Research Review: February 2022

Russia’s invasion of Ukraine dominated the geopolitical backdrop in February, driving market volatility sharply higher and reigniting investor worries of a global systemic crisis. Assets which tend to perform best during periods of sharply rising energy prices, such as commodities and value-oriented equities, continued to generate relatively strong performance in February, as well as in the first few trading days in March. Across the global equity landscape, emerging market equities—which began the year with solid relative outperformance versus domestic equity in January—faced meaningful headwinds in the latter half of the month, with growing contagion risk sparked by the Russian attack of Ukraine weighing on investor sentiment. Bond returns were broadly negative in February, with rate-sensitive sectors facing headwinds in the way of a continued “hot” inflationary environment and credit-sensitive sectors encountering renewed volatility amid rising credit risk premiums. Performance across the real assets complex was mixed, with REITs continuing to face challenges in the way of increasing interest rates and renewed prospects for a turndown in economic growth. At the same time, commodities—particularly energy—generated substantially positive returns amid surging oil and natural gas prices.

Economic Update

Russia’s Invasion of Ukraine Sends Oil Price to Highest Level Since Global Financial Crisis

News of Russia’s invasion of Ukraine in late February sent ripples across the globe, as fears of a destabilized geopolitical order amid a potential reassembling of the Soviet Union by Russian President Vladimir Putin provided a strong catalyst for the revival of financial market volatility.

Already faced with an enduring energy crisis before the Russian invasion of Ukraine, concerns are mounting across Europe of a sharp slowdown in economic activity, which would have wide-ranging implications for broader global growth dynamics, including domestically. Oil prices, which increased more than 50% in 2021, have gained an additional 50%+ year-to-date through early March, with WTI spot prices now at their highest level since 2008.

Substantial economic sanctions on Russia and the seizing of Russian financial market activity have essentially made the country uninvestable, with some major index providers dropping Russia from their constituency altogether. Moreover, through premiums required to protect against a Russian sovereign default, global investors are demanding the highest compensation to hedge this risk since the Global Financial Crisis. The cost to protect against a Russian sovereign default over the coming 1-year period has surged to more than 6,000 basis points, compared to the previous peak of approximately 1,150 basis points in 2009.

The ongoing crisis across Eastern Europe puts the Federal Reserve (Fed) in a particularly difficult position. On the one hand, recent sharp price declines across risk assets add to the mounting uncertainty regarding financial market stability, which ordinarily would necessitate a cautious approach to guiding investors through a period of monetary tightening. Moreover, model-based estimates of first-quarter economic growth reflect the potential for a 0% real GDP print, and the slope of the Treasury yield curve continues to flatten–both of which serve as headwinds to an overly hawkish Fed.

On the other hand, with headline and core inflation at 40-year highs and likely to keep running meaningfully above the Fed’s target, as well as a labor market reflecting meaningful strength—including a sub-4% unemployment rate in February—the Fed risks harming their credibility if they fail to execute on their dual mandate, which has pointed to the need to tighten policy since last summer.

Bond market participants continue to price in nearly six 25 basis point rate hikes throughout 2022 and a potential hike in 2023. Still, they are discounting the Fed to reverse course in 2024, with policy easing implied by the eurodollar futures curve in the one year from March 2024 to March 2025. Growing sentiment for this policy reversal on the horizon has coincided with a sharp flattening of the Treasury yield curve, which has declined to approximately 20 basis points between the spread on 2-Year and 10-Year Treasury notes.

To conclude, Russia’s invasion of Ukraine in late February has put the world on edge, reviving fears of a broader military conflict and its potentially dire consequences. After entering the year with strong positive momentum, commodity prices have continued to increase—particularly across energy, where crude oil spot prices jumped to a 14-year high. Despite a modest shallowing of the Fed’s anticipated near-term tightening path, bond market participants continue to discount numerous increases to the federal funds rate in 2022, the tightening of which is expected to reverse potentially as soon as early 2024.

Market Returns

Global Equity

• Global equity markets continued an inflationary and geopolitically induced sell-off in February. At the start of the month, investors retreated from risky assets as central banks across the world signaled tighter monetary policy, causing bond yields to rise and valuations to contract. Global equities continued their sell-off upon Russia’s invasion of Ukraine at the end of the month, which negatively impacted emerging market equities.

• Equities continued to trade off macro-economic news causing a headwind for equity markets across the globe. Value continued to outperform growth, as energy and utility sectors drove performance due to rising oil, commodity, and energy prices.

• Although rising inflation and interest rates have put pressure on the earnings outlook, fourth-quarter earnings results were strong. Of the 95% of S&P 500 companies that had reported their earnings for the previous quarter by the end of February, 76% reported a positive earnings surprise, and 78% reported a positive revenue surprise.

