Risks to Growth, Earnings, and Markets are all Skewed to the Downside

The effects of the conflict in Ukraine are complex and far reaching. Armed conflicts always create first and second order effects (First order effects: actions have consequences. Second order effects: consequences have consequences.) Only in the fullness of time will these effects become known.

From a short-term U.S. economic perspective, the most consequential first order effects revolve around energy and how the Federal Reserve responds. Our conclusions in this regard are:

  • Inflationary pressures get more intense as the price of energy rises
  • Interest rate hikes remain on the table, albeit with a more cautious approach
  • The odds of an economic soft landing are getting smaller
  • Risks to growth, earnings and markets are all skewed to the downside

Get Ready for More Inflationary Pressure.

Energy supply was already tight before Putin acted, and although Russian oil and gas are not technically sanctioned, intermediaries in the oil trade are increasingly unwilling to take on Russian oil and indirectly making supply tighter still. That is pressuring oil prices higher. It’s effectively impossible to forecast how high prices will go and for how long, but there are essentially two possible outcomes:

  1. Prices rise until a new supply can be added, most likely in the form of a nuclear deal with Iran which would lift sanctions on Iran and make Iranian oil available on global markets, or
  2. Prices rise until demand destruction occurs (i.e., a recession) returning balance to global energy markets.

Either way, prices are headed north until something gives way. That feeds inflation not only in direct linkages (fuel prices) but in indirect ways (feedstocks for other products, such as fertilizer and plastics).

Rate Hikes are Coming, but Not as Fast as Wall Street had Anticipated.

The Ukraine situation will not stop the Fed from addressing inflation with rate hikes, but it will make the Fed more cautious when raising rates as the potential of raising rates into a declining economy are now magnified. We were not in the camp that the Fed would be aggressive raising rates in the first place, but many were expecting as many as seven rate hikes this year. That has now been pared back to four hikes.

An Economic Soft Landing is More Difficult to Achieve.

The Fed’s goal has been to engineer a soft landing, that is, a slowing of the economy which allows supply and demand imbalances to self-correct, without pushing us into a recession. The Ukraine situation makes the already narrow margin for error that much smaller.

Risks to Growth; Risks to Earnings; Risks to Markets are all Skewed to the Downside.

Fourth quarter GDP rose by 7%, but much of that was due to inventory re-building. Without the large inventory build, GDP growth was a modest 2%. The decline of Omicron is a tailwind to economic growth over the next several quarters, but inflation, led by high energy prices, is a very strong headwind that appears destined to have a more persistent influence than a one-time omicron recovery bump. Inventory re-building will likely remain, but underlying growth is quite modest.

This inflation surge is coming when corporate margins are at an all-time high. Although it is possible that productivity increases are at least part of the cause, it is very hard to see how margins will not be under pressure as the year progresses. That implies that earnings estimates for this year are likely too high. Weaker growth and lower earnings are generally not the things that propel markets to new highs.



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By: Adam