During a volatile first half of the year, several key issues have risen to the surface. How these factors evolve will likely guide the direction of markets.
- The volatility that we have witnessed this year is driven by uncertainty around several key issues in the market.
- Specifically, the geopolitical fallout from the Russia-Ukraine war, the Federal Reserve’s (Fed) policy course to tame inflation, and a broader global shift away from easy central bank policy will be central to determining where markets go from here.
- As the situation evolves, investors may be wise to manage downside risk with an eye toward using ongoing volatility to seek long-term opportunities.
Following a tumultuous first half of the year, it has become clear to us that several emergent issues will likely influence the course of markets going forward. For one, the fallout from Russia’s invasion of Ukraine in February will have lasting economic effects, as commodity-rich Russia is a key supplier of natural resources.
What is the West’s Pain Threshold for Russian Sanctions?
How stringent Western nations will remain with sanctions will depend ultimately on how much pain these economies are willing to endure as key resources are choked off. Most prominently, Russia produces roughly 10 million barrels per day of oil. If large oil service companies are barred from working in Russia, it would be a challenge to keep up the current rate of oil production. Declining production would increase the pressure for other oil-producing nations to fill the gap ‒ no small task given the challenges of the Organization of the Petroleum Exporting Countries (OPEC) and limited investment to expand production in the U.S.
While oil is most conspicuous, Russia is a key source for other commodities as well, including industrial metals such as aluminum, steel and also nickel, which is a critical material for electric vehicle (EV) batteries. Given a concerted push to increase EV production, its importance has only increased, and any shutdown of commodity supply from Russia runs the risk of putting additional cost pressure on manufacturing.
Europe is enormously dependent on natural gas from Russia. If these countries choose to shun Russian natural gas, it’s unlikely they can fully replace the shortfall using other sources. Liquefied natural gas (LNG) prices would likely be bid up as they secure as much supply as possible from other countries, resulting in higher natural gas prices globally. Russia and Ukraine are also leading exporters of grains such as wheat and corn, and fertilizer materials such as potash and phosphates. While it’s unlikely that there will be Western sanctions on agricultural commodities, the disruption to these supplies as a result of the war has the potential to significantly affect food security, crop yields and prices going forward.
How Hawkish Will the Fed Be?
We have seen a recent pullback in commodities prices and some modest improvement in supply chains; however, the Fed will likely need to raise rates further to get inflation closer to its target of 2%. This makes for a difficult balancing act, and the potential for a “soft landing” has become less likely, in our opinion. It remains to be seen whether a potential recession would be short or prolonged, shallow or deep, but past Fed efforts to contain inflation have often led to a recession. However, we don’t believe this potential is fully reflected in either corporate earnings estimates or current valuations, and additional downward revisions may further unsettle the market as investors await clarity on the outlook for inflation, interest rates and economic growth.
Will Tighter Financial Conditions Drive a Market Rotation?
Following the Global Financial Crisis, central banks around the world maintained consistently dovish bents, leading to a period over the past decade-plus of low interest rates, low inflation (indeed, often with fears of deflation) and easy central bank policies. These factors helped to fuel enormous gains in the stock market, including high valuation areas and money-losing companies or those with weak balance sheets. We are now very likely in the reverse of that period, with rising interest rates, inflation levels well above central bank targets and less accommodative central bank policies all leading to a tightening of financial conditions globally.
In the unwinding of those longstanding easy-money policies, there is a risk that the “fuel” for markets is gone, causing a more significant pullback than we’ve grown accustomed to. This has already been seen in some high-multiple, money-losing stocks. Given the significant multiple expansion we’ve seen over the past decade, there could be more downside ahead, not only for those names but for the broader market as well. A day of reckoning may well be in store for non-earning companies and those with significant debt on their balance sheets as financing gets scarcer and more expensive.
This year, we have seen uncertainty around key issues drive a shift in market leadership as investors process the changing environment. Amid the volatility, investors may be wise to consider quality, reasonably valued companies with strong balance sheets and healthy cash flows, with an eye to managing downside risk. As the dust settles and the situation evolves, long-term opportunities may present themselves to those who are observant and patient.