Gerry Connor / March 31st, 2022

The Invasion of Ukraine is a Game Changer

In my last commentary I suggested that Russia’s invasion of Ukraine would aggravate inflation and slow economic growth, but not necessarily drive the US into a recession. However, Europe may not escape that fate as the overall environment for the global economy has worsened. The game changer is that the Ukrainian invasion has caused governments to reassess their energy and trade policies. Even with an eventual resolution of the conflict, it is unlikely that everyone will resume relations with Russia as though nothing had happened. Energy policies will reprioritize the battle between the environment and security. As I also suggested, this conflict may have grabbed the headlines, but I still think the real issue is how things play out with the Federal Reserve and this market “noise”, albeit heart-wrenching and disturbing, will eventually have to be factored into the bigger picture.

In the meantime, the market is focused on Europe, is oversold and would respond positively to any resolution to the Ukrainian conflict. The downside is the potential for the conflict to escalate, draw in NATO or go nuclear. Remember, it is in Putin’s best interest to appear unstable, which makes his threat of irrational options more plausible. What’s the old adage, “Crazy like a Fox”?

But, as the Ukraine moves off the front page, I think we’re going to refocus on where we are with monetary policy and the economy.

First Principles

To survive emotional markets, you have to rely on some time-tested principles to ground your decision making. We’ve talked about liquidity trumping economics and reversions to the mean many times. So, I thought it might be appropriate to start off with some of the basics as a foundation for our current thinking.

Let me start with the Phillips curve, which most of us learned about in Econ 101. It hypothesized that lower unemployment and tighter labour markets equated with higher wages. At the end of 2019, unemployment hit 3.5%, the lowest in decades and inflation remained muted. We were also still in the midst of a very loose monetary policy that hadn’t been reversed after the financial crisis in 2009. Academics concluded that the macro forces of technology, demographics and globalization in manufacturing had refuted the principle. COVID brought another dose of stimulative monetary policy, which drove demand for goods beyond the supply chain’s ability to deliver. We’re now back to 3.5% unemployment and wage rates, if you can hire someone, are going through the roof. So, Phillips is back in vogue. Some suggest that productivity will offset the lack of labour and we agree to some extent, but we saw this movie back in the 1970’s. The trouble is, back then, the baby-boomers were graduating from university and joining the labour force creating additional supply. Today, those baby-boomers are retiring and aggravating the shortage. So, I wouldn’t count on wage price escalation being transient and it is one of my core inflation components. This is a principle, reverting back to the mean.

The money supply theory, as promoted by Milton Friedman in the 1960’s, suggesting that more money chasing the same number of goods would cause inflation, was also questioned. After all, the Fed had been pumping enormous amounts of money into the system since the Great Financial Crisis without having any real impact on inflation. So, that theory was also dead. In that first episode of Quantitative Easing, the Fed used the commercial banking system to execute its policy. That’s traditionally how it was done and was referred to as exogenous money. But the banks didn’t lend it out, and therefore it never became excess to the system. With COVID, the Federal Reserve decided to go direct, and helicopter money, via the so-called endogenous approach. They funded the government instead of the banks, and the government distributed those funds through COVID benefits. And sure enough, people got bored sitting at home and went shopping with those dollars, and we all now know what has happened to the cost of just about everything from houses to autos since then.

This is part of the thinking behind Modern Monetary Theory (MMT) promoted by neo- Keynesians who still believe the government can print and spend money without limit or consequence. They also still hold that, in theory, the excess funds sitting in savings that was created by these policies will not be consumed or invested. The Monetarists disagree. They think there remains too much money chasing too few goods, which is supported by history. Statistically, the Fed engineered a massive 40% increase in the quantity of money against a backdrop of a relatively small change in nominal GDP since the end of 2019. From 2009 to 2022, monetary policy and inflation have disconnected with CPI averaging barely 2% while money supply grew an average 6.5%. Simplistically, the excess liquidity didn’t generate inflation as China provided the antidote of lower goods prices and cheap labour. Consequently, that excess liquidity went into financial assets, stocks, bonds and real estate. We still think the fuzzy thinking behind MMT will be challenged as the reality of recent Fed policy becomes apparent and you know my thoughts about liquidity. This is another theory that is coming full circle.

