The US economy continued to boom in the first quarter of the year as it recovered from the pandemic. By the end of March unemployment had fallen to just 3.6%, close to a record low and employers were reporting difficulties filling vacancies, forcing them to raise wages. Corporate earnings were strong and so was consumer spending. Nonetheless, for investors of all types, this was one of the worst quarters in a few years.
The stock market rally that had persevered through the end of December turned abruptly into a sell-off of both stocks and bonds. The S&P 500 (a broad measure of large US stocks) lost 4.6%, despite regaining some ground. US investors lost even more money in international stocks, with the MSCI ACWI ex-US (all major global stock markets except the US) down 5.4%. Sustainable investors had a particularly rough time as fossil fuel and mining stocks benefited from higher oil and metals prices while technology and clean energy stocks did particularly badly.
Bonds are usually the safer investment - but not this not time - with the benchmark rate on ten-year US government bonds rising from 1.51% to 2.75%. The Bloomberg US Aggregate Bond Index (a broad measure of US government and corporate bonds) lost 5.93% and kept falling in March. US municipal bonds – normally a nice conservative investment lost a surprising 6.23%. Short term government bonds are generally less volatile than longer-term bonds since they are not as sensitive to interest rates but they were far from a safe haven this time around
Inflation refuses to go away quietly
Rising inflation was an on-and-off concern for investors through much of 2021. By the beginning of this year, it was clear that inflation could not be dismissed as merely “transitory” and anticipation of tighter monetary policy became the key driver of markets.
Since mid-2021, each succeeding monthly US inflation report has shown a higher annual rate than the preceding one. In February, the annual rate hit 7.9%, another in a series of post-1982 records. March’s twelve-month inflation of 8.5% was even higher.
In the beginning, inflation was largely driven by supply issues in specific sectors such as used cars, as the economy suffered from post lockdown hiccups while consumers were flush with cash from COVID relief programs. This made Fed Chairman Jerome Powell’s dismissal of inflation as “transitory” and the Federal Reserve’s consequent inaction seem reasonable to many. Unfortunately, inflation has now spread across the economy even as it has subsided in the sectors that saw a spike in prices in the beginning. The prices of food, gasoline and other staples were rising even before the Russian invasion of Ukraine and rents have gone up sharply.
It's important to understand that inflation is not just a problem in the US but is a global issue. Europe, the UK, Mexico, Brazil, and many other countries are also confronting the highest levels of inflation in years, driven by the same factors that have caused inflation to rise in the US. Some of these countries’ central banks are already tightening monetary policy.
With inflation clearly here to stay for a while, many investors began to worry that the Federal Reserve would raise interest rates too quickly and cause a recession, while others worried that they would tighten too slowly and inflation would continue to be a problem. For a time, short-term interest rates were higher than long-term rates, a classic recession warning.
In March the Fed finally moved, raising its reference rate by 0.25% (25 basis points). Since then, several members of the Board of Governors have called for more aggressive rate hikes in public appearances. The Fed is currently expected to hike by 50 basis points in May and at subsequent meetings. It is also expected to start reducing its bond holdings at an accelerated pace. Since the Fed owns mostly longer-term bonds, this ought to increase the pressure on long-term rates to rise. Anticipation of the Fed’s shrinking its bond portfolio has already led mortgage rates to jump.
Historically the stock market has tended to panic ahead of the Federal Reserve beginning to tighten monetary policy and then rally once the tightening is underway. This time may very well be different because inflation is so far above the Fed’s 2% target and the Fed has been so slow to move that monetary policy may have to be tightened substantially. The current situation does not look much like the “soft landings” the Fed has engineered in the past. Growth remains strong but is very much at risk from rising interest rates, as are the markets.
One factor independent of monetary policy may help bring down inflation: as the US and global economies continue returning to more normal, post-pandemic activities, some of the distortions causing prices to rise may fade away. A key driver of the initial spike in inflation was that consumers were partly compensating for not spending on services such as restaurants, travel, concerts, etc. by spending much more on goods. This created all sorts of bottlenecks as global supply chains had to deal with unprecedented volumes. With re-opening, consumer spending is shifting back to services, easing the pressure on supply chains. The Omicron variant delayed this adjustment but now that it has resumed it could reduce some of the pressure on the Federal Reserve.
And now there’s a war too
Readers of this piece do not need to be reminded of the horrors caused by the Russian invasion of Ukraine. There are also major economic and market implications of the war. Perhaps the biggest concern is the war’s impact on inflation.
Russia is – of course – a major supplier of oil and gas, as well as coal. Actual disruptions to fossil fuel supplies have so far been limited but the market is anticipating problems and has already sent oil prices up over $120 per barrel, the highest price since before the 2008-09 financial crisis. The price has since fallen back to the $100 range but much of the world has been hit with sharply higher fuel prices and gasoline was the single highest contributor to US inflation in March.
Russia is also a leading producer of nickel, aluminum and steel, which Ukraine also produces. The prices of all of these metals have soared in recent weeks. As Europe and the US continue to reduce their dependence on Russian supplies of fossil fuels and metals these markets will continue to be unstable and high prices will remain.
