Feb 25, 2022

Meritage Current Market Update

Summary

Market volatility has remained very high since our recent update in late January. We have seen additional evidence regarding the persistence of inflation and now the unfortunate incursion by Russia into Ukraine. We don’t try to sugar-coat the times when stock prices are in turmoil, but we believe the uncertainties around the evolving Fed policy changes and the current geopolitical issues will become clearer in the coming months.

These days, the markets are quicker to react to newly revealed risks and opportunities. Today it reflects a more pessimistic outlook, which already incorporates multiple interest rate hikes, Fed tightening of liquidity, $90 – $100/barrel oil, and geopolitical tensions.

The risk of a Russian invasion has been on everyone’s radar for months, but there was reason to believe it was in Putin’s interest to use this as leverage to gain concessions on Ukraine and on other issues. His decision to invade reveals an ideological calling not supported by Russia’s economic interests. This makes anticipating his decisions more difficult.

Markets tend to discount geopolitical events relatively quickly. We expect the focus here will be less on the unfolding tragedy inside Ukraine, and more on Europe’s response and the impact of higher oil prices on our economy and inflationary pressures. The lasting consequences for world borders and geopolitical balance just adds to the risk premium carried by stocks.

Through this process, we rely on our risk control measures that begin with each client’s investment policy targets and our internal investment decision-making processes. On a day-to-day basis, we know that sentiment drives stock prices, while longer-term, fundamentals win out. As always, we appreciate the opportunity to do this on your behalf through both good times and bad.

Analysis

The market’s risk position has been building for some time as the returns over the past two and three years clearly exceeded expectations, given the pandemic and all of its implications. More visible was the extreme speculation that built early last year in some parts of the markets (now since deflated) and the longer-term outperformance of growth stocks over value.

History shows us these kinds of gains and divergences are not sustainable. Long periods of excess market returns will typically be followed by some reversion to longer-term averages. That can be gradual or it can be event driven, which has been the market’s more recent experience. For better or worse, cycles are shorter and the magnitude of market moves sharper. The financial tools that enable this heightened volatility facilitate overshooting in both directions. As such, the attempt to make large tactical portfolio shifts amidst these times increase the risk of impairing long-term returns.

Given the unprecedented nature of this cycle – a pandemic driven shut down of our economy in 2020 and subsequent uneven reopening, surging inflation and tight labor markets, record government debt, and the planned gradual winddown of the massive stimulus and liquidity policies, all without undermining the economy – it is not surprising to see stocks come off their highs and a meaningful rotation to companies with stronger valuation measures.

While we can’t predict the timing of a market turn, we can prepare. We know stock appreciation has lifted many clients’ equity exposure to the higher part of their policy ranges. Our ongoing discussions often address the merit of rebalancing back to targets or agreeing to maintain current allocations. Either way, the presumption is to hold these allocations through the cycle to assure participation when a bottom is made, which is rarely recognized at the time. We have also made some shifts from Growth strategy allocations to Value in client portfolios where appropriate over the past year to reposition the style diversification.

Our two value-oriented strategies – Meritage Value and Meritage Yield-Focus have held up relatively well in the recent downturn. The Meritage Growth strategy has given back some outperformance recently, but we expect it will continue to generate strong long-term results as we move past the current turmoil. With valuation becoming a more relevant attribute in stock prices as we emerge from a decade of zero interest rates, the companies held in our value strategies should continue to look very attractive, possibly leading to further style shifts in that direction.

Regarding fixed income, as all know, we build strategies for safety first, to offset the higher risk of equities. That has paid off in the past few months. The recent move higher in short and intermediate Treasury yields gives us the opportunity to lock in better than money market returns for safe investments going forward. We are also comfortable accumulating additional cash on the bond side until rates stabilize.

We hope for a quick and positive resolution in Ukraine. We appreciate your understanding as we move through this current period of volatility.

The Meritage Investment Team