The war is everything!
Of course, the title is an exaggeration, but not much of one. Oil supply and prices will continue to be an important factor for financial markets. Last week, one could follow the course of the conflict by following the path of the equity markets. The war clearly wasn’t everything. A lot of interesting and vital economic decisions must be made, and, because of the invasion, international economic relations may change for the better.
This past week, equities continued to lose ground. The Dow lost 1.30%, the S&P 500 declined 1.27%, and the NASDAQ fell 2.78%. As you will read in both the economics and indicators sections, the Ukraine conflict seems to be driving market volatility at the moment.
The outcome of the conflict is undoubtedly important to the global economy, but we will leave combat analysis to defense scholars. We will, however, highly recommend an interview in this past weekend’s Wall Street Journal with Robert Service, a Russian scholar from Oxford. It is very insightful.
One of the fears investors have expressed lately is the specter of the Federal Reserve overtightening. Given the continued high inflation rate, most investors and analysts were confident that the Fed would raise rates by 25 basis points,¹ but, as inflation fears rose, 25 basis points turned into 50, and the markets corrected in response. This past week, Federal Reserve Chairman Powell cleared up any confusion and let the market know he is in favor of a 25 basis point increase. This should have eased fears of excess tightening; however, it did not encourage investors. This is an indication of the importance and immediacy of investor concern. Another interesting point about Fed monetary policy—the system is awash in liquidity. Even with a Fed tightening, there will be excess liquidity for some time.
This terrible conflict has appeared to have strengthened relationships among the U.S. and its allies. Much has been written about the conflict, but mostly within the context of a military geopolitical nature. This, of course, is to be expected, but a lot of national and global economic problems existed before the invasion and will have to be dealt with. There is a lot of speculation about how the U.S. and Europe have become much closer. This by itself is a positive, but investors should think in terms of global trade. Even though China has been relatively quiet about its brother in the cloth, Russia, European attitudes have hardened. Does this change supply chains and trade dependency? How will trade imbalances be handled? Will the West go to fully floating exchange rates? How does the E.U. handle disparate growth rates, and what is the adjustment mechanism if all countries are Euro-denominated?
These are all important questions. Our job is to research them, and readers should expect us to report on them in much greater depth in the near future.
February’s economic indicators pointed to an improving labor market, a continuation of elevated inflation readings, and strong spending despite depressed consumer confidence. With the conflict in Ukraine ongoing, we again remind readers that economic indicators are backward looking, so any potential impacts have yet to show up in the economic data. Even though Russia is a relatively minor player in the global economy, we may see some short-term effects on economic indicators until the conflict comes to a resolution.
Inflation measures remain elevated relative to historical averages with the headline Consumer Price Index (CPI) increasing 7.5% year-over-year and 0.6% from the prior month. Other inflation gauges like the Producer Price Index (PPI), the Personal Consumption Expenditures (PCE) Deflator, and the Case-Schiller Home Price Index are also elevated with year-over-year readings of 9.7%, 6.1%, and 18.6%, respectively.² As we have discussed previously, inflationary pressures over the past year have been fueled by supply chain constraints, stimulus-fueled demand, labor shortages, and rising wages; however, we are starting to see improvements in these metrics and potential signs of “peak” inflation. For one, year-over-year comparisons should start to decline as we lap the higher inflation readings that began in March of 2021.³ While this will not reduce absolute price levels, we may see fewer record-breaking inflation readings. There are also some signs of easing supply chain bottlenecks with the Wall Street Journal reporting a decline in the ship backups in the Los Angeles and Long Beach ports.4 Additionally, over recent weeks, companies like Apple supplier, Foxconn, and Maersk have commented on outlooks for easing supply chain pressures in the second half of 2022. Supply chain congestion remains severe by historical standards, so we will watch for continued improvements on this front.
