Old School Cocktail: Inflation Mixed with Russia Conflict
For those of us who remember the 1970s and 1980s, the last few months may have seemed like a throwback to that era. Inflation was raging and the Cold War was in full effect. But, 30 years after the end of the Cold War and no signs of inflation, we have come full circle. Inflation is the highest in four decades and Russia has invaded Ukraine and is now effectively cut off from the western world due to economic sanctions – erasing progress that was made since the break-up of the Soviet Union.
Globalization was once seen as the great equalizer – bringing the world together socially and economically and lowering inflation in the developed world by efficiently allowing goods to be made overseas with cheaper labor. Prosperity soared in emerging markets such as Asia, Eastern Europe, and Latin America. In the U.S, the cost of goods remained lower, and while some jobs were exported abroad, the U.S. was able to focus on high-wage innovative industries. This trend began to reverse in recent years due to the trade war with China and has been unwound further by the pandemic and the war in Ukraine.
The war is obviously a tragedy from a humanitarian perspective and the headlines and images have been horrifying. From an economic standpoint, geopolitical events generally do not impact markets beyond initial short-term moves. So far, the war is following that historical precedent exactly – creating volatility in the initial days of the invasion, but markets have rallied and were higher at quarter-end than prior to the war starting in late February.
The S&P 500 finished lower by 4.6% during the quarter and was supported by energy, materials, utilities and financial equities that can outperform in an inflationary and/or rising interest rate environment. Domestic smaller companies, defined by the Russell 2000 Index, declined by 7.5% during the quarter. The MSCI EAFE Index of international developed equities declined by 5.9% and the MSCI Emerging Markets Index fell by 7.0%. International equities performed relatively well compared to domestic equities early in the quarter but the war, Covid surges in China, and a strengthening U.S. dollar were too much to overcome.
Bonds lost money during the quarter due to surging interest rates. The U.S. Aggregate Bond Index declined 6.0% during the quarter. Bond values decline when interest rates rise. However, the good news is that interest rates are meaningfully higher and fixed income expected returns should be more favorable since new bonds should be issued at higher yields. The Fed increased the fed funds rate by 0.25% for the first time in March and the market is already pricing in 0.5% hikes in both the upcoming May and June Federal Reserve policy meetings.
The Fed’s bark may be worse than its bite
The Federal Reserve’s “pivot” from a patient, lower-for-longer rate environment late in 2021 to a more aggressive push to higher rates in 2022 as been the biggest driver of financial conditions. Rising prices and supply-chain issues were once seen as temporary due to shut-downs and a lack of willing workers due to the pandemic. These trends are sticking around a bit longer than expected and inflation has yet to peak so the Fed is raising interest rates to cool economic activity (reduce demand) to fight inflation. Inflation-induced supply shocks like the pandemic and the war complicate the Fed’s decision-making because their tools target demand, but not supply.
This week’s Consumer Price Index output of 8.5% year-over-year is the highest in decades. However, we may be nearing peak inflation, as energy prices accounted for almost the entire increase from the prior month. This was largely expected since this is the first month of data that includes the war. Oil prices have trended lower since the initial invasion, so there is belief that we could see a reversal next month. Also, core inflation, which includes everything but energy and food, came in well-below expectations due to moderating inflation on the price of goods. For instance, the price of cars fell by 3.8% and should keep dropping and become a drag on inflation in the months ahead. Supply chains and product availability is slowly improving, and consumers have shifted spending priorities to services as the economy continues to reopen. The best outcome economically would be moderating inflation, which could allow the Fed to take their foot off the gas when it comes to raising interest rates.
