by Shawn Narancich, CFA
Executive Vice President
The Cape Comes Off
Our 2022 Investment Outlook features the Superman and Clark Kent theme, a metaphor referencing past extraordinary economic stimulus provided by the Federal Reserve and the U.S. government during the COVID-19 pandemic, as well as the supercharged earnings growth that served as a key tailwind for stocks last year. Our constructive thesis for this year foresees earnings growth that will slow but remain positive, a Federal Reserve moving short-term interest rates off the zero bound, considerably less fiscal stimulus and moderating rates of inflation. In pop culture terms, Superman takes off the cape as the extraordinary becomes ordinary.
A Brave New World
With the war on Ukraine raging and the western world seeking to isolate Russia economically, the price of commodities has skyrocketed, and stock market volatility is up. As the chart below shows, investors have already endured as many 2% market moves this year as they experienced in all last year, and markets are on track to surpass a typical year’s volatility.
Aside from the heart wrenching tragedy taking place in Ukraine, what is contributing to stock market fluctuation is the prospect that additional supply chain dislocations will make the Fed’s job of quelling inflation that much harder. Investors are attempting to gauge how the central bank’s anticipated series of interest rate hikes this year might change because of inflation that is now likely to peak and exit this year at higher rates than originally anticipated.
Change at the Margin
This week’s inflation report provided our central bank with its last key input before policymakers’ monetary policy meeting next week. Headline CPI weighed in at a new 40-year high of 7.9%, slightly above consensus estimates. Elevated food and energy prices are making their mark, while “stickier” components of inflation like rent are also percolating. With the benchmark 10-year U.S. Treasury yield bouncing back to the 2% level, rising mortgage rates should begin to help the Fed with its job of cooling housing demand and inflation. Coupled with a strengthening dollar that also helps to moderate inflationary pressures, the Fed appears set to deliver what investors expect next week – a 0.25% increase in the Federal Funds rate.
Rising Prices at the Pump
A risk to our call for inflation to moderate in the second half of this year is that spiking commodity prices bleed into “core” prices, causing central banks to act more forcefully in raising rates. Prices at the pump have spiked to more than $4/gallon since Russia invaded Ukraine, symptomatic of oil prices that have surged 45% year-to-date to over $100/barrel. At play here is the fact that Russia supplies more than 10% of the world’s oil. Even though Russian imports are a negligible portion U.S. demand, this week’s announced U.S. embargo of Russian oil created the latest catalyst for oil prices to spike.
An Energy Powerhouse
In the second half of 2021, the U.S. imported an average of 213,000 barrels/day of Russian crude oil, representing 3% of U.S. oil imports and approximately 1% of U.S. crude oil demand. Far more impactful is the 11.6 million barrels/day that the U.S. produces and four million barrels/day that we import from Canada (our largest source of imported crude despite no Keystone XL pipeline), which together account for the lion’s share of the sixteen million barrels of oil the U.S. uses daily. Yes, we do import some oil products from Russia (think heavy fuel oil used in marine transport), but we also export refined products as well. Backstopped by its tight oil production the result of America’s shale revolution, the U.S. is well placed to weather the Russian oil embargo. As for natural gas, the U.S. is today the world’s largest net exporter, shipping thirteen billion cubic feet/day of LNG to markets globally.
Getting Creative
More problematic for world energy markets is how Europe will cope with its relatively high dependence on Russian oil and gas, which account for 30-40% of its supply. Europe has announced a plan to wean itself off Russian gas, and while new German LNG facilities are in the works, such facilities take years to design and construct. A more immediate challenge for Europe is how to replace Russian oil. The geopolitical premium in oil prices today recognizes this challenge, but presuming China’s increasingly close alliance with Russia endures, Russia could theoretically sell all its six million barrels/day of crude exports to China, which imports ten million barrels/day. A top five supplier of Chinese crude oil today, Russia could become its largest supplier, freeing up Middle Eastern volumes from Saudi Arabia and Iraq to be rerouted to Europe. Granted, each region’s refineries are geared to process certain types of crude (heavy versus light oil, high sulfur versus low), but to a significant extent, trade flows seem capable of adjusting to a world where Russian oil exports do not disappear, but rather redirect.
The key takeaway is that Russian oil is still likely to be sold amid sanctions by the free world, much like Iranian oil still finds its way to markets in China and India despite current nuclear sanctions. Ultimately, such a scenario would not shut off a key source of Russian government funding, but western nations would at least lay claim to no longer financing the Russian war effort. As for financial markets, such an adjustment in the flow of world oil trade would likely preclude the worst outcomes of substantially higher oil prices, helping keep the “volatile” component of inflation at bay while reducing the chances that longer-term inflation expectations become unhinged.
Our Takeaways from the Week
Stocks remain in correction mode amid high inflation and the ongoing war on Ukraine
The Fed is set to begin raising interest rates next week