Highlights:
· Russia’s invasion of Ukraine exacerbated pre-existing supply chain and inflation issues. Longer term, the market will ultimately be driven by earnings more than geopolitical events.
· The challenge, which may prove a herculean task for central banks, is to bring down inflation without raising unemployment.
· As investors prepare for a new business cycle, they should remind themselves that change is constant and tuning out the concerning headlines and staying the course is critical to ensuring strong portfolio returns over the long-term.
Commentary:
“You’ve got two very large countervailing factors which you guys are all completely aware of [inflation and quantitative tightening]. You’ve never seen that before.”
-Jamie Dimon, Chairman and Chief Executive Officer, JPMorgan Chase
The most significant European war since World War II began during the quarter on February 24th when Russian president Vladimir Putin ordered the invasion of Ukraine. Our hearts go out to everyone affected by this humanitarian crisis. We will leave the analysis of this event to the geopolitical experts who can offer valuable insights in to this war. Rather, we will stick to our knitting and discuss the current state of the economy and markets, with the war now being one more factor investors need to digest.
We begin with the obvious – Inflation. Inflation was already an issue coming in to the year due to a tight labor market and to supply chains failing to keep up with elevated consumer demand. Add sanctions against Russia, a large exporter of natural gas, oil, and coal, and, along with Ukraine, a supplier of raw materials essential to semiconductor manufacturing, and the result is the highest inflation rates we have seen in four decades. Anyone who has recently shopped at a grocery store, dined at a restaurant, booked a flight, or paid a utility bill, has seen firsthand the effect of this inflation.
This war was the last thing the Federal Reserve and other central banks needed as they try to prevent consumer prices from spiraling out of control. The Fed has declared inflation enemy number one, and appears committed to implement multiple rate increases over the next several quarters to combat it. Their challenge will be markedly reducing inflation without significantly raising unemployment. In the meantime, so long as increases in prices outpace gains in wages, life likely will continue to be more expensive.
One bright spot for the Fed as it embarks on this journey is that the changing nature of the Covid pandemic appears to result in a declining number of cases turning into severe illnesses, despite a pick up in the number of cases recently. This is most likely due to the effectiveness of vaccines and booster shots that are now universally available in many countries, increasingly available treatments for people that are infected, and immunity for the tens of millions of people that have already been infected with the virus.
Economies and markets run in cycles, and all cycles eventually end. However, sometimes it is clearer than at other times when one cycle has ended and another has begun. Both short and long-term interest rates have been extremely low by historical standards since September 2007 when the Federal Reserve began cutting interest rates in an effort to cushion the bursting of the U.S. housing market. This low rate cycle lasted over 15 years, but seemingly came to an abrupt end in March when the Fed not only lifted their range on overnight rates above near zero for the first time in two years, but also promised to keep on doing so through 2023. The markets appear to be bracing for a transition in which investors, businesses, and consumers will have far less government support.
While the Fed and other major central banks, including the Bank of England, are planning their most aggressive cycle of interest rate increases in decades, Europe’s economic recovery to date has not been as strong as the U.S. and faces a bigger economic headwind from the war and related sanctions against Russia, an important trading partner for Europe. The European Central Bank (ECB) had been counting on a decline in energy prices to help stymie the rise in inflation and remove pandemic-era stimulus measures. While the ECB has indicated they plan to cease their bond-buying program later this year, they will have a hard time raising key interest rates so long as the war persists.
Central banks will have to maneuver a tight roping act of keeping inflation in check, but not limiting labor market strength and economic growth. Central bank officials have been struggling for almost 15 years to push inflation up toward 2% targets and fend off deflation. On some level, a normalization of monetary policy is probably welcome by many central bank officials that have had to rely on accommodative policies for longer than they likely would have preferred and that brought with it an era of negative real interest rates.