My point here is that there were a number of principles that were challenged due to circumstances, mostly China and globalization, that are now reverting back to reality. And the flip side to this is monetary policy and excess liquidity. There are some mitigating factors, but less liquidity is not good for financial assets.

There are a couple of other macro trends that also appear to be regressing back to their prior means. One is labour’s share of GDP, which historically averaged around 66%, but has dropped to around 59% and they want it back. It’s part of the social movement we’re seeing as workers feel that they have economically fallen further behind, and it is partially true. But some of this can be blamed on government policy that on the surface espouses transfers from the wealthy to the less fortunate. The fact is, Fed policy has benefited those who own stuff, generally the wealthy whether that be a house, a business or investments. Liquidity went to Wall Street not Main Street.

Wages are now going up, but not as fast as inflation. You may get a raise, but you still can’t afford to fill your car with gas, let alone have enough left over to take your family out to a movie and McDonalds. So, the support for unions is increasing and the Biden administration is one of the most pro-labour governments in recent memory. This fair sharing between labour and capital isn’t going to go away with a shortage of manpower.

This has a bearing on another factor that has swung to an extreme: profit margins. Before inflation took off in the mid 1960’s, corporate profits were about 12% of GDP, close to what they are today, and profit margins were also extended at that time. But with persistent inflation by the 1980’s, that couldn’t always be passed on, corporate profits decreased their share to 7% of GDP. Some of the things that later contributed to margin improvements such as lower labour costs, thanks to China and lower interest rates, thanks to the Fed are now reversing. So, corporate revenues will likely continue to rise due to inflation, but shrinking profit margins may hold profit growth in check, which is probably not good for stock valuations.

I could go on, but I think you get the point. There are some secular factors that have favoured financial assets that seem to be peaking out and potentially reversing.

What this means for the stock market remains to be seen. One thing is sure, I don’t sense that the wind will remain at our backs, so I’m cautious. However, where do you go when inflation heats up? Rising interest rates won’t be good for bonds, while equities have historically been a better hedge than other assets. I think the real issue is what you own. Companies that can respond to inflation by passing costs through will do better than those who can’t. So, stock selection, I think, will be paramount in contrast to indexing or trend following.

So, let me get a little more granular.


Every time you fill up your car or pay a heating bill you see the impact of the Ukrainian invasion. Europe is hooked on Russian gas, and oil, and there is no short-term solution. Morgan Stanley recently did a report that provides some perspective with respect to this problem. They calculate that 80% of energy comes from carbon (Coal, Gas & Oil). 17% is generated by Nuclear, Hydro or Biomass. All of which are hard to scale, especially in the short term.

Only 3% comes from Wind and Solar, which seems to be where we are going, and it can be brought on more quickly than other options. However, look at the proportions. You can double clean energy and barely put a dent in the others, which is the essence of the problem. Environmentalists and politicians have us going in the right direction but are oblivious on how to make it a smooth transition.

Oil inventories are at a multi-year low, there is limited spare capacity even in the Arab nations, investment levels are at multi-year lows and now there is downside risk to Russian supply, which provides Europe with 30% of its natural gas. Currently, half of the US energy companies have management contracts with incentives based on environmental conservation and capital return expectations with limited increases in production.
We’ve said for some time that we see energy having a secular influence on inflation due to the miscalculation on transitioning to Renewables. This just got worse with what is happening in Ukraine. However, two investment opportunities seem apparent. Europe has to pivot away from Russia. Renewables will be the first priority, but logistically they can’t fill the gap. LNG will also be an option and the US has a sizable number of permitted projects.

I also think the US policy will have to become more realistic. As stated, domestic E&P companies are not currently incented to ramp up production and are in fact being discouraged by environmentalists. Meanwhile, the Biden administration would rather play politics and do a deal with the likes of Venezuela or Iran before partnering with a friendly neighbour to its north like Canada. At some point, security and the environment will have to be better balanced. Furthermore, as Yardeni Research suggested, Americans aren’t going to want to hear that production isn’t ramping up as fast as possible because shareholders want dividends and share buybacks. It will be considered unpatriotic. So, the predicted death of oil and gas may have been premature.


