Society for Worldwide Interbank Financial Telecommunications, is the largest global provider for financial messaging services and helps facilitate payments across borders. If SWIFT sanctions were implemented, Russia’s access to international financial transactions would be greatly limited.

It’s been difficult to read the market’s reaction to the events, and analysts are split on what might happen next or even what President Putin’s motivations are. Let’s break down some scenarios and what it might mean for investors.

Back to the USSR

Perhaps the worst-case scenario is that President Putin wants to restore the USSR and is looking to accumulate the Baltic states once again. This could mean that the United States and European Union sanctions on Russia probably won’t be a deterrent. The New York Times reported that after Russia took over Crimea in 2014, President Putin has worked to make Russia “sanction proof” by reducing its reliance on the U.S. dollar. Instead, it has stockpiled other foreign currencies in its reserves. In addition, it has cut its budget in order to keep its economy and government functioning under sanctions. Furthermore, Russia has reoriented its trade to focus more on China and other sympathetic countries to avoid reliance on Western imports.

Additional invasions into the Baltic states will likely lead to war between Russia and NATO counties, oil prices would climb, and stocks would likely fall. Of course, these are just some of the economic issues and they pale in comparison to the loss of life.

NATO Expansion

After the Cold War, NATO’s lines ended in Germany. Over time, it has expanded its influence, pushing the lines further east to include Poland, the Czech Republic, and Hungary. Then in the 2000s, it added Slovakia, Bulgaria, and Romania. Later, it added three Baltic states including Latvia, Lithuania, and Estonia. Finally, in 2009, it also added Albania and Croatia. Of course, Russia has protested these expansions and view it as a major security concern.  

Ukraine has been trying to join NATO since 2008 but without success. However, as Ukraine has been moving closer and closer to membership, Russian protests have increased, and then in November 2021, satellite imagery showed Russian troops gather near the border of Russia and Ukraine. On December 7, 2021, President Joe Biden warned Russia that it would suffer economic sanctions if it invades Ukraine.  

Russia responded on December 17, 2021 with detailed security demands that included NATO ceasing all military activity in Eastern Europe and Ukraine. It also demanded that Ukraine and other former Soviet countries not be included in NATO. Since that time, President Putin has had meetings with President Biden, German Chancellor Olaf Scholz, and French President Emmanuel Macron. However, President Putin has expressed frustration that the talks weren’t progressing the way he’d like.

If the issue comes down to one of defense for Russia, then it could be a waiting game. Russia may continue to occupy portions of Ukraine for some time and try to ride out the sanctions. While the tensions could be difficult for Russia and its economy, the occupation is unlikely to affect the markets as long as Russian oil, gas, and other commodities are able to enter global trade.

Financial Factors

While Russia has the 11th largest economy by gross domestic product, it’s actually smaller than Italy, Canada, and South Korea. However, when it comes to commodities, Russia is a leader in commodity production. According to the U.S. Energy Information Administration (EIA), Russia was third in oil production for 2020, behind the United States and Saudi Arabia. So, while many observers don’t believe Russia can afford an all-out war with the United States and its allies, there are some economic advantages for Russia to push into Ukraine.

Russia provides 40% to 50% of Europe’s gas, and about 200 billion cubic meters of it goes through the Ukrainian gas pipe system. Ukraine benefits from this by collecting about $1.2 billion in fees from Russia, according to the Oxford Institute of Energy Studies. Russia’s Nord Stream 1 oil pipeline runs from its shores, along the floor of the Baltic sea, and into Germany.

In September, Russia completed its Nord Stream 2 gas pipeline that runs right along with Nord Stream 1. However, the pipeline has never opened because Russia is waiting on Germany to certify it. Germany buys up to 55% of its natural gas from Russia, so if the pipeline was to open, Russia could bypass Ukraine.

So, there are several layers here. The obvious one is the savings Russia gains from not going through Ukraine and the revenue Ukraine loses with the gas going elsewhere. Another is that Russia is complaining that the United States and the European Union are pressuring Germany not to certify the pipeline and instead pushing for acceptance of Ukraine in NATO as a way to promote U.S. gas sales in Europe.

In addition to preserving its defense against NATO, Russia may be applying its own pressure by using Ukraine as leverage to push through the certification of the pipeline. If Russia can’t save money using its brand-new Nord Stream 2, perhaps it can save money through the control of Ukraine. As part of the sanctions on Russia, Chancellor Scholz said that Germany put the certification of the Nord Stream 2 pipeline on hold.

