We’re not in Kansas anymore

By David Nelson, CFA

Investors entered 2022 with several issues that needed to be resolved. The bubble in non-profitable technology stocks had already started to unwind and inflation was well on its way to becoming a problem not just for investors and the FOMC but for everyday Americans. Add a war breaking out in Ukraine that escalated into a geopolitical confrontation between two nuclear superpowers, I think it’s safe to say that the first quarter was one of the more challenging in recent memory.

I think for many the irresponsible act of firing on a Ukraine nuclear facility by Russian soldiers was the low point emotionally.

Data by FactSet

Let’s review the quarter and what triggered the downturn as well as the recent rally off the lows. Like a company balance sheet there are assets and liabilities and a review of what’s worked and what hasn’t is key to positioning for the year ahead.

The Fed has finally kicked off its tightening cycle raising rates for the first time since 2018. At this point it is well understood by market participants as well as members of the FOMC that the Fed has fallen well behind and will have to move aggressively to bring down inflation expectations.

U.S. Yield Curve

Data by FactSet

The comparison of the yield curve a month ago vs today tells an important story. In the space of 4 weeks markets now expect the Fed to double the pace of the hiking cycle shifting from 25 basis points per meeting to 50bps.

There are many factors that are feeding the inflation cycle including supply chain disruption, rising wages, healthcare etc. but without question the single biggest driving factor is energy prices. Energy touches every line item of the income statement. Not just for companies but for every American.

Oil and natural gas prices had already climbed from a pandemic low of $21 to $91 before the Russian invasion was even underway. The outbreak of war and the ultimate decision of both the United States and Europe to lessen their dependence on Russian oil and gas spiked energy prices even further.

WTI Crude Futures Montage

Data by FactSet

In recent days, the administration has decided to release 1 million barrels a day for 180 days from the SPR (U.S. Strategic Petroleum Reserve). The release is designed to help lower or at least keep in check rising prices at the pump. My concerns are twofold. First past releases have had a short-lived affect and 180 million barrels is 1/3 of the current capacity of the SPR.

If the decision is to continue down this path than put in the spread trade right now. Don’t use just a verbal promise to replenish SPR later. Lock in the sale today of 180 million barrels at the current spot rate $100. Using the futures market buy it back on a forward basis for $90 or even lower if you take it out further. Take advantage of the backwardation of the futures curve. This would solve the immediate problem and replenish the SPR while at the same time locking in a profit. It’s unknown just how long the arbitrage would remain once announced but it is certainly worth exploring.

Inverted Yield Curve 

The inversion of the yield curve or the spread between 10-year yields and 2-year yields going negative has sparked fears of a recession. Of course, recession is a scary word, but it doesn’t have to be. It could just mean couple of quarters of modest negative GDP growth.

The spread between 3 month and 2-year yields is a more accurate barometer and is still in positive territory.

Supply chains continue to be an issue with key components in short supply. The Auto industry is still constrained by a lack of semiconductors a key component in today’s cars.

Another drag on the economy is housing as evidenced by the continued sell off of homebuilders and related shares. Houses are in short supply, but many purchasers are pulling back at the last minute even after they have found a home. Mortgage rates are rising at such a fast pace nervous buyers are holding off unable to lock in quickly enough or just hoping rates will fall from present levels.

Bright spots

The above paints a dark picture but of course needs to be viewed in context. Without question there are strong underpinnings to the economy even beyond a pandemic that is quickly moving to the rear-view mirror.


On Friday we learned another 431,000 people had landed jobs in March. While short of the 525K expected it was the 11th straight month of gains above 400k bringing unemployment down to 3.6% approaching the pre-pandemic low of 3.5%.

The dark cloud in this silver lining is of course companies still can’t find enough workers to fill key positions. To date there are still more jobs available then those unemployed. The miss match adds to the supply chain shortages forcing wages to rise faster than the economy’s ability to absorb. This in turn drives inflation expectations even higher.

Fluff coming out of the market

Some of the fluff in part triggered by extremely easy monetary policy has come out of the market. This chart from Goldman’s David Kostin shows the price performance of non-profitable technology shares. The decline started early in 2021 but most of the damage occurred this year. Rising rates forces equity investors to focus once again on fundamentals.

Fund flows are still positive

As you can see in the chart and table fund flows are still positive. In fact, year to date Exchange Traded (ETF) fund flows are positive in all asset classes. Speaks to the liquidity that still exists.

Data by FactSet

We’re coming into an earning’s season that should give us a sense of what we can expect for the rest of the year. How many will hit the numbers adjusting their business model to deal with current conditions and more important which ones didn’t?

Year to date despite the challenges already mentioned earning’s estimates for this year and next have held surprisingly firm. Either analysts aren’t seeing enough deterioration in their models to start cutting or given the uncertainty they are just going to wait and listen to what management is forecasting for the rest of the year. I suspect it is a little bit of both.\

We’re not in Kansas anymore

When you parse the data both good and bad the only rational view is what Dorothy told her little dog Toto in the Wizard of Oz. “I have a feeling we’re not in Kansas anymore.”

Bottom line – We haven’t been here before

After more than a decade of monetary policy that has flooded the system with liquidity along with a Fed Balance sheet that now stands at $8.9 Trillion, the ability to pivot on dime to fight off the worst inflation in over 40 years is challenged at best. Add $Trillions more in fiscal stimulus to recover from the pandemic it is going to take some time for markets and yes investors to adjust to the new rules of engagement. 

Those new rules include a return to fundamentals. What we pay for stocks will be a combination of earnings, cash flow and or dividends. Companies that grow those 3 data points faster than the competition will be winners. Every couple of decades we seem to forget.