Revising our framework to incorporate Ukraine war
Scenarios vary but on a 12-month view, stocks should be higher from here.
A prolonged period of elevated energy prices undoubtedly would be a drag on the U.S. economy and a severe hit to Europe, which relies heavily on oil and natural gas imports. It certainly would worsen the inflation outlook and complicate Fed deliberations.
But there are good reasons to think severe stagflation or worse, a recession, won’t ensue anytime soon on our shores. For one, these higher oil and gas costs are hitting at a time our economy can most afford it. Corporate profits are strong, company and household balance sheets are in great shape and jobs, incomes and economic activity are all rising. None of this should turn on a dime.
As important if not more, the U.S. economy is much more insulated from the negative effects of higher energy prices than it used to be. Unlike the 1970s, when two OPEC oil embargoes sent oil and gas soaring and import-dependent America into two recessions, Goldman Sachs estimates every $10 rise in the price of oil today only shaves about 10 basis points off U.S. GDP. Not great, but not a catastrophe.
A big reason is the fracking boom. The explosion in oil and natural gas shale rigs over the past 15 years transformed the U.S. from a net energy importer to a small net exporter—daily U.S. oil production has jumped more than 240% since 2005 on the strength of shale—making for almost as many winners than losers in the U.S. economy when energy prices rise. A near doubling in renewal energy production also has played a role—wind, solar and other renewables now account for almost a fifth of U.S. electricity generation—as have improvements in energy efficiency. TrendMacro estimates it now takes only 6% of the oil to produce a unit of U.S. GDP than it did in the 1970s and 1980s
No doubt higher energy prices bite, particularly at lower income levels where every dollar gets spent. The more that goes to gasoline and utility bills, the less that’s left for food, rent and other necessities. But for the broader economy, that bite is nowhere near as deep as it used to be.
Regular readers know that before we at Federated Hermes begin to analyze a new problem, we first spend a good deal of time trying to get our framework right for thinking about the problem. When the framework is wrong-footed, such as the error the Fed and many investors made in treating the Covid-induced “recession” as a normal economic downturn, no amount of good analysis can get you to the right decision. So, as we did in March of 2020, Federated Hermes’ macro team has spent considerable time over the last three weeks reevaluating its framework for 2022 in light of the devasting war in Ukraine.
First and foremost, let me say that our hearts and minds stand with the people of Ukraine. Watching the images of women and children trying to escape the devastation of their neighborhoods by the Russian military is heartrending, and yes, depressing. Most of us thought that this form of warfare was forevermore limited to the previous century. Clearly, it’s not.
This said, we have a job to do for our clients and this memo is written in that spirit. So please, accept it as offered.
The fourth 'F' now predominates
Early in January, we discussed the four cornerstones of our framework for thinking about markets in the post-Covid recovery: Economic Growth, Earnings, Inflation/Interest Rates/The Fed, and Valuations. Our central base case was for strong though decelerating economic and earnings growth, stubborn inflation and rising rates, and compressing valuations. All this would lead, we thought, to modest single-digit returns on stocks this year and next—to 5,300 and 5,500, respectively, on the S&P 500. Importantly, we expected considerable divergence in performance between so-called “value” stocks (financial, energy and big dividend-payers) and “growth” stocks, especially those growth stocks trading more on dreams and stories than on any prospect of near-term earnings and cash flow. This outlook was playing out right on schedule through the first weeks of 2022. Enter Ukraine.
The final of the four risks we highlighted in that same early January piece was a foreign policy development in the form of aggression in Eastern Europe by Vladmir Putin, or in Taiwan by Xi Jinping. Little did we guess the Putin risk would be this profound: a full-scale invasion of Ukraine that has now turned into a desperate war of attrition. So, how does this affect our framework for markets this year and next?
Unfortunately, because the outcome of the war and even Putin’s next move are so unpredictable, the primary impact of the rise in “foreign” risk on our framework is that it has led to a much wider and more dispersed set of possible outcomes for markets. Hence the wild increases in volatility over the last two weeks. After sifting through all the possible outcomes, we’ve compressed a veritable hornet’s nest of possibilities into two:
Scenario One: A quick end to the war (probability 40%)
In this scenario, the war ends in the next few weeks, either with a Ukrainian surrender or a Putin withdrawal following some kind of negotiated settlement. Although both sides seem pretty dug in, we assess there is as high as a 40% chance this could happen, as the Ukrainians continue to suffer horrific civilian casualties and the Russians military ones. A quick end is market bullish, as it removes some of the grimmer tail risk that markets are trying to discount. In this scenario, we’d expect commodity markets to settle down somewhat as supplies from the Ukraine and Russia trickle back into the global market. But we’d also expect that most sanctions would continue, only reinforcing the case for “higher for longer” oil prices. We would keep in place our standing forecast of short rates rising to 250 basis points by the end of next year and would raise our intermediate term oil forecast to $120. We think investors are overestimating the “demand destruction” element of $120 oil (see insert) but believe higher-for-longer oil would prove “demand dampening.” Ironically, this could prove helpful as the Fed’s current inflation problem is excess demand, so higher-for-longer oil would partly do some of the Fed’s hiking job for it. Net, net, we would expect economic growth to be slower than previously forecast—but no recession—with the increased margin pressure from commodity price inflation dampening our earnings outlook. The U.S. economy might then take as much as an extra year to achieve the GDP and earnings levels we’d previously forecasted for 2023. So, a quick end of the war roughly would get us back to our original base case, but probably push it back six months to a year. Assuming markets eventually stabilize around current levels, that would still give the prospect of 20% gains in stocks to 5,300, if not this year, by next.
Scenario Two: A grinding war of attrition that lasts months (60% probability)
We think this outcome is the higher probability for now. On the one hand, the Ukrainian people appear determined to fight to the last person, and Western countries appear united at least in aiding them through arms to carry on the fight, from the rubble if necessary. On the other, Russia’s Putin has painted himself into a very bad spot and may feel he has no choice but to fight his way out. So, a grinding war of attrition does seem to be the modestly more probable outcome.
This outcome is decidedly less favorable for capital markets. Pressures on commodity prices would be higher for even longer, and at some point, what we’d now view as a modest tempering of consumer demand could elevate the risk of the stagflation scenario that the markets worry about, particularly in Europe which has a greater dependency on imported oil and gas. In this scenario, we’d cut our economic and earnings growth further while keeping our interest-rate forecasts elevated. So, stocks would struggle to move ahead. On our current modeling, we’d cut our 2023 earnings forecast for the S&P 500 to $250, and our 2022 year-end target S&P level to 4,500.
Adding it all up
Given the wide range of outcomes, the rising risks of a stagflation scenario and the nastiness of the war over the next several weeks, our guess is that at some point soon the S&P could be in for one last decline, to the 20% correction level represented by 3,850. We’d note, however, that the broader market, reflected by the small-cap Russell 2000 Index, already has achieved this correction level and recently has been making higher lows. And with 12-month forward upside in either scenario above to between 4,500 and 5,000, prospective returns would be substantial were stocks to sink below 4,000. Even at current levels, valuation support is creeping back into stocks and is a reason not to grow too bearish; the median forward P/E on equities is now down to 16.7x. In the meantime, we recommend maintaining the modest equity overweights we’ve had since the start of the year in our PRISM® balanced portfolios, keeping bonds at underweight, and holding on to the extra cash raised in our September and January sales. We expect better re-entry levels to emerge. We also recommend remaining tilted toward the value stocks most likely to benefit in either scenario above: energy, financials and big diversified dividend payers.
And with all of you, I’m sure, we are praying for the people of Ukraine.