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Weekly Update 3/4/2022: Fed Chair Powell Testifies Before Congress as Ukraine Conflict Rages On

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Trading & Ukraine

Traders eyes were focused this week on the war unfolding in the Ukraine and Fed Chair Powell’s testimony before congress. Our hearts and prayers go out to people of the Ukraine – their military and civilians. As we wrote last week, the loss of life and massive disruption to the people of Ukraine is a true tragedy from a humanitarian point-of-view. At these early stages, there are few signs that it will have a devastating effect on the U.S. economy or the vast majority of its businesses. At SGK we do not have direct exposure either through equity or fixed income to Russian or Ukrainian companies. We also avoid areas of the market we consider to carry undue risk such as junk rated securities or emerging market equity or debt in the form of mutual funds or ETF’s. We are firm believers in the philosophy of knowing what you own. As small a weighting as Russia has in those types of securities – they are very difficult to divest of for ETF’s or mutual funds given Russia has been part of some emerging market indices and they kept their stock market closed recently. It is hard to see how the conflict would have an impact on core holdings such as Walmart or Ventas (the latter being a REIT focused primarily here in the U.S.) – but that is not to say there cannot be indirect impacts. Rising energy costs as a result of the conflict and further disruptions to the supply chain can impact different companies in unpredictable ways. With that said we have not seen signs of any unforeseen impact on any of our core holdings to this point.

We would like to acknowledge and say thank you to core companies that have taken a stance on the conflict. Russia’s invasion of Ukraine last week brought global condemnation, trade restrictions and financial penalties. Now the nation of 145 million is losing many of the world’s most iconic brands. Apple Inc. and Nike Inc. both announced plans Tuesday to halt product sales in Russia, cutting off the country to the most valuable technology company and the biggest maker of athleticwear. That followed Hollywood studios such as Walt Disney Co. and WarnerMedia (part of AT&T) pausing releases of new films in the nation -- including “The Batman,” which is hitting U.S. theaters this weekend and expected to become one of the highest-grossing movies of the year. Taken together, the moves reflect a cultural and commercial split unseen since the Cold War ended in the late 1980s. From the iPhone to Air Jordans, highly prized U.S. brands are vanishing from the Russian marketplace in a way that will be hard for consumers to ignore. When Ukraine Vice Prime Minister Mykhailo Fedorov urged the Apple to stop sales in the country (he wrote a letter directly to CEO Tim Cook), he said it could turn Russia’s young people against the war – and Tim Cook and Apple responded. Well done!

Inflation

In Fed testimony this week there were several points we would draw attention to that helped provide some level of comfort to traders and investors alike. When asked directly as we were viewing his testimony, Federal Reserve Chair Jerome Powell backed a quarter-point interest-rate hike here at their meeting in March to commence a series of increases. This helped provide reassurance to all of us that the likelihood of a “surprise” 50 bps hike was small – particularly given the conflict going on in the Ukraine. “I am inclined to propose and support a 25 basis-point rate hike,” Powell told the House Financial Services Committee Wednesday. “To the extent that inflation comes in higher or is more persistently high than that, then we would be prepared to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings.” Fed officials are pivoting to tackle the fastest inflation in 40 years and a few have publicly discussed the potential need to hike by a half point some-time this year if inflation comes in too hot. They get February data on consumer prices on March 10, five days before they commence their next policy meeting. While acknowledging the uncertainty posed by the attack on Ukraine, Powell said the need to remove pandemic policy support had not changed. The other key point that seemed to be overlooked by many but not us – he stated during testimony that the Fed stood ready to provide support in the event of signs of stress due to the sanctions the U.S. applied to Russian banks – including dramatic sanctions on the Russian central bank. The Fed could provide dollars where needed to the global economy through already established swap lines as they did during the pandemic and financial crisis. He specifically stated during testimony that they were monitoring the situation closely along with the U.S. Treasury and they had not witnessed any signs of stress to this point. That comment also helped lift sentiment in Wednesday trading.

On the issue of the Fed balance sheet – his comments were again measured and reasonable. The Fed chair gave no timing on balance-sheet reduction, a decision that is likely still pending for the Federal Open Market Committee. After rate increases start, trimming assets “will proceed in a predictable manner primarily through adjustments to reinvestment,” he said. Powell said he continues to expect inflation to decline over the course of the year as supply constraints ease and demand cools off in the wake of waning fiscal support and higher interest rates.

