Published on April 12, 2022

The war in Ukraine has further complicated the investment backdrop, and fears of a recession are rising now that the U.S. yield curve has inverted. Given so much uncertainty, we are focusing on what we can control and maintaining a defensive posture.

War Is Hell

As yet, 2022 has not been kind to investors. There are many crosscurrents and much uncertainty, and the war in Ukraine has thrown a wrench in the world’s economic spokes. Inflation was already rising, but now prices for oil, natural gas, wheat, and metals have soared. With this backdrop, the Fed, along with a few other central banks, has begun raising interest rates to combat inflation – better late than never. As a result, the amount of negative-yielding bonds around the world has declined markedly. Additionally, the U.S. yield curve has now inverted, giving rise to fears about an impending recession, or at best, stagflation. There seem to be more questions than answers now as we try to make rational choices about how to navigate through this volatile period.

The Russian invasion of Ukraine has changed the narrative for the markets. Seemingly overnight this humanitarian crisis has galvanized Europe and the West into action. Clearly, the goal is to resolve the conflict without igniting a third world war. While no one knows how this will end, the equity markets initially sold off sharply but have since recovered. Sadly, except for some (hopefully temporal) commodity supply dislocation this is less of an economic event than a geopolitical one. Russia and Ukraine are not economic powerhouses save for the export of some commodities, specifically oil, natural gas, wheat, and some metals, including nickel, all of which saw huge price spikes following the invasion. Volatility in commodity prices has calmed down a bit, although they still are quite elevated versus prewar levels. We would expect supplies from elsewhere to increase over time and for prices to ease. As the adage in commodity markets goes, the cure for high prices is high prices!

Luckily, the U.S. economy was in robust health before the Fed started operating on it, but a war and higher inflation make it trickier to navigate the Fed’s preferred path of a gradual interest rate normalization. As we said in a recent missive, the outbreak of war has not always meant a bear market for stocks. In fact, looking at 21 past geopolitical events, beginning with the attack on Pearl Harbor in 1941, the average number of calendar days to find a bottom was 22 and the average number of calendar days to recovery was 47. Russia invaded Ukraine on February 24th. The market hit its lowest point to date on March 8th and closed above its prewar level on March 16th. Luckily, thus far history seems to be repeating!

With prices rising across the world, central bankers’ focus is now squarely on fighting inflation. The big question on everyone’s mind is can they do so while engineering a soft landing, or will they inadvertently plunge us into a recession? We have pointed out in past outlooks that the Fed has a long history of being late with corrective policy and of having a ham-fisted approach, so fears of them causing a recession are not unwarranted. Inflation expectations have risen, both as seen in TIPS breakevens but also at the Fed, as heard in Chairman Powell’s recent testimony. What has been eye-opening is the rise in yields at the short end of the curve. The 2-year Treasury has risen 155 basis points year-to-date to 2.28% while the 10-year bond’s yield has risen 80 basis points to 2.32%. If you track the change from six months ago it is more revealing, with the 2-year rising 200 basis points and the 10-year still only increasing 80 basis points.

While the curve is mildly inverted today, which in the past has been a precursor of economic weakness, economists have been combing through history to find a good comparison to the current environment. Alas, as they say, history doesn’t repeat so much as rhyme. Roberto Perli of Piper Sandler Cornerstone Economics wrote a paper about the rarity of soft landings. Since 1961 there have been three times when the Fed raised the fed funds rate above what they considered the natural rate (that elusive level where economic activity is neither helped nor hurt) without causing a recession: 1965, 1984, and 1994. We are cautiously optimistic that they can do it again, but even if they succeed, there may be some collateral damage along the way. In 1994, the most recent soft landing, the Orange County Retirement System was caught offsides with a large, leveraged bet on interest rates that effectively sent it into bankruptcy, and today’s leveraged investors face a similar risk (which is a big reason we avoid leverage). We don’t expect anything as systemically significant this cycle, as regulators have done a nice job clamping down on bank risk taking, but at the same time, we always seem to be surprised at banks’ ingenuity at getting around regulatory constraints.

Let’s take a closer look at inflation. Clearly it is running well above the Fed’s 2% target. We have always felt that inflation targeting is a fool’s errand, but it does give people something to shoot for. The latest year-over-year increase in the U.S. CPI was 7.9%. With the fed funds target rate now at 0.25-0.50%, we should expect quite a few more hikes before we turn the corner here. Jim Bianco, of Bianco Research, points out that the Bureau of Labor Statistics has had many changes in the methodology of measuring the CPI since inflation last peaked in 1980 at 14.8%. If they were to use today’s methodology, it would have peaked at a mere 11.8%, meaning that we are not as far off from reaching that level as we think. Keep in mind that it took 20% rates to kill inflation then.

We are not suggesting that we will see 20% rates again because as Bianco points out, we are in a much better position economically now, with many states running surpluses that allow them to soften the inflationary blow for constituents. For example, there is a proposal in California to send each car-owning household up to $800 to offset rising gasoline costs. This also includes drivers of electric vehicles! While the press is quick to point out that wage growth, on average, still lags reported inflation, Paul Donovan at UBS posits that all is not lost because the big contributors to CPI are shelter, used cars, and gas prices. This means that if you are not buying a new (or used) car or are not in the market to buy/rent a new place of shelter, then your cost of living is well below the stated inflation rate and may likely be below your wage growth. We do not want to minimize the impact that higher reported CPI has on investor and consumer sentiment but do want to make the observation that large components contributing to the rise in inflation are not experienced by most people in their daily lives.

Beyond the effects on commodity prices from the war, what else could cause inflation to rise further? Asia, perhaps? Here in the U.S. the Omicron wave seems to be running its course, with both the number and severity of infections dropping sharply. Restrictions are easing and the re-opening of the economy may finally be starting in earnest. Contrast that to China, Korea, the U.K., and others, where new daily infections, mostly the BA.2 Omicron variant, are running at all-time highs. Whether we experience a fourth wave here is currently unknown, but it matters because a large reason for the current bout of inflation was the supply chain snarls experienced globally during the pandemic, combined with strong demand for goods. Supply shortages (e.g., semiconductor chips for cars) only compounded the problem, and price increases for raw materials, shipping, and labor made it even worse. Now China is shutting down cities again in an attempt to control their outbreaks. The net effect is that factories and shipping hubs are also effectively shut, further increasing the stress on a creaking supply chain and possibly worsening supply shortages. While we feel this is not a permanent phenomenon, it likely means that high inflation may be more persistent until we see a more synchronized re-opening and loosening of Covid restrictions globally.

Given so much uncertainty, how does one invest in this perilous era? Some things are well beyond our control, so all we can do is manage through them as best we can. Until there is more clarity, we feel it is better to take a more defensive posture and not bet on possible outcomes. Investing is not gambling in our view. Before going out on the risk spectrum, we would need to see one of two things happen. Either conditions need to settle down so we can begin parsing data and making value calls within a more rational framework, or as happens rarely, asset prices need to get hit so badly that prices are at levels that offer enough absolute value that it warrants diving into longer maturities. In the meantime, we have ample liquidity, which allows us the flexibility to keep adding shorter-term debt at yields that are comparable to longer-term debt given the shape of the curve, while we patiently wait to see if the market corrects, which would enable us to buy longer-dated assets at great prices.

Thank you for your confidence and support.

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Bradley Kane

Vice President & Portfolio Manager

Craig Manchuck

Vice President & Portfolio Manager

Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

It is not possible to invest directly in an index.

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.

The federal funds rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

A basis point (bp) is a unit that is equal to 1/100th of 1%.