Executive Summary

• Russia’s invasion of Ukraine induced the first equity market correction of more than 10% since the onset of the COVID-19 pandemic.
• Markets have broadly recovered most of the losses since mid-February as fears of further, rapid escalation and severe economic impacts appear to have subsided.
• However, the associated disruption of the supply of key commodities adds to pre-existing inflation pressures, which the Federal Reserve is now moving swiftly to contain.
• The Fed will attempt to thread the needle by tightening monetary policy enough to control inflation while not inducing a recession.
• The start of Fed tightening alone is not an immediate harbinger of a coming downturn but, alongside other information, indicates transition to the late stage of this economic and market cycle.

The Ukraine-induced correction

The first quarter of 2022 was one of the roughest periods for investors since the onset of the pandemic in early 2020. After nearly two years of a relatively straight climb from the crisis lows, equity markets, as measured by the S&P 500, entered correction territory in late February, with their first peak-to-trough decline of over 10% since March 2020 (Exhibit 1). The most apparent trigger of the decline was the well-publicized Russian invasion of Ukraine and the associated rise in fears of both a rapidly escalating global conflict and a severe impact on the global economy.

EXHIBIT 1: Market encountered its first 10%+ correction since the pandemic began

A review of historical geopolitical conflicts (Exhibit 2) reveals that the market’s reaction was not abnormal. Uncertainty was high, and tensions could have escalated further with other significant military powers joining the fray, potentially increasing the likelihood of an even larger conflict. That review of historical events also clearly showed the difference between various outcomes following such conflicts. Events that spiraled into larger conflicts and had more severe, and ultimately recessionary, economic effects resulted in further market declines following the initial correction. However, during events that were not associated with a severe economic impact, markets eventually found their way back to previous levels as the fears of the worst outcomes subsided.

EXHIBIT 2: Path following geopolitical events depends on the impact on the economy

We again have been reminded about the ugliness of war by the seemingly countless stories of atrocities committed against the Ukrainian people. Tensions have run high, but outside of the regional conflict within Ukraine, so far they have not resulted in direct military conflict between Russia and another major military power. The U.S. and other leading NATO nations have shown restraint and have largely kept their fingers off the triggers of their own military forces, choosing instead to walk a fine line with a combination of financial and logistical support to Ukraine and sanctions on Russia. As a result, the economic impact from the crisis has remained contained mostly to Russia and Ukraine (Exhibit 3). The teeth of sanctions are taking a bite out of the Russian economy, which is clearly in decline. Similarly, Russia’s financial markets, both equities and bonds, have been presumed essentially worthless or near worthless. Meanwhile, economists have, on average, only modestly reduced their economic growth estimates for the U.S. and other major countries.

EXHIBIT 3: Outside Russia, economic expectations have fallen only modestly so far

The U.S. and other major economies have been reasonably well insulated from direct exposure to the Russian and Ukrainian economies as well as their financial markets due to their smaller size and lack of integration into the global economy. However, the likelihood of longer-term second-order effects remains. In particular, both Russia and Ukraine provide a disproportionate share of the world’s supply of some key commodities, most notably oil and natural gas, with much of Europe reliant on Russian supplies. Wheat, corn and seed oils are often the second most-cited group of items. Beyond that, neon and palladium, both used in automobiles and semiconductor manufacturing, provide additional opportunity for further disruption (Exhibit 4).

EXHIBIT 4: Russia/Ukraine could have outsized impact through key commodities

Inflation and the Fed

This, of course, leads directly into the next piece of this mosaic — inflation. Inflation was a rising concern for investors through much of 2021 but was expected by many to fade into the background in 2022. Since the end of 2021, such expectations have shifted quite dramatically. Russia’s invasion of Ukraine has added kindling to the already-burning inflationary fire just as base effects from the prior year were beginning to roll off and even supply chains were beginning to show some signs of improvement.

Inflation expectations for 2022 have risen from close to 3.0% at the turn of the year to over 5% as of the latest estimates. Inflation around 5% is a good degree slower than 2021’s rapid 7% gain (Exhibit 5, left) but is still reasonably above the Fed’s comfort range and runs the risk of becoming more embedded into the behavior of businesses and consumers. If such economic participants begin to assume this higher inflation will persist longer, they will likely accelerate purchases to get ahead of the increase, further fueling the increase with their own collective demand in a self-reinforcing, momentum-like manner. Market-implied inflation expectations of over 3.0% for the next five years (Exhibit 5, right) seem, in part, to indicate some likelihood of longer-lasting inflation, again at a lower level but still above the level that the Fed may prefer to see built into longer-term expectations.

