As I’ve stated many times over my 38-year career, I cannot predict the future. Yet many people still want to hear my thoughts on recent market volatility and what the future may hold: the primary drivers of market volatility in 2022 are Russia’s war in Ukraine and the U.S. Federal Reserve Board (Fed) war on inflation.
Russia’s invasion has had global ramifications beyond politics and national sovereignty. Ukraine is a major supplier of wheat and soybean to the developing world and prices reflect the interrupted supply. Of course, Russian energy deliveries to Europe have been curtailed leading to prices five times higher than in the U.S. Meanwhile, our attempts to meet natural gas demand in Europe translates to higher prices in our homeland.
Recent battlefield successes by the Ukrainian forces have surprised most experts and there is a growing consensus that Russia will fail in its attempts to squash the independence of these proud people. Russia’s military hardware, software and rigid culture have proven no match for the highly motivated citizens of Ukraine. Of course, Western military aid has been crucial in their defense, just as offensive weaponry has become essential in reclaiming the eastern borders of the nation.
It is anyone’s guess how far Putin will go trying to reverse momentum that clearly favors the Ukrainian defenders. Will he use tactical nuclear weapons and risk NATO’s wrath? If the Russians cannot handle the citizen defenders of Ukraine, how long would it take Western air superiority to end the charade? Will the Russian elite allow Putin to remain in power as his “special military operation” destroys the national economy, not to mention their wealth and privilege? Even Russia’s allies, including China and India, have begun rejecting his path with public denunciations. Though the conflict may slow down during the brutal winter months, it’s likely the Ukrainians will reassert themselves in the spring and the Russian people will begin to count the cost of Putin’s folly.
In the U.S., the Fed recognized their error in keeping interest rates at historic lows while extending Quantitative Easing far beyond the point at which our rebounding economy showed signs of inflationary pressure. The Fed Chairman, Jerome Powell, is now channeling the determination of one of his heroes, Paul Volcker. Many of you will remember Volcker as the Fed Chairman who strangled inflation in the early 1980s by raising the federal funds rate to 20% (June 1981). Inflation averaged over 7% from 1973 to 1982 and required severe measures to squelch consumer expectations. This year consumers have been surprised by rising costs, but their expectations still reflect inflation declining in 2023. Another significant difference from our inflationary experience fifty years ago is the dramatic slowdown in the growth of our money supply. We have seen an 80% reduction in M-2 (a principal measure of the U.S. money supply) since February 2021. This contrasts sharply with runaway M-2 growth throughout the 1970s.
All this to highlight Fed expectations that interest rates should have the needed effect by 2023 without lifting the federal funds rate beyond 4.6%. At a recent luncheon, I heard a prominent portfolio manager with BlackRock state their expectation is the federal funds rate will top out at 4.25%. This individual says the metric they watch most closely is applications for unemployment. If those numbers begin to climb, we can expect to see inflation subside, perhaps enough to prompt the Fed to back off their necessary war against inflation. Another metric watched closely by BlackRock is workforce participation. Since the pandemic, more than 2.5 million people left the U.S. workforce and this contributes to the ultra-tight labor market and wage pressures. A recent article in the Wall Street Journal suggested people are beginning to return to the workforce after experiencing the rising cost of living. This is encouraging news for the future.
To summarize, the global headwinds buffeting economies around the world, may begin to slow within the next 6-9 months. This does not mean market volatility will also be tempered. Instead, we can expect a bumpy road ahead, but the stock and bond markets will eventually stabilize and account values will again offer reassurance about your financial future.