Both equity and bond markets suffered in February over expectations of rate hikes and the growing Russia threat at Ukraine’s borders. Indeed, after weeks of troop movements and denials, Russia invaded Ukraine towards the end of the month, sending investors to safety and bringing new volatility to markets.
The S&P 500 ended the month down 3.1%, and U.S. Treasuries declined 0.7% as the market priced in six rate hikes for 2022.
Energy was a primary driver of inflation in 2021, as gasoline costs surged 50% and fuel oil costs jumped 41%, a situation you may have been noticing at the gas pump. Prices have continued to rise this year, and the situation with Russia adds a new challenge. Russia is the world’s second-largest oil producer and the top natural gas producer. The day Russia launched its land, sea, and air invasion on Ukraine, oil exceeded $100 a barrel for the first time since 2014.
Russia is home to roughly $75 trillion worth of natural resources, and as a result of the conflict, several metals have touched multi-year highs, including copper, aluminum, and palladium. For example, Russia is the world’s leading exporter of palladium, a critical metal for automotive exhaust systems and mobile phones.
Food exports could be impacted as well, with Russia and Ukraine accounting for nearly a quarter of global wheat exports. Ukraine happens to be Europe’s breadbasket, with 71% highly fertile agricultural land. Significant exports like barley, corn, and vegetable oils have notably skyrocketed in price.
In the midst of this (hopefully temporary) shock, we have the overall context of rising inflation. January’s Consumer Price Index, a measure of the change in cost of a basket of goods and services, rose 7.5% year-over-year.
The Russia invasion now threatens to keep inflation running hotter. As a result, the Fed has to tackle the tricky balancing act of fighting inflation by raising rates while still promoting financial stability in the face of these new geopolitical tensions. Markets will be keeping a close eye on the March meeting of the Federal Open Market Committee, which is expected to kick off the first round of interest rate hikes.
Another important point of context for Fed decision-making is property. Real estate values have continued to soar, spurred on by low rates and a shortage of inventory. Average home values in 481 cities are now over $1 million, more than double the number of cities reaching that level since 2016.
With the Fed signaling an acceleration of rate hikes, interest rate markets have adjusted, fueling a rise in US mortgage rates. The 30-year fixed mortgage rate touched 4.08% last week. While we are still hovering around historic lows, mortgage rates are starting an upward trend. This could help cool the rising cost of housing in terms of prices, but again, how this plays out could be impacted by the context of policy and what is going on in Europe. This is another important area for investors to keep an eye on.
Investors are currently flip-flopping between equities and safe havens, prompted mainly by geopolitical changes and uncertainty about the Fed’s moves. Even if we haven’t hit the bottom yet, in times of crisis it’s important to maintain a measured approach and manage risk carefully. Keep in mind we are coming into the year with a solid economic backdrop. Despite headwinds, corporate earnings remain strong and retail sales have grown.
That said, going forward, eyes are on the Russian-Ukraine conflict, any spillover inflationary effects, and the Fed’s plans for interest rate hikes and monetary tightening. Next month the Fed will likely start hiking rates to begin the path to rate normalization. We expect to see some knee-jerk reactions from markets as they digest these ongoing developments.
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