In February, the CPI hit 7.9%, a forty-year high and that’s before the impact from Russia’s invasion of Ukraine. The politicians will want to focus on core inflation, which is running at 6.4% and doesn’t include food and energy. Explain that to your family when they are at the grocery store. Another index that just focuses on necessities such as food, shelter, gas and utilities shows that their prices rose 16% last month. Goldman Sachs estimates that every $10 increase in the price of Oil hikes inflation by 0.2%.

However, 75% of core CPI consists of services. Commodities such as autos and apparel make up the balance. Shelter is about 42% of CPI and 60% of services. In the last twenty four months, the price of a median home has increased by 33%. This eventually works its way into homeowner’s equivalent rent over about two years. In the twelve months ended September 2021, the rent of a one-bedroom apartment rose by 19.8%, which will continue to work its way into the numbers as leases roll over. Rents are a lagging indicator and are another of my secular inflation factors besides wages and energy.

So, sure, bottlenecks will get resolved and some commodity prices will come off the boil, but a sustained residual rate of inflation above the Fed’s target is highly likely.

We’ve suggested that the economy is doing fine and that inventory building and the ‘coming out’ impact on services like travel and entertainment would add to its strength. One can always find contrarian indicators but this forecast through this spring still looks accurate. However, as we move through the year things don’t look as promising. Growth is going to slow once manufacturers get caught up with demand regardless. The Russian invasion will aggravate inflation for energy, and crops, and it will create further manufacturing bottlenecks. These types of cost increases are effectively a tax. They take money out of the consumer’s pocket that could have been spent on other things. So, they slow down the economy and have recently also led to a number of forecasts for ‘Stagflation’. I won’t argue that we’re headed in that direction, but exactly where we cross over from growth to stagflation isn’t well defined. There are a lot of comparisons to the inflation of the 1970’s, which are also partially valid but beyond what we want to accomplish here.

Regardless, Fed Chairman Powell has suggested that the jump in oil prices could add 0.9% to inflation and cut nearly 1/2% from US GDP.

Those forecasting a recession point to past correlations between oil price shocks and a decline in the economy. This is supported by the earlier mentioned impact of higher energy prices on consumption and what is referred to as the Fiscal Cliff, or the lack of any further government stimulus as compared to the previous year.

But there are some mitigating factors. First, energy is a much smaller component in the household budget. It peaked at around 9.5% in the early ‘80s and has since declined to about 4%. Second, consumers have something like $3.0 trillion in surplus savings while wage growth is running close to 6%, and everyone who wants a job has one. Consumption isn’t going to fall off a cliff.

So, GDP growth will slow down, and inflation will remain stubbornly and aggravatingly high.

Federal Reserve

There was all kinds of speculation as to what the Fed would do prior to the invasion of Ukraine. Most forecasted seven increases this year starting with a 0.50% jump. That got toned down and we all now know that the Fed initiated a 25bps increase with Powell suggesting that 1/2 point increases are probable as inflation is more intransigent than expected. The reality is that there isn’t much the Central Bank can do except to use a very blunt tool to reduce demand. That leaves them with a choice between recession and enduring higher than acceptable inflation. They’re handcuffed by both their own overstimulation and by fiscal policy which has left government debt at a record $30tn, up about 30% since 2020. Even a rate increase to 2% would translate into an extra $600bn of interest payments. Powell is no Volker, so my bet is that he incrementally addresses the issue but tries to avoid a decline in the economy and lost jobs. Maybe that will be accomplished by the Fed simply adjusting what they now believe is an acceptable rate of inflation from their 2% target to 3% or 4%, and declare that a victory.