The war’s effect on food prices has not been felt as strongly here in the US but Ukraine’s inability to ship its exports of wheat and sunflower oil has already caused soaring food prices and shortages in the Middle East and elsewhere. Egypt is particularly dependent on Ukrainian wheat and has already had to devalue its currency. With this spring’s planting already severely disrupted, global trade in wheat and vegetable oil is likely to remain under severe pressure for at least the next year.
The war has also disrupted Russian, Belarussian and Ukrainian fertilizer exports. For the US, all this just means a little more inflation but for some parts of the world, the social and political consequences could be severe.
For those of us who remember the Soviet Union having to import vast quantities of North American wheat back in the day, this turn of events is a little disconcerting. Capitalism really is more efficient than Communism.
Foreign investors in Russian equities have been unable to sell their holdings since the war began and will likely have to write them off as a complete loss. Fortunately, the Russian stock market has been steadily shrinking with respect to global markets so the losses are more than manageable for the market as a whole.
Russia is more of a problem for bond investors. Until sanctions hit the Russian government had very solid finances and was rated Investment Grade by all the leading credit rating agencies, so its bonds were widely held. Russian bonds were downgraded to Junk practically overnight and given that sanctions block the Russian Central Bank’s access to most of its foreign reserves, default seems to be only a matter of time.
Are sustainable investors being responsible?
Russia’s invasion of Ukraine raised some key questions for sustainable investors. ESG (Environmental, Social and Governance) index funds run by Vanguard and Northern Trust were found by Bloomberg to have added to holdings in three leading Russian companies – Sberbank, Gazprom, and Rosneft – shortly before the invasion. While Sberbank is a reasonable option for an investor using ESG criteria, Gazprom and Rosneft are not just giant fossil fuel companies with poor environmental and safety records, they are renowned for their poor treatment of shareholders other than the Russian government. In fact, I believe that these are the poster children for stocks that should never be in any sustainable investor’s portfolio. That they were included in some ESG indices (I have written previously about this issue with Black Rock’s ESG index funds and Bloomberg did an expose on MSCI’s ESG index business in late 2021) and held unquestioningly by fund companies promoting ESG funds demonstrates a shocking lack of commitment to true ESG or sustainable investing. To put it simply, I do not consider that this was responsible investing.
A second issue provoked by the invasion is more philosophical. Should ESG investors ever have put their money into a problematic country like Russia, no matter how good the individual companies in which they are investing? Is it sufficient to perform ESG analysis on individual companies without doing the same for the countries in which they are based? After all, investing according to ESG criteria is supposed to reduce risk. Should companies in countries whose governments pose ESG risks be excluded by ESG screens, regardless of how committed they are to sustainability?
I would answer by pointing out that all investors, not just ESG investors, were caught out by the war, including bond investors who routinely look at country risk as part of their investment process. To rule out entire countries on ESG grounds denies a basic premise of sustainable investing: that rewarding companies for good ESG practices can lead to progress for society as a whole. More than anything what happened demonstrates the pitfalls of index investing, especially where ESG is concerned.
More encouraging was the news that on March 21st the SEC announced new rules requiring listed companies to disclose audited greenhouse gas emissions just as they are currently required to publish audited financial statements, having previously announced that these rules were in the works.
Companies will be required to disclose not just their direct (“Scope 1”) emissions from their operations, but also their indirect emissions (“Scope 2”), which are the emissions produced by consumers of the energy the company produces. These emissions data must be audited by an independent third party. Companies must also report their Scope 3 emissions, which are all greenhouse gas emissions associated with their activities from the beginning of the supply chain to the end-users. Scope 3 emissions are considerably harder to assess and will not have to be audited. The draft rules are now in the mandatory public comment period before the final version is able to go into effect.
The SEC is following the lead of regulators in Europe and Brazil and is building on years of work by the Sustainability Accounting Standards Board and other organizations to establish accounting standards for carbon emissions. Nonetheless, there is going to be fierce opposition to the proposed new rules from both fossil fuel companies and politicians allied with them. Opposition to potential action along the same lines as what the SEC is proposing recently derailed President Biden’s nomination of Sarah Bloom Raskin to the Federal Reserve Board. Senator Joe Manchin has announced that he has joined with Republican Senators to oppose the new rules.
If the SEC succeeds in implementing the proposed rules, the resulting transparency would be a major boon to investors who are trying to understand the impact of climate change on their investments. This would enable the markets to take a more active role in addressing climate change. As I have said before, the markets got us into this mess and the markets are going to get us out of it.
Is It Over Yet?
Many economists believe that inflation peaked in March and will fall in the upcoming months. Supply chain issues are fading as consumers return to spending more on services instead of goods and oil prices have fallen back from their war-driven spike. But rents are still rising, oil prices are likely to remain high and food prices will continue to be pushed upward by the war. Inflation is not likely to return to the normal 2% range until some time in 2023.
The uncertainty over the outlook for inflation means that monetary policy is likely to continue driving financial markets. The Fed is just beginning to tighten and will likely continue until its 2% inflation target is in sight. This will continue causing turbulence for both bonds and stocks. Bonds may not return to their usual safe-haven status until the Fed is well along in its tightening cycle. Stocks may suffer from slowing growth and the reduced attractiveness of more speculative, longer-term growth as interest rates rise. This is not the time to be investing in aggressive growth strategies.
Urban Larson
Principal
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