Vladimir Putin’s attack on Ukraine jarred global financial markets. Western democracies have responded with financial sanctions against Russia and its citizens, causing the ruble to suddenly lose roughly one-third of its value relative to major foreign currencies. Global investors are rushing to divest their Russian assets, but their efforts are frustrated by a lack of natural buyers and by the fact that the Russian stock market has been closed since February 25th. Nobody knows what Russian financial assets are currently worth.
Commodity prices and defense stocks jumped after the invasion. In the midst of a broad stock market selloff, Merrill Lynch sardonically proposed a new list of FAANG assets replacing the old investor favorites of Facebook, Amazon, Apple, Netflix, Google. The new FAANG according to Merrill? Fuels, Aerospace, Agriculture, Nuclear, Gold.
Russia’s decline is stealing attention from China’s ongoing financial problems. The Hang Seng Index has been in steady decline for the past year, a decline that recently accelerated after the U.S. Securities and Exchange Commission threatened to delist many Chinese stocks from U.S. exchanges due to opaque ownership structures and questionable audit quality. Following last year’s default by property developer Evergrande Group, foreign investors are questioning whether the secular growth of China’s economy is attractive enough to justify owning the ugly financial assets attached to it. Price action dictates the narrative in financial markets. Buying speculative assets looks wise when prices are high and foolish when prices decline, the exact opposite of investing’s fundamental maxim of “buy low, sell high.”
Europe faces a risk of falling into recession, as many European countries rely heavily on Russian energy imports and also on Chinese demand for their exports. The natural tailwinds of a post-Covid rebound may not be strong enough to power through the twin headwinds of Russian military aggression and Chinese financial unrest.
It helps greatly that the U.S. does not rely on Russian energy imports. Although rising global energy prices still act like a tax on American consumers, higher prices also stimulate the country’s domestic energy sector. America is approximately neutral in energy trade. It is therefore hard to imagine energy price fluctuations having a major impact on the overall U.S. economy.
On a related note, inflation remains a problem. February’s CPI report showed a 0.8% sequential increase. 12-month trailing inflation is 7.9%. Backing out volatile food and energy, the trialing inflation rate is 6.4%, the highest tally since August 1982. Housing prices rose 19% in 2021 according to the Case-Shiller index but only slowly enter into the CPI market basket due to quirky methodology. If housing prices plateau in the presence of rising interest rates, then we could hit a point where CPI overstates rather than understates current-period inflation. We are not there yet, however.
The bond market appears to be bracing for multiple rate increases. After pausing at the beginning of the Ukrainian invasion, interest rates have generally resumed their prior trajectory higher, with the most dramatic increases occurring at the shorter end of the yield curve. However, the Fed is reluctant to turn hawkish, and global unrest has complicated consensus expectations around interest rates. Global investors initially fled to safety in U.S. Treasuries and dollar-denominated assets, producing a dollar rally that could possibly provide cover for the Fed to slow-walk its interest rate path.
Short-term rates have been rising, producing a “flatter” yield curve. There has been some concern that the increasingly flat yield curve could signal recession. Another interpretation is that the flat curve expresses investor confidence in the Fed’s ability to subdue inflation. As we mentioned above, it has been decades since inflation ran this hot. Nobody really knows what to expect next.
But no matter what happens with respect to inflation or interest rates, remember: Even though stock valuations remain somewhat stretched by historical standards, we remind readers that stocks are real assets which tend to keep up with inflation over time. Bonds yield less than inflation right now and look highly likely to lose some purchasing power over time.
In the April 2022 issue, for example, we recommended a large-cap asset management business, a mid-cap automotive/internet play, and an online entertainment company. All three stocks are projected to outperform the broader market over the next five years.
A further market decline would probably produce some screaming opportunities. Be sure to subscribe to the #1 newsletter for 2021, the Investor Advisory Service, to receive our top stock ideas each month to help your portfolio outperform the market.
Reprinted from the April 2022 issue of the Investor Advisory Service stock newsletter, rated #1 for performance in 2021 by Hulbert Ratings.
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