1st Quarter, 2022
Markets react badly to excessive withdrawals of liquidity.
THE MARKETS
U.S. markets have just completed an unusually weak quarter, in which both equities and fixed income lost ground. The causes were many and varied, including broadening global inflation, an abrupt change in Federal Reserve posture, and the war in Ukraine. Fixed income performance was affected by both rising interest rates and a re-rating of risk in the corporate sector. Stock performance continued to be heavily influenced by a rotation from growth to value. At the sector level, this translated into negative returns from all sectors except energy and utilities. Technology and pandemic-related healthcare stocks were punished, whereas classic oil-related stocks and industrial commodities were in favor. The performance of consumer and industrial stocks was uneven, with valuations contracting in many cases, in spite of strong corporate earnings.
The quarter has seen the largest geopolitical reset since the collapse of the Soviet Union and subsequent German reunification, with likely, but not yet quantifiable, global economic consequences. This in turn has begun to unleash rapid changes that could provoke stress on long-established financial engineering practices. The global central banking effort to normalize interest rates and limit credit in areas where excess leverage lurks appears to have turned the heat up on levered financial strategies.
As an example, last week Japan experienced the first tremors of financial over-leveraging. The tremors were made visible by the Bank of Japan’s strong action to support its currency, which was being pressured by risk abatement actions of large players in the Yen carry trade. This long-practiced strategy involves borrowing money in countries with stable currencies and ultra-low interest rates (like Japan), then lending in countries with higher interest rates. The investor profits by keeping the spread. Carry trade strategies can become high risk, as small fluctuations in exchange rates can lead to massive losses for the levered investor.
What is at stake now is the prospect of a sea change that confronts the validity of many financial strategies in an environment of permanent change or new norms. Any rush by market participants to unwind trading positions rapidly could be well beyond global central banks’ ability to manage currencies and interest rates for domestic monetary purposes. As such, there is a specter of systemic risk and destruction of capital that is as yet unpriced in the market.
Although central banks are using their distinctive tools to unwind years of easy money, these moves have not been coordinated. Markets generally react badly to excessive withdrawals of liquidity, and the lack of coordination increases the risk of overreaching. This raises the prospect of hard economic landings or outright recessions. As we have said in previous letters, we must focus on future liquidity needs now as a prudent protection from market volatility, in the event that resets become the new norm.
THE ECONOMY
In the current state of geopolitical uncertainty, it is not realistic to embrace specific economic growth forecasts. However, we should examine how consumers and corporations are reacting, since their optimism and resilience have implications for future growth expectations. We can then better gauge growth prospects against the backdrop of inflationary pressures, supply chain disruption and renewed interest in local versus global production.
Growth in the U.S. continues to move forward despite disruptive global factors. Employment has risen and skill shortages are still prevalent in many job markets. While the recent positive news in the labor market is a welcome sign of economic strength, it is not without complication. There is anecdotal evidence that part-time employment is showing gains driven largely by the necessity to keep household income ahead of inflation. This puts greater pressure on the Federal Reserve to pick up the pace on delivering anti-inflationary medicine, with the additional challenge of global inflation running ahead of employment compensation.
One of the key resets taking hold is a rethinking of globalization and a renewed interest in localized production near market venues. The strategy envisioned by the late GE chairman Jack Welch, who wished for barges large enough to move factories to the lowest cost markets for labor and materials, is no more. Increased usage of artificial intelligence along with closer market proximity will go a long way to replacing the fragility of just-in-time supply chains. Reengineering supply chains will initially demand greater capital expenditure, which in turn should power growth during the reset period.
In Europe, growth has been temporarily interrupted due to the Russian invasion of Ukraine and use of economic sanctions. However, the German led pivot to rearmament will provide a strong economic boost sooner rather than later, and it is not funded by deficit spending. Postponed consumer consumption will resume once hostilities abate and the destruction of the current conflict will likely lead to reconstruction. In essence, we are in the midst of a conflict driven economic pause, which has to absorb significant capital outflows. This too will pass.
