2nd Quarter, 2022
Investors must remain steadfast until the existence of the green shoots is reliably confirmed.
THE MARKETS
The second quarter has taken broad market indices into classic bear market territory. Equities are down 20% along with a global rout in fixed income markets. The severity of this cross-asset class volatility is a phenomenon that has rarely been experienced.
The year began with cautious optimism that COVID had been tamed and new norms were being assimilated into a post-pandemic era. Global growth expectations were being recalibrated. Pandemic induced inflationary forces were deemed largely transitory, with the expectation that supply-chain disruptions would likely dissipate. The US economy seemed primed to grow, buoyed by a strong labor market and ample liquidity in consumers’ wallets to satisfy their pent up demand. Central banks were aggressively discussing plans to unwind global stimulus packages, which had been in place since 2008. These packages led to global markets that were awash in cheap money with interest rates ranging from negative to near-zero, creating a super-cycle corporate debt issuance.
Against this seemingly constructive backdrop, the growing presence of inflation was essentially ignored. Central bankers continued their focus on a 2% inflation target despite the clear warning of January’s 5.9% cost of living adjustment (COLA) applied to social security payments.
Suddenly, with the Russian invasion of Ukraine, the policy focus shifted from rear view mirror thinking to the clear and present danger on the horizon for which there was no playbook except for the sledgehammer of interest rate increases.
Inflation is like the proverbial Greek Hydra, it regenerates with vigor. Global inflation travels in waves and is a ruthless destroyer of capital. The current bout of inflation has reached an intensity that directly challenges political stability in many countries. Thus, we now find ourselves with some 62 central banks trying to tame inflation independently. The risk is that we face unintended consequences of uncoordinated monetary policy made worse by the economic and humanitarian casualties of Russian aggression.
Markets will likely continue to be disorderly until the forgoing challenges see the fog of war lifting or effective fiscal and monetary policies show promise of putting the inflation genie back into the bottle. The overriding risk appears to be overreach. With many monetary authorities having suffered a significant loss of public confidence, triggering a recession in an effort to tame inflation becomes a genuine concern for all.
Although there is open discussion in the investment community about central bank credibility, this skepticism does not appear to be fully priced by the markets. As a result, the risk for further downside price volatility remains significant.
One direct result of higher US interest rates is upward pressure on the US dollar. This has a negative impact on corporate earnings for both exporters and companies with significant overseas operations. A stronger dollar contributes to higher energy prices, increasing geopolitical risk, particularly in emerging markets.
When market sentiment has been beaten down with ferocity there often arises the mirage of green shoots, which can spawn a relief rally. Investors must remain steadfast until the existence of the green shoots is reliably confirmed.
THE ECONOMY
Recent deterioration in consumer and business confidence data reinforce our expectation that inflation is the top concern on the minds of business leaders and consumers alike. In Europe, the fear of inflation is even more acute because of the Ukrainian conflict and the perilous energy situation they face as a result. Inflation expectations of 10% or greater are common.
With the economic landscape shifting in ways not seen in at least three decades, confidence will likely remain under duress. Credible forecasts for growth are trending down to the low single digits. Against a mid-single digit inflationary backdrop, corporate profits may increase in nominal terms but decrease in inflation-adjusted terms.
Until the latest pivot by the Federal Reserve, the domestic economy was poised to continue its recovery path from the ravages of COVID-19, elevated concerns over rising inflation and the expansion of supply chain disruption into the service sectors. The Federal Reserve’s sudden embrace of inflation as public enemy #1 seems to imply that its pivot is unconditional and carries with it the risk of unintended recessionary consequences as well as increasing fiscal stress on the government.
Similar scenarios are now playing out in some sixty other central banks. Forecasts of a return to trend or above trend growth have largely been reversed. Outlooks that are clouded by the fog of war and the metastatic spread of global inflationary pressures continue to hit one wave at a time. Public discontent is rising, tempting politicians to meddle with energy and other consumer related prices. This would give nothing but short-term relief and will most likely saddle us with another hurdle of long-term negative consequences.
Forecasting future growth without resolution of Russia’s unprovoked war in the Ukraine, the impending energy shortages in Europe and supply chain disruption in the service sectors is akin to playing a grand game of pin the tail on the donkey.
At present, it seems more practical to focus on trends in consumer and business confidence and pay close attention to profit margins, corporate free cash flows and the likely fall out in price to earnings ratios. Market valuations were elevated in the COVID era of cheap money and historically overshoot on the downside when there is an abundance of fears, as was the case with the initial onslaught of COVID two years ago.
INVESTMENT STRATEGY
In our previous letter, we expressed concerns about the unknowns of the “new neutrality” of the Federal Reserve’s rate path. In its June meeting the Federal Reserve did a full pivot and made it clear that its new mandate was an unconditional policy of reining in inflation to 2% and implemented a 75 basis point rate increase with the promise of more to follow until data begins to show its policy of containment is gaining traction. Thus, the previous primary goal of unwinding quantitative easing (QE) appeared to be relegated to secondary concern. While the Federal Reserve’s action was late to the party, it remains open to debate whether it can be effective as inflation has become a global problem and central banks have different methods of attack. In the longer-term view, it seems likely the delay in the pivot will prolong the effort to contain inflation due to its now global nature.
Such an outlook increases the risk of further depressing free cash flow and valuation multiples for risk assets. While valuations have retreated from last year’s record levels, they are still in a range that is vulnerable to compression.
We continue to monitor the stocks that we have long-term confidence in and are always looking at the emergence of new factors that will influence businesses, sectors and markets. We will stand fast with the selections that show signs of resiliency and opportunity.
In regards to fixed income, our past policy of short duration continues. We favor US government obligations at the expense of corporate bonds in the present environment. While yields on Treasury bills have risen sharply in the past several months, they still do not deliver a real adjusted return. However, they remain good insurance against further market volatility.
GEOPOLITICAL UPDATE
In our last correspondence, we focused on five points of a global geopolitical reset. Here we offer an update to keep current with the ever-changing fallout of geopolitical tensions and to put out a likely road map as to where these situations may take us.
1. The humanitarian and refugee crisis continues to grow faster than the government and nonprofit aid groups can provide relief and resettlement assistance. The cost of reconstruction when and if a peace is achieved is growing exponentially.
2. The German pivot to rearmament has broadened to include deployment plans for NATO to commit 300,000 troops and equipment to buffer the members with Russian borders. Additionally Finland and Sweden have given up their neutrality and will become full members of NATO, an outcome that will increase the tension with Russia.
3. Economic disruption largely through sanctions continues to broaden and the departure of non-Russian service providers such as in energy, banking and other infrastructure and technology groups is beginning to debilitate the Russian economy and in particular energy production.
4. The global climate change conundrum has begun to tilt towards an accommodative policy that accepts the continued expansion of fossil fuels in tandem with technological advances in alternative energy so that standards can be achieved without runaway disruption.
5. A reset of US relations with China continues with growing tensions over US support for Taiwan. In addition, China’s support of Russia, particularly the purchase of sanctioned oil, is most unwelcome. Meanwhile the COVID policy in China appears to be creating a backlash from the middle class against the strident government lockdowns.