EXHIBIT 5: Inflation expectations have risen materially

As a result, the Fed has become quite active and intentional in both its monetary policy shifts and its telegraphing of coming shifts. The Fed has quickly moved to downshift its bond-buying activity, reducing the magnitude of its purchases quickly enough to effectively end those purchases in March. It also began its rate hike campaign, voting through at its March meeting the first rate hike since 2018. This rate hike was only 0.25%, but the Fed members’ projections and minutes from that meeting as well as public comments made by voting members since then point to a willingness to raise rates in 0.50% increments for the next couple of meetings. This ultimately leads to expectations that the Fed is on a path to raise rates by 1.50-2.00% in 2022, well ahead of previous expectations (Exhibit 6).

EXHIBIT 6: The Fed has also telegraphed a swift removal of monetary stimulus

The increased willingness of the Fed to shift its monetary policy plans and convey those intentions clearly place on full display its commitment to containing inflation in 2022. Further, this shift in policy and communication has been heard by market participants; not only has the market priced in a faster pace of rate increases over the next two years, but the market’s expectation regarding the longer-term level of interest rates has also shifted upward across the time horizon as shown in the Treasury yield curve (Exhibit 7). This upward shift in rate expectations has come with a notable flattening and even a hint of inversion in the Treasury yield curve.

EXHIBIT 7: The yield curve inversion points to some softness … eventually

Yield curve inversion is commonly highlighted as a predictor of recessions, an accurate observation, but one that by itself lacks a good degree of power and utility for investors. The yield curve’s track record of calling eventual recessions is fairly good but fails to impress those who realize such recessions are predicted with a rather lengthy average 18-month lag and much variability in a world in which recessions occur on average every 5-7 years (Exhibit 8). Additionally, the yield curve does little to inform the length and depth of those recessions or their impact on corporate profitability, which may be more important to investors during those periods.

EXHIBIT 8: Markets continue to rise after yield curve inversions until a recession occurs

By definition, yield curve inversions more precisely highlight the building expectations for a situation in which the Fed must backtrack on rate hikes due to softening economic circumstances at some point in time. A yield curve inversion between 2-year Treasuries and 10-year Treasuries as we have seen recently suggests such a situation may occur sometime in the next two to three years. Further, the yield curve does not fully inform us as to the driving factors of the need to reduce rates — is it because the economy has slowed too much, or is it because the Fed actually managed to slow inflation and no longer needs as tight financial conditions to bring inflation down further? We will only find out the answer to this question over time.

Late-stage concerns suggest expectations for more modest gains and rising downside risks

Independent of the reason for the very modest yield curve inversion, such market pricing, alongside other observable factors, does inform our evaluation of the economic and market cycle and its rapid transition from mid to late cycle. The economy has come a long way since mid-2020, with GDP rebounding fiercely to approach potential, unemployment declining steadily to levels that are sparking wage inflation and a Fed that is shifting itself quickly from protecting against the deflationary downside of a pandemic to containing rising inflation. All of this is occurring against a backdrop of above-average equity valuations (Exhibit 9), with hints of irrational exuberance in growthy tech issues, cryptocurrencies and perhaps even some pockets of residential housing. Some gas remains in the economic tank, particularly in select international economies where excesses have yet to develop and there is room to normalize further from the pandemic. However, geopolitical conflict and inflation are hastening a late-cycle response from the Fed.

EXHIBIT 9: Valuations still on the higher end of target ranges

iven the transition to the late stage of this economic and market cycle, it is becoming more important for investors to review and consider rebalancing the asset allocation of their portfolios toward their previously established targets, willingly recognizing some of the gains accrued since the pandemic lows. It is during this environment that outsized allocations to risk assets such as equities typically introduce more downside risk than is justifiable, making the sizing of those risks in portfolios far more important.

Further, the picture for expected returns for asset classes is now in flux, more than it has been in the past, with Glenmede’s expected returns on fixed income now rising to levels that finally exceed longer-term inflation targets (Exhibit 10). Fixed income returns may even eventually provide an attractive alternative to some overpriced portions of equity portfolios, but that circumstance has yet to arrive. For now, there remains a reward for taking incremental risk, but that reward differential has been shrinking and bears close monitoring as the Fed continues on its path of monetary policy normalization.

EXHIBIT 10: What to do and what to watch in 2022