Apr 06, 2022
The gradual transition of the financial backdrop back to pre-pandemic conditions encountered new challenges in the first quarter, unnerving both stock and bond investors. At stake is an economy looking to maintain its upward trajectory, having already managed through multiple COVID waves, surprisingly tight labor markets, supply chain disruptions, and a major shift in Fed policy. Add to the list surging inflation and a brazen act of war.
Coming into this year, the Fed had already signaled a series of interest rate hikes and ending their liquidity support in response to inflationary pressures. Investor assumptions around the pace and scale of these changes have been recalibrated multiple times as inflation has continued to surprise on the upside. This changing backdrop has also reshaped investors’ perspective about equity risk and valuation.
Markets have generally recovered from the initial shock and subsequent sell-off, sparked by Russia’s invasion of Ukraine. The uncertainty around the ultimate resolution will continue to weigh on the global economy and complicate the task at hand for central banks around the world. While markets tend to look past the humanitarian toll of geopolitical acts, this invasion has an impact on investor sentiment that is already on edge. Markets will also continue watching how China plays its hand in their complicated alignment with President Putin.
What We Know
There is little historical precedence for the economic/investment cycle of the past two years. Some might say that’s been the case since the financial crisis of ‘08/09. This past quarter is another example of how quickly the outlook can change, as the risk of recession was quite low just months ago. We will offer a few observations below about what is known or built into current market expectations and provide our thoughts on our outlook in the next section:
- The Fed’s unconventional strategy to let inflation run above its target for a period of time backfired. They have acknowledged being behind the curve in their efforts to contain inflation, having underestimated both supply constraints and demand. Their rhetoric has become more hawkish to assure the markets that they see inflation risk as more problematic. The odds have increased that they will raise rates by ½ percent in May and June.
- Both supply chain pressures and inflation were supposed to ease in the second half of the year. Progress will come harder with sanctions on Russia expected to remain in place for the foreseeable future, keeping pressure on oil and other commodity prices. Higher interest rates will not do much to help supply-side constraints, like access to semiconductors, but it may temper the demand for autos and housing.
- The pandemic revealed major flaws in the just-in-time inventory system. De-globalization (on-shoring) represents a major shift in manufacturing priorities – moving from the most efficient use of capital and lowest cost to safe and dependable access of goods. This will lead to local sourcing of capital, employment opportunities, profit margin pressures, and higher selling prices.
- Wages have been rising, but real (inflation adjusted) wages have fallen because gains have been less than inflation. Monthly job statistics have remained strong.
- Most geopolitical experts (and the rest of us) misjudged President Putin’s intentions. It is now understood that neither conventional thinking nor the economic interests of his country drive his decisions.
- The level of a coordinated pushback from NATO countries is complicated by the systemic risk of a Russian default, the repercussions to countries relying on Russian imports, and the unpredictable behavior of a dictator who has no capacity to accept defeat.
- China is struggling to implement their own cultural transition away from western ideals without undermining their own growth prospects. There may be a possible thawing of our relationship with China amidst a more complex trading backdrop.
- Investor sentiment, a contrary indicator, hit extremely bearish levels in early March that coincided with the recent bottom of the market.
- The early year rotation out of highly valued growth stocks and speculative story stocks into value stocks was extraordinary. Growth stock P/E multiples have contracted.
- The sell-off in bonds this quarter was among the worst in decades. Bond yields had previously been held in check by the Fed’s massive purchase program and the influence of negative yields on foreign bonds.
- Corporate earnings should provide insight on input cost pressures and management’s assessment of any slowdown due to cost of living increases. Analysts will be inclined to reduce their earnings expectations now, establishing a lower bar to exceed later in the year.
- Asset Mix: We are maintaining policy target equity weightings. Rising bond yields now provide a more attractive base level of interest for funds dedicated to safety.
- Valuation: We believe the strong rotation back to value stocks is more credible this time because it coincides with a reversion back to more normal financial conditions. Basic company fundamentals have become more important in driving stock prices.
- Economy: GDP growth was expected to pick up coming out of the Omicron headwinds. That is now less likely. Underlying conditions still remain supportive – tight labor market, underleveraged consumer, strong corporate cash flow, and China reaffirming their commitment to growth. The recent flattening/inversion of the yield curve reflects an expected slowdown. Our macro work shows we are moving toward the late cycle stage of growth, but there is not enough evidence to conclude a recession will follow anytime soon.
- Equity Style: Value strategies should fare well if the Fed’s rate hike program is successful in achieving a soft landing. Secular growth will become more attractive if the economy stalls. Either way, we expect economic growth to eventually moderate, favoring a longer-term growth style tilt.
- Stocks: Our quantitative work continues to favor high quality, strong free cash flow margins. Stock selection will tend toward larger companies with markets in turmoil, leaning more toward defensive versus cyclical exposures. High volatility and fear create opportunities to find overlooked value for each of our equity strategies.
- Bonds: Higher bond yields provide some offset to pricing weakness if rates continue to move higher. The backup in municipal bond yields over the quarter restores their appeal in taxable portfolios. Corporate bond spreads should continue to widen. We will stay higher quality and look for opportunities to extend duration.
In uncertain times, markets are good at pricing in worse case outcomes and rallying when those concerns do not fully materialize. This pattern will likely continue as the Fed navigates a relatively narrow path to rein in inflation while keeping the economy on a growth path.
Part of this challenge for Fed Chair Powell is self-imposed by getting a late start and part is simply bad luck regarding the timing of the invasion and its impact on oil and other commodity prices. It is probably not a coincidence that an oil price shock has accompanied most of the post-war recessions even as the U.S. has become more energy efficient.
History shows that stocks do weather rate hike cycles reasonably well, with prices moving higher 12 months after the first rate hike and averaging 9% over the last 12 rate hike cycles. The pullback from highs that occurred in the first quarter is not out of line with the average correction of 14% that markets usually experience during the course of any year. In the market’s favor is a large part of the Fed’s $6 trillion stimulus/relief expenditures that are sitting unspent in many states’ coffers. There are also some encouraging signs that the trends of the Great Resignation are reversing, with more eligible workers rejoining the work force, though not yet in all disciplines.
It is difficult to handicap the end-game between Russia and Ukraine. A wide range of outcomes remains a month into this conflict, all of which will likely result in a generational change in geo-economic relations among nations. The implications of this sea-change to markets will be in how it affects global growth and trade. Assuming worst case scenarios are avoided, the market’s focus should return to matters of Fed policy, inflation, economic growth, and corporate earnings. There is plenty of uncertainty in how these variables will interact in the near-term, but as long-term investors, we can have more confidence that the eventual outcome will be positive for equity investors. For now, riding through a bumpy cycle still looks like the best path to get there.