These comments just showed that the Fed Chair was applying a healthy dose of common sense to the equation when he stated: “The bottom line is that we will proceed but we will proceed carefully as we learn more about the implications of the Ukraine war for the economy,” he said. Equity average began to rise immediately after that comment as we were monitoring the proceedings. Investors increased their bets on the pace of rate hikes this year as the Fed chief spoke, pricing in around 140 basis points of tightening staring this month -- which will mark the first increase since 2018. U.S. stocks advanced and 10-year Treasury yields rose. Powell said the labor market is “extremely tight,” essentially a message to lawmakers that the central bank has met its maximum employment goal in current conditions, which opens the door to its inflation fight. He said employers are having difficulties filling job openings, while workers are quitting and taking new jobs helping wages rise at the fastest pace in years. This common sense approach is prudent in our view. Unlike St. Louis Fed President Jim Bullard’s comments – he is a proponent of aggressive rates hikes including a 50 bps hike in March – which seem to just put added stress on markets, Chair Powell has a more measured approach. Some forms of inflation are a sign of economic strength – rising wages for example and a tighter employment picture are positives for the economy. Other forms of inflation are not necessarily entrenched – supply chain disruptions for example – and should work their way out of the system over time. Powell seems to understand this – Bullard does not seem to grasp that concept. Inflationary expectations remain contained. If people were concerned that an automobile would be significantly more expensive a year from now due to runaway inflation – they would buy that car now. There are few cars on lots because there are few chips to go around to put into cars. So that car may actually be more expensive now then it will be a year from now when hopefully there are more cars on the lot as these supply chain issues work their way out of the system. This is a different type of inflation – Bullard advocating raising interest rates aggressively will make that car more expensive for those looking to finance the purchase and especially those living paycheck to paycheck. So yes raising interest rates will slow demand and bring down prices – some will not be able to afford to finance the car. But how does that help the supply chain issue and the economy long term?! We suggest Bullard quit yakking so much on TV – it seems he enjoy the limelight as he shows up on CNBC about 2-3 times a week lately – and actually spend some time in the real world – like visit a local automobile sales lot and speak to someone who understands the complexity of what is currently going on. Enough said by us on that topic!

Manufacturing

In other domestic economic news, U.S. manufacturing activity advanced in February after an omicron-related setback a month earlier, as new orders growth and production accelerated. The Institute for Supply Management’s gauge of factory activity increased to 58.6 from 57.6 in January, according to data released Tuesday. Readings above 50 indicate expansion. The median projection in a Bloomberg survey of economists called for the measure to improve to 58. ISM’s new orders measure advanced nearly four points to a five-month high of 61.7 following Covid-19 related softness in January. While production improved, the data highlight how manufacturers are still struggling to keep up with demand for consumer merchandise and business equipment. The group’s gauge of order backlogs swelled to a six-month high and supplier delivery times slowed further. “The U.S. manufacturing sector remains in a demand-driven, supply chain-constrained environment,” Timothy Fiore, chair of ISM’s Manufacturing Business Survey Committee, said in a statement. The omicron variant “remained an impact in February; however, there were signs of relief, with recovery expected in March.” Sixteen manufacturing industries reported growth in February, led by apparel, textiles, paper and transportation equipment. A measure of prices paid by producers eased from the prior month but may soon move higher as the cost of commodities including crude oil jump with Russia’s invasion of Ukraine. Many manufacturers have passed along higher costs for both materials and labor to consumers, helping to fuel the fastest inflation in decades. The ISM employment index declined to its lowest level since October, though continued to indicate hiring growth in the sector. Meantime, the group’s gauge of export orders jumped to a one-year high of 57.1, while a measure of imports picked up.

Unemployment

U.S. companies in February added more jobs than forecast as Covid-19 cases dropped and restrictions eased, encouraging more Americans to work. Businesses’ payrolls rose by 475,000 last month, according to ADP Research Institute data released Wednesday. The median forecast in a Bloomberg survey of economists called for a 375,000 rise. The initial January print showed a 301,000 plunge in the month, the worst since April 2020, but was revised up to a 509,000 gain. The greater-than-expected job growth points to a labor market rebounding strongly from the omicron variant’s spread in January, which led to business closures and kept many workers at home sick. Covid-19 cases have dropped significantly and restrictions are easing across the country, which should help wary Americans get off the sidelines and back to work. When the ADP report comes out it always precedes the monthly government payroll report which as of Wednesday was expected to show that private payrolls increased by 383,000 in February. The ADP figures don’t always follow the same pattern as the Labor Department’s data. ADP’s payroll data represent firms employing nearly 26 million workers in the U.S. so it is a report we pay close attention to. We like the fact that it breaks it down by size of the company too. Large businesses, those of at least 500 workers, added 552,000 jobs; while medium-sized businesses, between 50 and 499 employees, added 18,000 staff to their payrolls. However, small businesses lost 96,000 jobs over the month, the data showed. "Small companies lost ground as they continue to struggle to keep pace with the wages and benefits needed to attract a limited pool of qualified workers," Ms. Richardson said. By sector, services providers gained 417,000 jobs, and 170,000 of them were created in the leisure and hospitality sector. Goods-producing businesses added 57,000 jobs. The report, carried out by the ADP Research Institute along with Moody's Analytics, is based on data through the 12th of the month.

