Will China's Supply Chain Issues Cause Problems For The Fed This Week?

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(Monday Market Open) Geopolitical risks are bearing down on the markets as a new week of trading is about to kick off. Equity index futures were much higher overnight but have significantly trimmed those gains. In fact, the Nasdaq futures were up about 100 points but turned negative before the open.

Investors had reasons for positivity with news that virtual peace talks between Russia and Ukraine have seen progress. Russia may be seeing pressure from various places. Over the weekend, there were reports of Russia getting low on munitions and seeking help from China; however, China has denied the report. Additionally, Russia may be at risk of defaulting on debt payments as the ruble has weakened significantly and much of Russia’s assets are tied up in sanctions.  

Numerous commodities are pulling back on the news around the Russia-Ukraine conflict. Crude oil was down about 4% before the opening bell. Natural gas was down 1.61%. And RBOB gasoline was down 2.7%. Other commodities that have been directly related to Russia are also falling in premarket action. Palladium futures were down 7.48%, and wheat was down 2.94%.

However, the news that appears to be more directly related to the equity markets today is coming out of China. A surge in Covid-19 cases has caused China to institute more lockdowns in Shenzhen and other cities. China is experiencing its worst outbreak since the pandemic started in 2020. The news caused the Hang Seng Index to fall 4.97% and the Shanghai composite to drop 2.6%.

The lockdowns are renewing issues with supply chains. Apple (NASDAQ: AAPL
) is one company that could get hit hard. Six of Apple’s suppliers, including Foxconn, have had to halt production due to the lockdowns. Volkswagen and Toyota TM have also had to halt production in their factories in the region. The problems aren’t just manufacturing-related. Hong Kong fears that food supply disruptions could hurt the city-island because it imports 90% of its food. Consumers have already seen shortages in foreign import goods.

The news in China could complicate the picture for the Federal Reserve, which is expected to meet this week to determine interest rates. Because the Fed can’t do much to control or help with supply chains, the market is still expecting the Fed to raise rates just a quarter of a point. The Fed has a tough job in trying to address inflation that has been rising at a 40-year record pace and not crushing an economy struggling with numerous issues, like the supply chain and war in Ukraine.

Before the Fed’s interest rate announcement on Wednesday, it will have the chance to review two more important reports. First, the Producer Price Index (PPI) will be released on Tuesday and is expected to rise at 10% year-over-year. Much of these input costs come from commodities that have been rising over the last year and have been particularly volatile in the previous weeks. If companies can’t pass these prices on to consumers, they’ll likely see profit margins shrink and earnings fall.

Then on Wednesday morning, the retail sales report will be released providing an insight into how rising prices are affecting consumers. Inflation often leads consumers to forego or reduce luxury items and focus on consumer staples.

Reviewing the Market Minutes

Stocks jumped out of the gates on Friday with news that Russian President Vladimir Putin described shifts in peace talks as positive. However, stocks faded early with the S&P 500 (SPX) and the Dow Jones Industrial Average ($DJI) registering losses on the day. The Nasdaq Composite ($COMP) registered a more significant loss by dropping 1.36%.   

Every sector finished the day in the red, although materials, utilities, and energy were right on the bubble. Consumer discretionary and technology were at the bottom. Energy and materials were the only positive sectors for the week. The Energy Select Sector Index rose more than 2.9%, while the Materials Select Sector Index exceeded 1.1%. The Financial Select Sector was basically even for the week. Technology, real estate, and consumer discretionary were the worst performers with their corresponding indexes down 2.5% to 3% for the week.

Despite a volatile week of commodity trading, wheat futures had the biggest week, rising more than 4%. RBOB gasoline futures were up a little more than 2%. Crude oil futures were up 1.85%. Heating oil futures rose 1.68%. And natural gas futures were the odd man out, falling 7.23% for the week. Taking a look at the commodity markets as a whole, the Bloomberg Commodity Index futures rose just 1.05%. In the last three months, each of these futures product has grown substantially with gasoline, oil, and heating oil rising more than 50% in that time frame. Wheat grew more than 40%. The commodity index rose more than 30%. And natural gas climbed nearly 25%. Rising commodity prices are likely to feed the inflation monster. 

CHART OF THE DAY: INFLATION RACE. The Bloomberg Commodity Index futures (/AW—candlesticks) have risen 30.31% in the last three months. RBOB gasoline futures (/RB—blue) rose 55.75%. WTI crude oil futures (/CL—yellow) have risen 53.65%. Heating oil futures (/HO—red) climbed 52.71%. Wheat futures (/ZW—gray) rallied 40.44%. Natural gas futures (/NG—pink) are up 24.83%. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Electric Outage: Despite the rise in fossil fuel commodities, electric vehicles (EV) have struggled in 2022. The performance of EV makers that are actually making cars today versus those that have plans at some time in the future include Li Auto LI, which was down 31% year to date, Tesla TSLA, which was down 33%, Lucid LCID, which was down 44%, Nio NIO, which was down 52%, Xpeng XPEV, which was down 55%, and Rivian RIVN, which was down 63%. Tesla is the only American company to produce a significant amount of cars and the only company to produce a profit. Chinese companies Li, Nio, and Xpeng have sold tens of thousands of vehicles but none have made a profit yet.

Then you have significant number of EV companies like Lordstown RIDE, Fisker FSR, Canoo GOEV, Xos XOS, and Faraday FFIE that have no earnings or no track record, and most of them aren’t even manufacturing EVs yet. These stocks are down 42.2%, 34%, 30%, 17%, and 10% respectively.

If stocks continue to pull back and yields continue to rise, it’s difficult to say how much patience investors will have with these companies. Additionally, traditional automakers like Ford F, General Motors GM, and many more are entering the space, making it much more competitive. Then related commodities are also skyrocketing like lithium, which is used in EV batteries. Lithium has risen from about $10,000 per ton a year ago to around $80,000 per ton today, which means it could take even longer for these companies to turn a profit.

Wrapping Up Earnings: Speaking of earnings, the Q4 season is all but wrapped up with just four companies in the S&P 500 that haven’t reported yet. 76.2% of these companies have beat earnings, which is higher than the historical average of 65.9% but smaller than the recent four-quarter average of 83.9%, according to Refinitiv.

The energy sector continues to shine with the highest percentage increases in earnings growth despite technology having the largest percentage of surprises above expectations. Financials, consumer discretionary, and communication services are projected to have negative growth rates in Q1 while energy, industrials, and materials are expected to have the highest. But if 2022 has taught us anything, the future can be unpredictable.

Pressure on Putin: According to The Telegraph, Russia is at risk of defaulting on its bonds, which would effectively be bankruptcy. The World Bank warned that the sanctions leveled on Russia have been crippling, and Russia and its partner Belarus are now nearing default. Russia must make a $117 million coupon payment on a sovereign Eurobond next week for its $40 billion debt. There is a 30-day grace period, but Russia can’t make the payment in its highly devalued rubles, and most of the foreign currencies that Russia holds have been tied up with financial sanctions.

Russia’s default could have a contagion effect because a default could result in large losses for banks, hedge funds, and mutual fund companies holding Russian debt. However, governor of the Bank of England, Andrew Bailey, described the exposure to Russian debt as small and not a systemic risk outside of Russia itself.

Image sourced from Unsplash

TD Ameritrade® commentary for educational purposes only. Member SIPC.

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.