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Strategy Update

Navigating Economic Headwinds

Nearly all financial assets have been challenged this year by a mix of inflation, slowing economic growth and growing geopolitical risks arising from the war in Ukraine. All of these negative factors are intertwined. The conflict has elevated food and energy prices around the world, adding to already high levels of inflation. Inflation has required immediate action by the Federal Reserve, which has raised interest rates aggressively enough that economic growth is starting to slow. The same factors have proved a toxic mix for investors, as grinding and persistent declines have led to the worst start for stocks since 1970, and by some measures, the worst start for U.S. bonds since the 18th century.

To some extent, these losses are hard to square against the causes outlined above. In other market declines from recent memory, stocks were pummeled when the world stood on the brink of a global pandemic, or a financial crisis that shook the entire capitalist economy to its core. To most people these were far greater threats, but there is one key difference today. Those crises were met with trillions of dollars of stimulus; the full force of governments and central banks around the world. Bond markets rallied with the stimulus, and eventually so too did stocks. This time around, however, with inflation as the root cause, governments and central banks can be no savior. Instead, they must tighten the supply of money and curtail economic activity to tamp down inflation. With no salve, both the stock and bond market have churned lower through the year. There has been little to no panic in the decline, but the end result has still been a painful reset of stock and bond prices.

In thinking about when financial markets will reach their nadir, it is important to separate stocks and bonds. Stocks must continue to wrestle with the twin fears of inflation and slowing economic growth, the latter of which is likely to depress corporate earnings. Bond investors generally need only fear sustained inflation. A recessionary environment has often been a positive for bond prices, as investors flow into the relative safety offered by bonds. And even though inflation remains incredibly high, there are reasons investors are starting to anticipate that current levels may represent a peak. The housing market has begun to slow in many parts of the country, consumer spending has moderated for two months in a row, and gas prices have come off their early summer highs. All of these factors, if sustained, should begin to tame inflation as the year progresses. The bond market seems to have anticipated this, and already longer-dated bonds have begun to recover from the lows set a month ago. If inflation is indeed peaking, it seems likely the bond market has seen its low point already. The same cannot yet be said for stocks. While a very mild economic slowdown may be priced into stocks already, investors are still trying to evaluate the scale and scope of a possibly deeper recession.

The greatest reassurance for most investors at the moment can be found in a long-term view. As the price of assets have declined throughout the year, the long-term potential of those assets has improved in mathematical terms. For much of last year, U.S. Treasury bonds offered long-term rates of return of just over 1%. Those same bonds now will return just over 3% a year to the patient fixed-income investor. By the end of 2021, many stocks were stretched, with little room for advancement. The valuation on the overall market was high and offered smaller future returns. After the 2022 bear market in stocks, starting valuations are far more attractive. Stocks now offer a better starting point for a long-term investor than they did through much of last year. The timing for taking advantage of these improved circumstances is critical, but we are encouraged in many cases when we start to plot out future returns on investments.

Current Strategy

A recovery in stock and bond prices now depends on investors overcoming the three headwinds we outlined: increased geopolitical conflict, inflation/interest rates, and the risk of a recession. The war in Ukraine still carries the possibility of surprise, most notably if Russia cuts off all energy supplies to Europe, but we feel that investors have largely begun to look past the economic impact of the war. And even as inflation recently recorded a new high, there are signs from the bond and commodity markets that portend lower inflation going forward. It is the growing risk of recession that has replaced the war and interest rate rises as the primary fear for investors. It is hard for investors to guess the duration and depth of a recession that hasn’t even started. It’s similar to seeing ominous clouds on the horizon, but not yet knowing the magnitude of the wind and rain to come. Once the recession begins, investors may be more willing to hazard a guess on its eventual end and stocks often rally on that forecast.

The bear market of 2022 has proven to be just as challenging for us as it has for most other investors. While the stock sales we made late last year and early this year look wise in retrospect, our investments from 2021 have run into significant headwinds. We thought a bifurcated market in 2021 could lead to decent gains in some less highly valued companies, even as we anticipated a steep fall in many high-flying technology stocks, crypto currencies, IPOs (initial public offerings), and SPACs (special acquisition companies). The pumped up and bifurcated nature of the market reminded us of the 2000 dot.com bubble. Back then the technology stock bubble collapsed, while formerly despised sectors such as food, consumer staples, and basic industrial companies found new favor with investors. We thought the pattern could repeat in 2022, but the rapid and sustained rise in inflation and interest rates and the war in Ukraine have conspired to undermine all asset prices. The decline has encompassed not only very overpriced sectors of the market, but lower valued stocks as well.

We anticipate a recovery in stock prices when investors start to sense that the economic storm will abate. It is difficult, if not impossible, to tell when a critical mass of investors will decide that the time has come to more aggressively buy stocks. So we think that it is important to maintain a portfolio of high quality companies that have been tested by, and survived, past recessions. That describes almost all the companies currently held for our clients. We will add similarly high quality companies to portfolios as prices dictate.

On the fixed income side, we have made some investments into shorter-maturity bonds for many clients, and we will continue in the face of higher yields. Treasuries with maturities that extend out one to three years offer meaningful income now, and as the Federal Reserve raises overnight interest rates, cash balances will yield income as well in the months to come. Our largest purchase was in an inflation-proof Treasury that matures in 2025, which we feel will help serve as a modest inflationary hedge this year and into next. Our hope is that inflation will be contained well before 2025, but that between now and then we will have benefitted from the current inflationary boost to the bond.

The accounting for this kind of bond, referred to as a Treasury Inflation-Protected Security, is complex, so we have included an insert for holders of the security to retain for reference. Our goal is to build a ladder of bonds, each with extended maturities, so that the fixed income portfolio for clients matures over time. We hope the end result will be a bond portfolio that produces meaningful income for years to come.