At this point, there has only been one fed funds rate hike, but longer, market driven rates are considerably higher based on comments made by Jerome Powell and other Fed presidents pledging to attack inflation with tighter economic policy. The minutes from the March meeting showed internal discussion for reducing the Fed’s $9 trillion balance sheet by aggressively selling bonds starting as soon as May, which would be unwinding the stimulative “quantitative easing” that was in place until just recently and otherwise known as “quantitative tightening”. All this talk with very little action has tightened monetary conditions considerably, and it may not be a coincidence that the equity rally starting in late March began almost to the day of the first rate hike. Sometimes the rumors, anticipation and uncertainty weighing on financial markets can be worse than the actual event itself.
Global Asset Allocation Strategy
The strategy operated in a substantial risk-on mode from the depths of the pandemic market bottom through 2021. At the U.S. market high-water mark on 1/3/2022, the strategy reduced risk dramatically to get back to neutral risk targets. Equities and fixed income were reduced, and cash was raised considerably.
On that first trading day of 2022, in anticipation of rising interest rates and given the unfavorable expected returns of bonds, four “bond alternatives” were added and fixed income was reduced by about 30%. A bond alternative is any investment that is uncorrelated to bonds and interest rates and has shown historical risk and volatility levels that are in-line with a typical bond investment. Bonds and bond alternatives must be able to preserve capital during equity drawdowns. Examples of bond alternatives include merger and acquisition (M&A), arbitrage, defensive market neutral equity and other hedging strategies. It was critical that all four new positions illustrated actual long-term performance that we feel can generate systematic, positive returns and remain uncorrelated with bonds. Consistency was favored over the possibility for higher returns. Across the board, the early results have been quite good, as these positions were the best performers within the strategy during the first quarter. The goal was to beat bonds, and this was done handily.
Within the bond portfolio, the duration remains quite low at 2.5 to 3 years. This means that bonds are maturing within 3 years or less and able to be reinvested at higher yields. Bonds have lost money early in 2022 due to rapidly rising interest rates. However, short-term bonds have fared much better and typical intermediate-to-long term bonds with durations of 6 years and greater have been absolutely crushed and most investors did not realize this magnitude of losses was even possible after 40 years of declining interest rates and mostly positive performance. Rates could continue to rise a bit higher, but fixed income expected returns are considerably more favorable today given that yields are so much higher. This is a key consideration in the expected returns assumed in our financial planning modeling.
Equities are one of the best investments to contend with rising inflation and overall exposure is now 1-2% greater than target allocations. This is because we completed a second, although more “selective”, rebalance into equities on 3/15/2022, just off the current market floor. Additions were mostly to domestic growth equities that were hit the hardest early in the quarter. Equity purchases were primarily funded with the excess cash left over from the 1/3/2022 transactions.
The current market floor was tested repeatedly. Conditions became “oversold” and there was sufficient technical support to provide a bounce higher. The incredible rally since 3/15/2022 has been one of the strongest rallies on record over such a short period of time. Thus, equities are currently just a small notch above target allocations. We are evaluating our next move and would not be surprised to see a re-test of the recent market floor or consolidation sideways. The corporate earnings season is just underway and will likely play a big role in the direction of the market in coming weeks and months.
We have faded international equity exposure given the war and Covid shut-downs in China. The overseas environment is considerably more challenging. We favor domestic companies, especially smaller and mid-sized companies that currently show very favorable valuations and greater insulation from the challenges overseas.
Focus Equity Strategy
Equity market leadership shifted away from technology toward more traditional sectors during the quarter. Commodities and energy have been the runaway leaders, accelerating after the start of the Ukrainian war. While oil and gas has dominated the headlines, Russia and Belarus are also leading producers of fertilizers (specifically potash), and gold has rallied on the uncertainty, while other metals, uranium, agriculture, and certain chemical commodities shot upward as well. Industries that use energy, such as transportation and manufacturing, mostly underperformed. Banks were mixed, as they usually benefit from higher interest rates, but concerns over emerging market exposures, short-term funding costs, and overall uncertainty weighed on certain names, while insurance did well. Health care, telecom, utilities and domestic noncyclical consumer names did well due to their defensive nature. Technology has suffered due to high valuations combined with rising interest rates.