If Russia is hoping to get certification of its pipeline, then we may be in a standoff scenario again where Russia remains in the Ukraine and tries to outlast the sanctions. It’s also important to realize that Europe is struggling with an energy crisis and has high environmental standards that makes Russian natural gas a vital commodity. So, Mr. Putin definitely has some leverage here.

Right now, it appears that neither Russia nor NATO wants to do anything to disrupt the flow of oil or gas, which may be why the market appears to have confidence that the Russian invasion isn’t going to escalate much further.

Commodity Outlook

Even before Russia moved on Ukraine, oil prices were climbing quickly along with its related products including natural gas, gasoline, and heating oil. Oil supplies have struggled to keep up with demand and were hindered by pandemic restrictions. The bad news for consumers is that we’re heading into the higher demand months for oil as the Northern Hemisphere is coming out of its winter hibernation and ready to travel (assuming Omicron allows it). With that said, commodity issues don’t end at just gas and oil.

According to Reuters, the rising price of oil has energy companies opening and reopening higher-cost shale basins. Colorado’s DJ Basin, Wyoming’s Powder River, Louisiana’s Haynesville, and North Dakota’s Bakken have all seen increased activity in extraction. The cost of oil extraction from shale is still higher than other forms of drilling, but many experts have pointed out that costs continue to decline.

With so many oil companies experiencing tremendous earnings growth, many explorers and drillers are likely flush with cash and can put out the capital investment needed for new rigs. In recent years, banks have been less likely to fund oil exploration in favor of green energy projects due to favorable treatment in the form of government grants and loans. This means that gas and oil companies may have to rely more heavily on retained earnings and non-bank loans.

However, the February Short-Term Energy Outlook (STEO) from the EIA showed that the EIA was far less bullish on oil prices. The EIA is projecting oil prices to stay around $90 per barrel in February but forecasted a decrease in oil prices through most of 2022 and targeting $68 per barrel in 2023. The EIA was pointing to resolution of supply chain disruptions and rising oil production as reasons why its forecasts were lower. The next report is schedule for release March 8 and should reflect any changes in production or concerns about Russia and Ukraine.

The EIA forecast differs from many of the other analysts I’ve mentioned in the past. Goldman Sachs (GS) analysts are projecting $105 in 2022 and higher yet in 2023. Morgan Stanley (MS) analysts are at $110. BofA Global Research is at $120. And JP Morgan (JPM) is at $150. However, Citigroup (C) analysts are in line with EIA, forecasting an oil price of $65 by the end of 2022. The wide variation in oil price projections could make forecasting costs difficult on many companies and stock analysts.

Laying the Wood

Another commodity that falls in the “hot” category is lumber. Lumber futures prices shot up four straight days in February, triggering limit-up events. A limit up or limit down is the maximum amount an exchange will let a futures price move during one trading day. Lumber prices have risen about 20% in February. Lumber is still about 16% off its January highs and 30% off its pandemic high, but the trend has been up since bottoming in August. With supply chains opening up, you’d think prices would be more stable. However, much of the timberland in the northern hemisphere is under snow and hard to log.

According to Fortune, the run in lumber prices from August through January was due in part to a bad wildfire season in Canada and then heavy rains and mudslides in the fall. But overall, it’s a matter of demand. Many builders are buying more lumber to avoid getting caught off-guard in case of another wave of COVID-19 or more natural disasters, but the strong economy is keeping demand high too. So, higher lumber prices may be here for a little while.

Proving Metals’ Mettle

Oil has been and will be the major commodity around the globe, but some investors are seeing MIFTs as the new FAANG investment. MIFTs stands for “metals important for future technologies”. There’s not an official list of MIFT commodities, but they often include lithium, tin, copper, graphite, silicon, titanium, aluminum, niobium, cobalt, manganese, and nickel.

Let’s look at a couple examples of how these metals have been rising. Tin is a major component in technology because it’s used to solder electronic circuit boards and microchips. According to Rio Tinto (RIO), in 2018, 50% of tin was used for electronics. Tin futures have experienced enormous growth over the last year, increasing nearly 200%.

While the growth in tin is impressive, it hardly compares to lithium, which is seeing high demand from various technologies but particularly in electric vehicle batteries. After reaching its bottom in August 2020, lithium futures have grown more than 1,000%.