INVESTMENT STRATEGY
Financial markets have been saturated with geopolitical risks, and concerns about COVID-19 have become a distant memory. However, COVID continues to morph into new variants and is by no means behind us. We are mindful of its potential economic and social consequences in building and managing portfolios. The Russia-initiated Ukrainian conflict and resulting western-led economic sanctions may have a prolonged negative impact on global growth and will likely add to prevailing global inflationary pressures, thus raising the bar for central bank measures to contain inflation without triggering recession. The quest for a determination of a new “neutral rate of interest”, meaning a rate where monetary policy neither accelerates nor decelerates the economy, is clearly hampered by the clouds of war. As Mohamed El-Erian, the well-respected global economist, said recently, “I doubt if anyone can say with confidence where neutral is.”
With the armed conflict and central banks seeking a containment strategy for inflation without knowing where rate neutrality lies, liquidity must remain the primary focus of our current strategy. The risks of miscalculation continue to rise. Our first line of defense continues to be insuring sufficient cash to fund client needs, maintaining high quality and short duration fixed income portfolios, and investing in businesses with significant and durable current cash flows. As always, managing your assets to maintain and enhance purchasing power is central to our strategy.
In IIM’s stock selection process, balance sheet strength and business resilience in the face of adversity are essential. Along with this, the proven ability of management to navigate rapidly unfolding economic and social risks successfully is critical. We seek to identify and focus on new norms and the opportunities created by economic, demographic and social changes as we build and manage equity portfolios expected to remain durable across a spectrum of outcomes. Our concern over the uncertainty of interest rate neutrality and the increasing risk of central bank missteps leads us to keep bond portfolios well below index duration and makes US Treasury bills, short duration US Treasury notes and corporate bonds the primary choice for the reinvestment of maturities.
GLOBAL RESET POINTS
Just as we were seeing the end of the first wave of the global pandemic and endemic shock, the post WWII geopolitical order ruptured with Russia’s invasion of Ukraine. The resulting economic and political fallout continues to shower the world with unwelcome change likely to be permanent, again forcing us to deal with and accept new norms.
While the pandemic was a global public health emergency, the Russian invasion was a deliberate act of geopolitical and economic destruction, which invokes Newton's Law of action and reaction. Although some consequences are within the realm of logical outcomes, there may well be unintended consequences for generations to come. We would note the following game changing reset points:
1. An unexpected humanitarian and global refugee crisis that will probably involve displacement of a fifth of the Ukraine population of 30 million. We are now seeing a refugee outflow of nearly four million into Europe, which is still struggling with the Syrian problem.
2. An astonishing pivot by the new German Chancellor, Olaf Scholz, to re‐arm Germany after 75 years of disarmament. This involves an immediate down payment of $113 billion for military hardware and creates a rallying point for other NATO members to increase their military preparedness spending as well. Importantly, it fosters a newfound solidarity.
3. Global economic disruption resulting from the massive sanctions enacted against Russia by the United States and European democracies. This leads to destruction of capital, decreased international trade, stranded assets and further unintended consequences.
4. A politically driven reset of the global climate change conundrum. This is born of heightened awareness of national security requirements triggered by the Russian invasion. The primacy of national energy self‐security, previously pushed aside by the call for immediate carbon neutralization, is under reassessment. Major global powers have been reminded of the importance of dealing from a position of strength in the area of energy independence in order to successfully promote many global issues, including climate change and alternatives for energy stability and reliability. A more coherent public and private sector collaboration working at “warp speed” for an energy initiative could become a beneficiary of Russian aggression.
5. A reset of the long‐term strategy towards China should begin now, lest any more international authoritarian regimes become emboldened by Russia’s hostilities. The perception that Western democracy is ineffectual exists in some countries. Revealing that perception as inaccurate could be an important factor in countering long‐term quests currently telegraphed by China.
For now, it is high risk to cling to any economic forecasts until the “fog of war” begins to clear. Key signs to watch for are resolute national leaders, resilience in general populations, and astute corporate sector responses. All together, these reactions could lead to a spirit of renewed economic confidence. Let’s not just wait and see ‐ look for the green shoots everywhere!