Applications for U.S. state unemployment insurance fell by more than forecast to the lowest level since the start of the year, as Covid-19 cases decline and restrictions ease. Initial unemployment claims decreased by 18,000 to 215,000 in the week ended Feb. 26, Labor Department data showed Thursday. The median estimate called for 225,000 applications in a Bloomberg survey of economists. Continuing claims for state benefits were little changed at 1.48 million in the week ended Feb. 19. The drop in claims is consistent with a strong labor market recovering from the omicron variant, which forced some businesses to close. The trend should continue as loosening Covid restrictions are likely to encourage Americans to go to work, and employers are keen on retaining workers as activity reignites. The data came ahead of the government’s monthly employment report, which is currently forecast to show the U.S. added 415,000 jobs in February. A separate report Wednesday showed that U.S. companies added a greater-than-forecast 475,000 jobs last month, according to ADP Research Institute. A separate report from the Bureau of Labor Statistics showed that nonfarm productivity in the U.S. during the fourth quarter rose a robust 6.6%, an excellent sign for the U.S. economy. The higher the productivity of the workforce the less inflationary impact rising wages has on the economy. Both the weekly jobless claims figures and this productivity number sent the U.S. dollar trading higher relative to other currencies on the strength of the data.

U.S. hiring boomed in February while wage growth slowed, showing a robust labor market that likely keeps the Federal Reserve on track to raise interest rates this month and offering some respite from strong inflationary pressures. Nonfarm payrolls increased 678,000 last month -- the most since July -- after upward revisions in the prior two months, a Labor Department report showed Friday. The advance was broad-based across sectors. The unemployment rate edged down to 3.8%, and average hourly earnings were little changed from the prior month. The median estimate in a Bloomberg survey of economists called for a 423,000 advance in payrolls and for the unemployment rate to fall to 3.9%. The employment report -- the last the Fed will receive before its March 15-16 meeting -- highlights a steadily improving, though extremely tight labor market. While declining Covid cases and looser restrictions likely helped boost hiring, employers are still scrambling to fill a near-record number of vacancies, making it tough to meet resilient demand by households and businesses alike. “If the recovery can keep up its current tempo, several key indicators of labor market health will hit pre-pandemic levels this summer,” Nick Bunker, economic research director at Indeed Inc., said in a note.

Labor demand is likely to continue to exceed supply, limiting the pace of job growth and putting upward pressure on wages. Friday’s report showed average hourly earnings were little changed in February and up 5.1% from a year ago, a deceleration from the prior month. The average workweek ticked up to 34.7 hours. Traders focused on the flat average hourly earnings figure, sending the yield on the 10-year Treasury note lower. S&P 500 futures remained lower however due to the overnight headlines coming out of the Ukraine and the pressure that put on the European bourses. Even though wage growth lagged expectations, strong hiring and the lower unemployment rate support the Fed’s plan to raise rates this month. Chair Jerome Powell reaffirmed that plan this week after Russia’s invasion of Ukraine, which has led to a surge in oil, metals and grain prices and clouded the U.S. economic outlook. He said he favors a 25 basis-point increase to kick off an expected series of hikes this year.

The labor force participation rate -- the share of the population that is working or looking for work -- ticked up to 62.3%, and the rate for workers ages 25-54 rose to the highest since March 2020. While improved, a combination of factors like child care challenges, Covid-19 concerns and early retirements have whittled down America’s workforce. Before the pandemic, the overall rate was over a percentage point higher. In testimony to lawmakers Wednesday, Powell noted the decline in labor force participation is “certainly something that’s now contributing to wage inflation and actual inflation and to the labor shortage that we’re currently seeing.” He also said the U.S. is “at least” at maximum employment, defined as the highest level that’s consistent with price stability. In our view, this easing of labor shortages appears to be starting to slow the pressure on wages, which could provide a glimmer of support to the optimists on the FOMC that inflation might come down later this year. This report was welcome news indeed with all of the negative headlines coming out of Europe and it is a sign of just how robust a level the U.S. economy currently operating at.

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