Aside from the cost of money there is its availability or liquidity issue. I see this as a bigger problem for financial assets than the economy. Although interest rates remain the focus, the reality is the level is still almost de minimis and a rise to 1/4 of one percent or even three hikes from now at 1% doesn’t seem like a very high hurdle rate that should slow things down much, except maybe for housing. However, a withdrawal of surplus funds through Quantitative Tightening (QT) is different. Earlier in this piece, I recounted that easy monetary policy executed through the commercial banks had failed to stimulate the economy but had a significant impact on financial assets. So, the next round of stimulus went direct and did help the consumer. This time QT will probably play in reverse and is likely to affect Wall St. more than Main St. as savings and the commercial bank lending play a role. The FDIC insured assets are about $11.2 tn, so 10%-15% loan growth could add approximately $1.1 to $1.7 tn to money supply to counteract the QT. This liquidity will be provided to Main St. and supports economic growth. Furthermore, consumers have an estimated $3.0tn in excess savings that can be spent, which will also add to liquidity. Both sources will support economic growth and inflation.

However, the Fed owns about 1/3 of both the US Treasury and mortgage market. Its balance sheet has doubled since the pandemic to 40% of GDP. Someone will have to provide this lost liquidity. So for the Fed, the risk of policy error is pretty high as they will be tightening into an eventually slowing economy. Soft economic landings are pretty elusive even in less challenging times.

Stock Market

At the risk of getting too theoretical, there are three things that affect stock prices:
1) Changes to a company’s growth rate,
2) The discount rate, essentially interest rates,
3) The risk premium, the need for a higher rate of return in difficult environments.

Logically, companies that grow faster get higher valuations. Interest rates are used to discount that growth and higher discount rates lead to lower valuations. And finally, higher risk premiums translate into lower valuations. Why is this important? Because the difference between a correction and a bear market is the extent to which a contraction in liquidity and the rise in risk premiums get passed through to the economy resulting in a decline in earnings. In a correction, the price decline is usually a rise in the risk premium and the discount rate causing a fall in price earnings ratios without much change to economic growth or earnings. In a bear market, the impact of the earnings decline is greater than the increase in the risk premium or discount rate.

What we’re seeing right now is higher inflation driving higher interest (discount) rates and the Ukraine war impacting risk premiums. It’s led to a correction. The good news is that the market adjustment has not yet been credit-induced. Interest rates have only just increased, but by 25bps and no liquidity has been withdrawn from the system, except that required by the economy. Furthermore, the air is coming out of the Mega Caps, which have seen their valuations drop from 33.8X earnings at the start of the year to 26.5X. For the S&P 500, forward P.E.s have declined from 21.5X to 18.1X. Value index P.E.s have declined from 17.4X to 15.7X while growth stocks have seen valuations contract from 29.7X to 22.3X as forward P.E.s are inversely correlated to inflation. So, what we have seen so far is about what one should have expected. The most overvalued sectors are seeing the greatest adjustment and value is doing better than growth because it is less adversely affected by interest rates and has a better ability to adjust prices and pass-through inflation.

So, where do we go from here? Right now, you can’t build the case for a bear market based on a recession, although things are going the wrong way and the Fed seems to be caught in a Catch 22 with rising inflation and slowing growth.

What gives me the greatest concern are the reversions that I mentioned earlier. Inflation and especially higher wages will have an impact on profit margins, which will curtail profit growth. The Fed is going to have to drain some of the excess monetary policy liquidity that it created, oil shocks have historically not been good for the market or the economy and lastly, the Fed can no longer provide a safety net for the market. In past market declines, the Fed has been there to lower interest rates and inject liquidity. This time it would seem that they have few bullets left to fend off a Bear.

Excess savings and bank liquidity will initially temper any impact on the economy, but I doubt that it will save Wall St. as the funds will be needed for energy transition projects, defense, inventories (just in case) and re-shoring projects filled with productivity-enhancing robots. Risk premiums and discount rates will go higher impairing improvement in the market averages. But, there will be pockets of strength for selective investment made in the right areas. Riding the trends or momentum and indexing will be last decade’s investment strategy. We’re now back to playing some defense and old fashioned stock selection.

Macro Strategy Partnership
Bridgewater Research

Yardeni Research
Morgan Stanley