• Europe ex-UK equities were especially hard hit due to the start of the Russia/Ukraine war. The European Union depends heavily on Russian commodity exports; approximately 25% of its crude oil imports and 40% of its natural gas imports come from Russia. Western nations’ quick sanctioning of Russian companies and oligarchs adversely impacted performance, as energy supply became more limited, prices climbed higher, and large European bank valuations fell. Meanwhile, UK equities were relatively flat for the month. The Bank of England started the month by raising interest rates 25 bps, as the UK economy continues to see a strong recovery with inflation more subdued than in the U.S. The region benefitted from minimal exposure to Russian energy, as UK oil and mining industries drove market performance.

• Japanese equity returns were slightly negative, as Japan has minimal direct trading exposure to Russia. Thus, the Russian-Ukrainian conflict had only a marginal direct impact on the Japanese economy. However, the war implies a longer time frame of higher energy prices than previously expected, potentially increasing long-term inflationary expectations for the country, which has struggled with deflation.

• Emerging market (EM) equities were significantly affected by the actions of Russia, as Russian equities and the ruble plummeted to near zero. As the month came to an end, MSCI reported that Russia would be removed from the Emerging Markets Index and all other residual indices, putting even more downward pressure on Russian equities and currency. Although many EM import countries, such as India, were hindered by rising energy prices, some nations benefitted from rising commodity prices as net exporters.

Fixed Income

• Interest rate volatility once again captured the rates market for the month. During February, the 10-year U.S. Treasury yield rose 4 bps to breach the critical psychological 2.0% level before retreating to 1.83% amidst a flight to quality. Although long rates rallied, short rates—as measured by the 2-year Treasury—sold off when the curve began pricing in a hawkish Fed amidst rising commodity prices and red-hot CPI readings. These opposing dynamics continue to pressure the 10-year/2-year Treasury spread, which finished the month at 39 bps, the lowest level since March 2020. This widely followed barometer for recession expectations continued its march towards 0 bps through the first week of March, reaching a new cycle low of 24 bps on March 4, 2022.

• Fears of stagflation have begun to creep back into the market on the back of soaring headline and core CPI prints and concerns of prolonged economic expansion. The Atlanta Fed’s GDPNow tool estimates a 0.0% year-over-year first-quarter GDP growth as of March 1, 2022. Furthermore, the median sell-side estimate for February’s CPI print comes in at a staggering 7.9% increase on a year-over-year basis. However, sell-side estimates still project growth moderating to long-term trends near 2.0% through 2024.

• Corporate credit was not insulated from broader risk-off sentiment, with the Bloomberg Barclays U.S. Credit Index and Corporate High Yield Index returning -1.9% and -1.0%, respectively. High yield credit spreads were subject to volatile swings as Treasury yields and sentiment drove demand for credit. High yield funds have witnessed over $20 billion of outflows through the end of the first week of March, creating unfavorable liquidity within the asset class. Additionally, the new issue market remains weak, with issuers pulling deals due to market volatility. February marked a 23-month low in high yield issuance with only $9.3 billion of new paper coming to the market.

• The average 30-year fixed-rate mortgage reached a cycle high of 3.9% as mortgage rates followed Treasury yields higher. Despite mortgage rates rising over 100 bps since December 2020, February’s S&P CoreLogic CS 20-City reading for December measured home price appreciation of 18.6%, 0.5% above the market expectation. However, pending home sales for January declined -9.1%, coming in below sell-side estimates of -1.8%. Cooling housing activity and rising mortgage rates have extended the effective duration of the Bloomberg US MBS (30Y) Index to roughly 5.0 years—markedly higher than the low reading of 1.3 years witnessed in March 2020. Given the movement in effective duration, extension and contraction risk have moved closer to parity, as extension risk had dominated the asset class over the past two years.

Real Assets

REAL ESTATE

• Publicly listed real estate continued to underperform through February 2022. Downward pressure during the beginning of the month came in the form of concerns over accelerated interest rate hikes, while geopolitical risks further pressured global markets. Infrastructure, single-family home rentals, regional malls, and industrial REITs posted the most significant declines, while office, lodging, and specialty REITs were the top performers for the month. The FTSE-NAREIT Index remained flat through the first week of March.

• During the pandemic, office and lodging REITs have often underperformed relative to other REIT property types, including data centers, industrial, and cell towers. However, these sectors outperformed in February and year-to-date. Investor sentiment in these sectors improved on the decreased likelihood of pandemic-related government restrictions and lockdowns. Vacancy rates among the office and lodging sectors have remained below pre-pandemic levels, leaving room for both to catch up to the recoveries felt in other REIT sectors in 2021. In contrast, infrastructure and data center REITs continue to underperform in 2022.