We have maintained most of our positioning in Focused Equity with an overweight in high quality financial companies, and underweight in technology-related stocks, and modest overweights in telecom, energy, gold and health care. We view our overweight in telecom as a substitute for utility exposure, while we remain underweight in consumer staples. Cash remains slightly more elevated than normal.
During the quarter, we sold three stocks: Alibaba (BABA), and small positions in a Software ETF (XSW) and a Fintech ETF (FINX). All three sales were opportunities to harvest tax losses, though our primary motivation for selling Alibaba on the eve of the Russian invasion of Ukraine was to reduce geopolitical risk. The valuation of Chinese stocks has been overtaken by the geopolitical risks, even though the fundamental analysis still suggests they are still quite cheap. Focused Equity has never had any direct exposure to Russia (though many US-based companies were forced to divest or abandon assets there), and our direct exposure to China is now very small.
We also added to our position in AMD, a semiconductor company that makes computing and graphics chips. AMD competes directly with Intel (which we also own), and in the last few years has had meaningful design leads over its rival. Sales have benefited. We expect them to maintain the design lead for a while, and we think a structural change in the industry will allow them to compete with Intel in ways they have not been able to in the past. All of this suggests to us that their market share is durable and will continue to increase. This against a rising tide of explosive global semiconductor demand.
As always, we look for companies that will survive and even thrive in a variety of economic and geopolitical environments. The world is chaotic, so we want investments that have the quality, valuation, and risk profile to withstand the storms that will inevitably hit our portfolios.
Divergent signals increase uncertainty
The U.S. economy is fresh off the best year of economic growth since 1984. The job market has finally snapped back, with unemployment at 3.6% and wage growth of 5.6% that was often seen as the missing link in the recovery after the 2008 financial crisis. The U.S. consumer has excess savings left over from the pandemic stimulus and less debt. It would appear that the U.S. has moved into the endemic stage of the pandemic and the economy should continue to “reopen” now that the recent variant surges have retreated.
The key risk is inflation and how many rate hikes the Fed will make. Domestic growth should slow from the strong pace of 2021 as rates rise, especially if energy and food prices continue to increase. Talk of a possible recession has picked up due to slowing growth and speculation that the yield curve could “invert” if the Fed continues to raise short-term rates. A yield curve is inverted when the yield on longer dated bonds, such as U.S. Treasuries, is lower than shorter-term yields. Generally, we see the U.S. treasury yield curve invert 12-24 months prior to a recession. The curve is currently inverted from 3 to 10 years, which is not a great sign, but the front-end remains incredibly steep. It is the front-end that is the most accurate predictor of recessions historically. Complicating matters further is the fact that the Fed has manipulated the yield curve in their efforts to stimulate the economy through buying, and soon to be selling bonds. The Fed has purchased mostly longer bonds to facilitate this process and will be allowing these bonds to mature and possibly even sell these bonds in coming months, in a process known as quantitative tightening, which should create a steepening bias. Thus, it is unclear how reliable the yield curve is today.
We expect growth to slow as the Fed raises interest rates. Recession fears have risen predominantly due to the shape of the yield curve. But, it’s important to realize that yield curve inversion only suggests that a recession could be on tap 12-24 months from initial inversion – and only a small portion of the curve is inverted. Even if the yield curve truly inverts and a recession becomes likely, domestic equities have increased an average of 19% from initial inversion prior to recession. Investors must stay mindful of this and stay calm and avoid knee-jerk reactions. We will continue to monitor economic conditions, including the yield curve and LEI data. As we have done twice this year already in the more diversified Global Asset Allocation Strategy, we can proactively shift risk at a moment’s notice to take advantage of underlying market currents.
As always, please let us know if you have any questions relating to this update or anything else financial! We are available to discuss current developments in greater detail and answer any questions at any time!
Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser. Financial and exit planning services offered through Alliance Private Wealth LLC are separate and unrelated to Commonwealth.