First Quarter 2022 Commentary - War and Remembrance(of Rising Interest Rates)

Updated: Sep 18


Herman Wouk concludes War and Remembrance, “…war is an old habit of thought, an old frame of mind, an old political technique.” With Russia waging war on Ukraine, Vladimir Putin appears to fit this description, with visions of restoring Russia as a global power. The world has become more interconnected, but Russia is an outlier, its global trade as a percentage of GDP having shrunk over the last couple decades.

In response to this invasion, the rest of the world is forcing Russia to become even more isolated by cutting it off from the global financial system and imposing other economic sanctions, which is making life difficult for Putin, the Russian oligarchs (wealthy business leaders with political influence), and the citizens of Russia. It is not clear that Putin expected such a unified show of strength from other nations, and it’s unlikely he expected this much resistance from Ukraine, who is fighting valiantly. The world, save China, disapproves of Russia’s actions. This is reminiscent of the rise of Islamic State about a decade ago, a group that virtually the entire world seemed to despise. We don’t hear much about Islamic State anymore. The ex-post rallying cry of championship sports teams aside, it’s hard to succeed when everyone is against you.

China is walking a tightrope. It does not want to be seen supporting Russia’s actions, but it also doesn’t want to lose its anti-west ally. In recent years China has shown a notion to subsume Taiwan, but it is certainly taking note of the world’s response to [Russia’s] unwarranted aggression.

The stock market’s behavior in conjunction with the war has been interesting. After falling dramatically in January and most of February, stocks actually rose when Russia ultimately invaded. Then they fell to new lows before staging a massive rally in the latter part of March. Figuring out how a war will affect stocks is extremely difficult, partly because history shows the market’s reaction to war is inconsistent.

Of course, there are other variables that are affecting stocks, with perhaps the largest being monetary policy. The Federal Reserve (Fed), which is charged with maintaining a stable price level, was late in realizing inflation wasn’t “transitory.” But even after recognizing this in late 2021, it was slow to adjust its policy of low interest rates and the purchase of assets. The Fed telegraphed for several months that it would be raising rates in March, but in the meantime it continued to add to its asset portfolio, injecting liquidity into the economy by buying Treasury Bonds and mortgage-backed securities. This was happening while inflation was surging! When you’re in a hole the first thing to do is to stop digging. As of March, the Fed has finally ended its asset purchases, with its balance sheet standing at $8.5 trillion.

For context, during the 2008 financial crisis, the Fed expanded its balance sheet from about $1 trillion to about $2 trillion, a level less than a quarter of today’s. This was considered a gargantuan increase and a reflection of the seriousness of the crisis. But even after the economy recovered, the Fed continued its purchase program, growing its portfolio to $4 trillion by 2014. It actually managed to reduce it to just below $4 trillion in 2019 but then took it to $7 trillion practically overnight in the early stages of the pandemic. Despite the economic rebound and persistently high inflation, the Fed chose to continue its purchases through 2021 and into 2022, topping out at $8.5 trillion. During the financial crisis, the Fed’s easy money did not lead to a dramatic acceleration in the amount of money in circulation, but this time it did, which was evident two years ago. This acceleration in the growth of the money supply has been a major factor in the increase in consumer prices that Americans have become all too familiar with.

The Fed now must determine the best way to go about reducing its portfolio, but it surely is afraid of unnerving markets by draining too much liquidity too quickly. The market – and economy to a lesser extent – seems addicted to easy money. Easy money helps support securities prices and leads to speculative bubbles, as we have seen. The promise of the “Fed put,” the belief that the Fed will come to the rescue when there is trouble, is very much in doubt. For decades monetary authorities have essentially been able to be as loose with policy as they wanted, since various forces were keeping inflation suppressed. But now with inflation becoming more and more entrenched, it may become a much more difficult balancing act for the Fed. Officials are focused on reigning in inflation, but they also don’t want to push the economy into recession.

The yield curve, historically a reliable indicator of future recession when it inverts, has been flattening, a somewhat ominous sign, but it’s technically not yet auguring a recession, given the still-low 30-day Treasury yield. Of course, this 30-day yield is almost sure to rise in the coming months given the Fed’s plan to raise rates. This expectation is embodied in the 2-year Treasury yield, which has risen at an incredible rate over the past few months. In early November, before the Fed signaled its commitment to fight inflation, the 2-year Treasury bond yielded 0.40%. By year end it had risen to 0.73%. At the end of January it hit 1.18%, and in February 1.60%. As we type this it sits at 2.33%. This is an incredibly rapid increase and is one sign of tighter financial conditions. It remains to be seen how these tighter conditions will affect the economy. Housing, which has been so strong, is showing some initial signs that it might be cooling – hardly surprising given the rise in mortgage rates from 2.65% a little over a year ago to over 4.60% today.

One more note on rising yields. You’ve probably heard for years that bonds are the safe alternative to stocks. For the better part of 40 years they indeed have been, as interest rates, which move inversely with bond prices, have fallen. But as we have warned, with interest rates so low the risk-reward in bonds has been poor for years, and investors can lose money in a rising rate environment as they see their bond prices decline. For example, someone who bought (or already owned) a 10-year Treasury bond last fall when it was yielding 1.5% has seen the value of that bond decline by about 8% as the yield has risen to 2.3%. If the investor bought (or already owned) that same bond last summer when it was offering 1.2%, they have lost over 10% of their principal. At a 1.2% yield, it takes more than 8 years to earn 10%. So by reaching for that paltry yield last summer and holding through today, the investor lost more than 8 years of return.

And that’s just on a nominal basis; when we add in the effects of inflation it’s even worse. Currently inflation is running at about 7% annually, so call it 5% since last summer. This means that if the nominal return on the bond was minus 10%, the real return was minus 15%. Even with the rise in interest rates to 2.3%, purchasers/holders of bonds today are starting out close to 5 percentage points in the red on an annual real return basis.

The big question going forward is whether the economy and stock market can withstand the rise in interest rates and tighter monetary policy. Loose money has helped support stock prices, so it stands to reason that a reversal of this may provide a headwind for the market. Despite the sharp correction in some of the speculative areas of the market, our sense is that there is still a significant amount of excess in some segments. The meme stocks, though well off their highs, continue to draw the interest of speculators. AMC, the movie theater chain, has seen its stock price double since it announced in mid-March it was buying a major stake in a gold miner. Management defended the head-scratching deal by contending that it has expertise in understanding balance sheets and solving liquidity problems. This reminds us of the conglomerate craze of the 1960s, when various unrelated corporate entities combined using the rationale that the expertise of the managers extended across industries. Low interest rates enabled that merger boom, but the game ended when rates rose. In the