2022 began on an optimistic note, with the hope that Covid would recede and life would start to return to normal. That didn’t last long. Sharply rising inflation data and interest rates soon spooked both bond and stock investors, sinking global financial markets.
Then, on February 23rd, Russia invaded Ukraine and most of the developed world imposed extensive economic sanctions on Russia. Since Russia is a significant marginal supplier of oil, gas, metals and wheat, commodity prices spiked, causing additional strain on economies and markets.
These challenges pale in comparison with the heart-breaking human cost borne by the Ukrainian people who have seen their cities leveled, family and friends killed and lives upended. They have shown enormous resolve and courage in the face of overwhelming adversity, providing inspiration for the entire free world, but that does not diminish their suffering and ongoing struggle.
A framework for analysis:
Part of our job as advisors and portfolio managers is to create some semblance of structure and order out of chaos and confusion, at least with respect to markets and investing. To do this, we construct a framework for looking at the world that considers secular and cyclical trends, major headwinds and tailwinds, shaping forces, changing conditions, and current economic data. This framework allows us to think about ranges of probable outcomes, assess new information and make sensible conclusions with respect to asset allocation and capital investment on an ongoing basis.
This is especially helpful during challenging times, including the last few years with the pandemic, supply chain disruptions, high levels of inflation and Russia’s brutal invasion of Ukraine. In almost all cases, it is important to stay invested relative to your long-term objectives and know that actions tend to produce reactions, problems tend to beget solutions, and markets tend to defy consensus expectations and appreciate over time.
Investing is a journey, but the road can be rough and is full of curves and hazards. Different conditions warrant different strategies and solutions, and the conditions that exist today are quite different than those that existed even a few years ago. Many former tailwinds are now headwinds: we now face persistent inflationary pressures versus deflation; interest rates are rising versus falling, and the Federal Reserve is becoming a net seller versus buyer of bonds and other financial assets; and extraordinary government spending programs are ending. It is unlikely that any major new spending programs will make it through Congress. Finally, global trade conditions have become increasingly frictional; realigned by a new, more adversarial and less stable geopolitical reality.
Almost all major asset classes suffered declines during the quarter, other than commodities and precious metals. Commodities rose a whopping 25.5% and precious metals were up 6.9%. (Chart 1).
Most notably, bonds, the traditional defensive asset in conventional asset allocation frameworks, underperformed stocks. The broad U.S. aggregate bond index lost 5.9% while the U.S. stock market declined 4.6%. Global bond indexes underperformed global equities for the quarter.
Within the U.S. equity market, stocks bottomed on March 14th before staging a sharp recovery to close out the quarter (Chart 2). There was a large divergence in performance between value and growth styles, with value outperforming growth, and large companies outperforming medium and small. Technology stocks, which dominate growth indices, experienced the sharpest declines.
Inflation and Interest Rates:
High inflation readings from almost all parts of the economy led to a much more hawkish outlook from the Federal Reserve and a sharp increase in interest rates – as well as expectations for future interest rates - especially at the short end of the yield curve. As seen in Chart 3, the interest rate on two-year Treasury Notes rose from 0.73% on December 31st to 2.28% on March 31st. The interest rate on the ten- year Treasury Note rose from 1.52% to 2.32%.
Meanwhile, the labor market continued to tighten: wage growth rose to 6.7% and the unemployment rate fell to 3.6%, one of the lowest rates recorded in the past 50 years (Chart 4).
Commodity prices were already high before the Russian invasion, and the attack on Ukraine and subsequent economic sanctions have caused them to surge even higher. As seen on Chart 5, Russia and Ukraine are significant marginal producers and suppliers of energy, metals, and wheat.
We do not see any quick or easy solutions to the crisis in Ukraine. Russia seems to have made a massive miscalculation about how things would play out, and has so far shown themselves to be as incompetent as they are brutal in executing their campaign. If Putin’s original goal was to restore the glory and power of the former Soviet Union, instead he will likely be responsible for the collapse of the Russian economy, as well as Russia’s standing as a legitimate player among developed nations. Putin has also elevated Ukrainian president Volodymyr Zelenskyy into a global hero and himself into a pariah and war criminal. If his goal was to check the power of NATO and create disunity among Western Nations, instead he has emboldened NATO and unified much of the West with a new sense of common purpose. But these failures do not mean that he will go quickly or gently into that good night. He can do a lot of damage and cause immense suffering in the mean time. Things could easily get worse before they get better.
We therefore expect prices for energy, wheat, and other commodities where Russia is a significant marginal producer to remain elevated until alternative solutions can be developed. This may take several years. The global economy will likely have to deal with sustained shortages and higher prices to maintain sanctions on Putin and the Russian economy.
Europe will bear the brunt of the economic cost and may enter a recession as a result. Europe will also have to deal with a flood of refugees from Ukraine, who will need food, housing and assistance.
The bottom line is that with a very tight labor market in the U.S. and shortages of energy and commodities around the globe, higher inflation and interest rates are likely to persist for the foreseeable future.
At the end of the quarter, the rate on the two-year Treasury Note rose above the rate of the ten-year Treasury Note, producing what economists and market watchers refer to as an “Inverted Yield Curve.”
Historically, an inverted yield curve has been a very accurate harbinger of a subsequent recession as Chart 6 from Goldman Sachs shows. It is also important to note that historically, an inverted yield curve has not been a very good predictor of when the recession would occur, how severe the recession would be, and what the market would do before and during the recession.
Economic growth in the U.S. is slowing for all the reasons outlined above, but is doing so from a high starting point. GDP growth this year is still forecast to be close to 6% before slowing to under 2% next year. Historically, equities can still produce positive returns even in the face of rising interest rates and decelerating economic growth, as long as the economic growth remains positive. Although the risks of a recession in the U.S. have increased, we do not currently see one on the horizon.