At some point, we believe a normalization of monetary policy will lead to a normalization of asset prices as well. Domestic, large capitalization growth stocks, and in particular technology stocks, have led financial markets during this low interest rate business cycle. It is easy for many investors to lose sight of the importance of diversification during such a cycle. All one needed to do was invest in the S&P 500, or really just a handful of technology stocks, in order to achieve outsized returns. We have been preaching for a few years that at some point other segments of the equity markets, such as small cap, value, and international stocks, will experience their own period of relative outperformance. It is impossible to know when such a period will begin and end, but to quote the great Bob Dylan, “the times they are a-changing” and we remain confident that investors committed to a diversified portfolio will reap the benefits of having exposure to asset classes across all capitalizations, investing styles and geographic locations.
Investors are rightfully concerned about what a new business cycle means for their portfolios, especially since this last cycle, that seems to have recently ended, was so rewarding. If we have indeed entered a new cycle, it will be at a time that is characterized by many factors including the global response to a war initiated by Russia, inflationary pressures, a strained global supply chain, tight labor markets and fractures in the free-trade vision that has guided American economic policy for almost 30 years.
Is there a scenario where the Fed risks causing a recession, as it did in the 1980s by aggressively raising interest rates, to end stubbornly high inflation? Yes, but this is just one of a myriad of scenarios that might play out over the next few years. On the one hand, consider that over the last 80 years the Fed has never lowered inflation by 4%, as it is attempting to do now, without causing recession. On the other hand, many investors would probably be surprised to learn that U.S. stocks generally did better during Fed tightening cycles than during easing cycles. Why? Because Fed tightening more often than not occurs in in the second half of U.S. business cycles, whereas easing tends to overlap with recessions more often than not. Thus, it is not a forgone conclusion that the current economic expansion is over just because interest rates are on the upswing.
In the over 30 years we have been in this business, we have still not met an investor who can consistently time when to exit the market and when to get back in. Before investors run to the sidelines, they should consider that the cycle that began in September 2007 coincided with the worst recession since The Great Depression and global equity markets plummeting to levels not seen in the prior 15 years. This was followed by the longest equity bull market on record.
There is no question that potential world war is frightening. Its potential and, hopefully, its avoidance bring with it a host of unknowns. We are not downplaying the seriousness of these potential risks. However, there will always be significant uncertainty to keep investors on edge. As these current issues are dealt with over time, the likely result will be increased volatility along the way. Nevertheless, global economies will resume their growth, albeit not necessarily all together and certainly with fits and starts. Successful long-term investing concedes the only constant is change.
It is important to also consider, 1) sadly, how common wars are, and 2) how resilient markets have historically been to geopolitical risks. Market valleys consistently gave way to market peaks. Whether or not we are headed for another valley, when this might happen, and how low the valley might be, remain unknown. What we do know is this though:
· Rebounds can come as quickly and unexpectedly as the sell-offs they follow.
· In order for a diversified equity portfolio to compound over a long period, volatile equity markets and share price declines must be endured.
· Selloffs driven by geopolitical events tend to be shorter-lived. Longer-lasting bear markets typically occur due to a decline in earnings expectations.
· Staying invested and focused on the long-term, regardless of how bumpy the road gets, is a critical component to the investment policy we espouse for our clients.
Readers of this commentary know that we like to end with a quote by someone far smarter than us. This quarter’s commentary is no exception. We think this quote from Morgan Hausel, one of our favorite financial authors, perfectly sums up what we have been trying to convey in this commentary:
“History is ‘just one damn thing after another,’ said Arnold Toynbee. Dan Carlin’s book The End is Always Near highlights periods – from pandemics to nuclear war – where it felt like the world was coming to an end. They exist in every era, every continent, and every culture. Bad news is the norm.
Even during what we remember as prosperous periods, like the 1950s and 1990s, there was a continuous chain of grief. Adjusted for population growth, more Americans lost their jobs during the 1958 recession than did in any single month during the Great Recession of 2008. The global financial system nearly fell apart in 1998, during the greatest prosperity boom we’ve ever seen.
The world breaks about once every ten years, on average. For your country, state, town or business, once every one to three years is probably more common.
Sometimes it feels like terrible luck, or that bad news has new momentum. More often it’s just Littlewood’s Law at work. A zillion different things can go wrong, so at least one of them is likely to be causing havoc in any given moment.”
Urban Financial Advisory Corporation – April 2022