There are several mining stocks that produce tin, lithium, and all the other MIFTs including Freeport-McMoRan (FCX), BHP Group (BHP), Albemarle (ALB), Sociedad Quimica y Minera de Chile (SQM), Livent (LTHM), and Lithium America (LAC) to name a few. But buying the stock isn’t always the same as buying the futures contract because there are several other factors like capital expenditures and company management that can cause issues for investors. 

Growth vs Value

FIGURE 1: LEVELING UP. Crude oil futures (/CL—candlesticks) are trading at levels not seen in about eight years. If these levels hold, oil prices could oscillate between about $85 and $110 per barrel. Data Source: FTSE Russell, S&P Dow Jones Indices, Nasdaq. Chart source: The thinkorswim® platform. Futures and futures options trading involves substantial risk, and is not suitable for all investors. Futures shown for economic discussion purposes and not in relation to futures trading. For illustrative purposes only. Past performance does not guarantee future results.

Earnings Outlook

Inflation isn’t just showing up in CPI reports; it’s also a common theme in earnings calls. According to FactSet, 75% of S&P 500 companies have cited inflation on their Q4 earnings calls as of Friday. Of the index’s 500 companies, 337 have reported and 246 of them mentioned inflation. The consumer staples and materials sectors have had the highest percentage of companies mentioning “inflation” with 100% of consumer staples companies using the key word.

One reason this is important is because inflation may be causing companies to revise their earnings forecasts. When comparing the current profit margin estimate against the estimates on December 31, margin expectations are lower. The December 31 estimates for Q1 2022 were 12.4% but are now 12.3%. Similarly, the 2022 calendar year estimate was 12.8% but is now 12.7%.

We’ve noted many times that energy is the dominate inflationary sector because oil is king among commodities. The materials sector has been a distant second, even though it covers so many other commodities from metals to lumber. Materials have been among the top in price and earnings growth. However, the industrials sector could make a push to surpass materials because the sector has had the second-highest estimated earnings growth rate for Q1. While industrials were able to exhibit some relative strength against materials, the sector has some work to do to slide in behind energy.

One recent positive development from earnings reports is that stock valuations appear to be getting better, according to FactSet. The S&P 500 forward 12-month P/E ratio has fallen below its five-year average. Additionally, it has fallen below its 2020 high and is testing its 2018 high. Despite the growth in the energy sector, it has the lowest forward P/E ratio of all the sectors, but it’s also well above its average. Materials has the third-lowest ratio and is also trading below its five-year average, which some investors might see as sign for an undervalued sector. The consumer discretionary and technology sectors have the highest forward P/E ratios.  

Unfortunately, the earnings surprise percentage has also fallen below its five-year average. This means that companies aren’t beating earnings by as wide a margin as they have in the past.

Omicron Outlook

It probably can’t be overstated how much COVID-19 and the policies around the pandemic have affected economic and stock growth. Several times in the last year experts have predicted that the virus was nearly behind us only to see a new variant pop up and restrictions increased. However, many experts have pointed to the fact that Omicron has been more contagious but less severe and could be a sign that the virus is in its late stages. Let’s hope this is the case.

With that said, the Center for Disease Control (CDC) reported a 43% decrease in the seven-day moving average for COVID-19 cases in the last week. The seven-day average topped out around 800,000 daily cases in January and is currently seeing about 100,000 daily cases. The drop in cases in the United States and round the globe has governments lifting restrictions. At the end of January, Denmark lifted all of its restrictions. The United Kingdom is ending its vaccine passport program for nightclubs and large venues. The CDC is expected to change its recommendations soon, but many states including California, Utah, and Vermont have moved into their endemic stages.

The Dow Jones U.S. Travel & Leisure Index has begun to exhibit relative strength against the S&P 500 and appears to be led by the hotels group. The Dow Jones U.S. Hotels Index doesn’t appear to have suffered the same problems that the airline group has with COVID-19 and its variants. Unfortunately, large hotel chains, particularly those with high international exposure, may struggle if geopolitical risks continue.

The AMEX Airline Index has also gained in relative strength against the S&P 500, but it may see troubles in fuel prices if oil prices continue to climb. Airlines may be coming out of one pocket of turbulence and into another.  

Good trading,
JJ
@TDAJJKinahan

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Key Takeaways

  • Interest Rates and Geopolitical Strife Are Causing Volatility in Stocks and Commodities
  • Projecting President Putin’s Possibilities 

  • Will Omicron Finally Allow Companies to Grow Earnings?  

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