One obvious takeaway from the Russia-Ukraine war is that much of the developed world is still overly dependent on fossil fuels and that a lot of these fossil fuels come from disreputable places like Russia, Venezuela, and the Middle East. There are no quick fixes for this but it does underscore the geopolitical as well as the environmental case for alternative energy sources such as wind and solar, which are now cheaper than gas, nuclear and coal. We expect spending on energy infrastructure to continue to accelerate in the coming decade for this reason (Chart 7).
Another takeaway is that the relationship between the U.S., Europe and China is likely to become more strained as China flexes its own economic, political and military muscles in Asia and around the world. While both Russia and China are autocracies, Russia is a marginal economic power with nuclear weapons. By contrast, China is a rising economic superpower, a major manufacturer of consumer and industrial goods and the world’s largest consumer market.
In recent years, under President Xi, China has shown a willingness to play by its own rule book, and with an increasingly heavy hand. Besides its brutal crackdown on the Uyghurs and other dissident populations, the Xi government went after large Chinese technology companies last year as part of their “Common Prosperity” initiative, resulting in a massive loss in market value and exodus from the Chinese stock market by foreign investors. Currently, in an effort to deal with a breakout of Omicron, the Chinese Government is shutting down entire cities to control the virus’ spread. This is unlikely to work with such a highly contagious variant, especially among a population with little protection from effective vaccines. Finally, China has been reluctant to acknowledge or condemn Russia’s actions in Ukraine and is still offering to support Putin with the purchase of Russian oil and commodities.
China likely has an interest in maintaining good trade relationships with the United States and Europe, its two largest trading partners, while also doing things to undermine their long-term growth and dominance. China also needs Russian oil and commodities to fuel its growth. Russia therefore serves a useful purpose for China in the near term.
The trade war that started during the Trump administration was more reactionary and political than strategic, but is likely a harbinger of things to come. We expect more adversarial friction and competition between East and West as China seeks to advance its own interests.
At the very least, China is showing itself to be a less reliable trading partner and a less attractive place for marginal investment for many Western firms. The potential market is large, but so too are the risks, if property can be confiscated, factories, ports and entire cities can be shut down at a moments notice, and people can be arrested or disappear for speaking out against the government. This is one reason why we expect to see more “re-shoring” of manufacturing facilities back into the U.S. and Mexico to increase the proximity and reliability of company supply chains.
As a side observation, it is interesting to note that China and Russia both provide a good example of how heavy-handed autocracies tend to encourage capital flight rather than investment.
India has also been relatively silent on the Russian invasion so far and continues to import Russian oil. As the situation in Ukraine deteriorates further, it will be hard for India and other countries who are currently espousing a neutral position to maintain that posture without suffering some economic and political cost.
Investment Outlook and Strategy:
Putting this all together, our outlook calls for the following:
- High but moderating inflation this year and next. We expect energy and food prices to remain at or near current levels for the foreseeable future. Wage and rent inflation should also remain stubbornly persistent given the shortage of available labor and housing. Inflation for other goods and services should decline as supply increases to meet demand.
- Rising interest rates across the yield curve, as central banks hike short-term rates and start to shrink their balance sheets. Although interest rates are increasing, they are still low on both an absolute and historical basis.
- Strong, but slowing economic growth, especially in the U.S. as the economy returns to a post-Covid normal.
- Slower growth and a probable recession in Europe.
- Ongoing supply-chain issues, exacerbated by the war in Ukraine and China’s current battle with Covid.
- Elevated levels of market volatility around incremental news flow.
We started the year with a belief that stocks and real estate were more attractive than bonds and cash, that value-oriented equity strategies were more attractively priced than growth-oriented strategies, and that there were more opportunities outside the U.S. than within.
With our outlook for elevated inflation and rising interest rates, we continue to think that bonds are an unappealing asset class to own other than as a defensive cushion in portfolios. Within that defensive cushion, we are focused on shorter-term maturity bonds, which now actually pay a positive nominal interest rate, and credit-driven strategies including Corporate and High-Yield bonds which currently offer reasonably attractive yields relative to their risk.
We still think that value-oriented strategies are well positioned to benefit from the economic recovery in the U.S. The current environment favors companies and sectors that are less impacted by, or benefit from rising commodity prices, such as energy-related stocks. Banks and other financial stocks should benefit from rising interest rates.
Given the significant sell-off in technology and healthcare during the quarter, we think that valuation levels are getting more attractive, especially in biotechnology and healthcare. We also think cyber security is an attractive and very necessary area for investment.
Europe and Emerging markets look inexpensive relative to the U.S. but we have trimmed our exposure to both areas given our current concerns about Europe and China. In the near-term, the U.S. offers a safer harbor for investment and the market sell-off has provided opportunities to redeploy capital back into the U.S.
Our real estate investments are primarily focused on multi-family housing and industrial infrastructure and continue to perform well. If anything, the ongoing supply chain disruptions and war in Ukraine have created an additional tailwind for investment in manufacturing and logistics within the U.S. Demand for housing also remains strong relative to available supply, and apartment buildings offer good inflation protection since rental leases reset more quickly than commercial leases.
Other alternative strategies such as private credit, private equity, and long/short strategies also make sense in this environment and allow a lower allocation to traditional fixed income in moderate and conservative portfolios.
As always, we continue to invest with a global focus; balancing investments targeted at areas of long-term growth and innovation with more defensive equity, alternative and fixed income strategies aimed at mitigating volatility and risk.
Please let us know if you have any questions and/or if there is anything we can help you with relating to your financial life. And, if we can ever be of any help to a family member or friend, we always welcome referrals from our clients.
Jurika, Mills & Keifer