We have discussed the phenomenon known as the wage price spiral before—the idea that untethered inflation expectations could lead to a demand for higher wages, resulting in firms raising prices to offset increased input costs, causing workers to expect even higher wages, and so on. For this reason, we continue to monitor labor supply and the trajectory of wages. While wage inflation is elevated, hourly earnings dipped lower to 5.1% year-over-year in the most recent release and came in below expectations for a 5.8% increase. We have also seen improved labor force participation in recent employment reports. Labor supply and wage growth have an inverse relationship, and, as the pool of available labor increases, employers will face less pressure to offer higher salaries in order to fill open positions. The New York Federal Reserve Inflation Expectations survey offers further reassurance. While the median one-year expected inflation rate remains high at 5.8%, the three-year rate is a much more tolerable 3.5%. Both measures have come down from their October highs, but the main takeaway is that, at the present, medium-term expectations have not risen much as short-term expectations, and three-year expectations remain in the 2-4% range they have been in since 2014.5 In other words, it seems we are still not dealing with the threat of unanchored inflation expectations.
The Russian invasion presents an upside risk to inflation in the short-term, however. Ships are struggling to access Ukrainian ports, and airspace restrictions could lengthen cargo travel times, prolong deliveries, and add to freight costs—all of which could drive up costs for businesses and exacerbate existing supply chain constraints. Additionally, food manufacturers face the risk of reduced wheat supply and fears of a Russian oil ban have caused oil prices to spike to around $120 a barrel. The general rule of thumb is for every $10 increase in the price of oil, there is about a half of a percentage point increase in the headline CPI number. All of these factors could present upward pressures to inflation in the short-term.
The labor market continued on its positive trajectory with employers adding 678,000 jobs over the course of the month. Notably, leisure and hospitality jobs increased by 179,000 after an Omicron-impacted January. The unemployment rate declined to 3.8%, and the total number of unemployed persons declined to 6.3 million. After nearly two years, the labor market has improved drastically from a peak unemployment rate of 14.8% and total number of unemployed persons topping 23 million. Despite significant improvements, the issue of labor supply, or lack thereof, remains a challenge. After falling from 63.4% to 60.2% between February and March of 2020, the labor force participation rate has been slow to recover. As of Friday’s report, the participation rate of 62.3% sits more than a percentage point lower than it did in February 2020, and with job openings still hovering around 11 million, labor supply is still a significant issue. Labor supply improvements have been gradual and non-linear, but we will watch for progress to continue as we begin to enter a more normalized post-COVID environment.
Consumption and spending metrics were strong this past month; however, consumer confidence remains low. Retail sales came in higher than expected increasing 3.8% month-over-month, while Personal Consumption Expenditures were also strong, growing 2.1% in January. Both releases came after unexpected December declines. There continues to be a divergence between what consumers are feeling and what they are doing. The Michigan Consumer Sentiment and Conference Board Consumer Confidence indices remain historically low. Consumers cited inflation and less confidence in economic policies as reasons for weakening financial prospects and indicated reduced likelihood of buying large ticket items like homes, automobiles, and major appliances. At current levels, the surveys suggest a moderation in growth over the near term; however, substantial consumer savings and strong demand for labor could provide for further resilience in consumer demand.
Economic indicators have been volatile as COVID-19 continues to complicate the global economic landscape. At this point, we have yet to see the impact that the Russian invasion of Ukraine will have on economic indicators. While the United States is insulated from the Russian economy relative to other regions, particularly Europe, there may be short-term repercussions.
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1A basis point is one hundredth of a percent.
2The Consumer Price Index measures the change in prices paid by consumers for goods and services. The Producer Price Index is a price index that measures the average changes in prices received by domestic producers for their output. The S&P Case-Shiller Home Price Index measures the change in value of the U.S. residential housing market by tracking the purchase prices of single-family homes.
3March of 2021 was the first reading above 2% at 2.68% year-over-year
4Berger, P. (2022, February 10). Ship backup at Southern California ports is receding. The Wall Street Journal. Retrieved March 4, https://www.wsj.com/articles/container-ship-backup-at-southern-california-ports-is-receding-11644523945.
5Center for Microeconomic Data. Survey of Consumer Expectations – Federal Reserve Bank of New York. (n.d.). https://www.citationmachine.net/bibliographies/b217f978-55dd-46f4-b553-14f4022e5ddd.