It has been a challenging start to the year for investors, with losses across many asset classes. But before addressing the economic impact of the war, we feel compelled to state that it pales in comparison to the humanitarian impact in Ukraine. Tens of thousands have died; new war crimes seem to come to light with each passing day. The brazen attack shocked many, but despite what Putin claims, it has been a failure so far when measured against his initial ambitions. The Ukrainian response has been nothing short of heroic, and Russia has helped unify Western geopolitical aims at a time when they seemed splintered. Still, any grander optimism feels premature, especially as the horror of war continues.
The economic cost of the war has been most acutely felt by Russia and Ukraine, with a large drop in economic activity expected in both countries. While the Ruble has recovered after swiftly losing almost half of its value, sanctions and a withdrawal from Russia by many Western companies will still damage that country’s economy. The other economic impact of the war, with far-reaching effects globally, has been to drive up the price of many commodities, including gas, oil, nickel, aluminum, steel, wheat and corn. Russia and Ukraine are major exporters of many of these commodities, and the conflict has directly affected supply, with the notable destruction of a massive steel plant in Mariupol. The war has also affected other commodity markets, as traders have driven up the price of natural gas futures, anticipating diplomatic fallout that centers around gas exports from Russia into Europe. Many basic commodities are more expensive today than they were two months ago, as a result of the war.
Domestic inflation, most directly felt in the U.S. through the increased cost of gasoline, has added to prices that were already rapidly rising. A year ago the rise in prices was most acute in used and new cars, with other pockets of inflation for products that were in short supply. One argument at the time was that inflation was transitory, a lingering effect of the pandemic. The past year has shown that argument to be incorrect. Certainly some prices have started to correct (for used cars, for example), but many other goods and services are rising in price this year at a rate not seen since the early 1980s. Inflation is running around 8.5% at last measurement. The enormous increase in energy costs has pulled inflation higher since the start of the war, but even stripping out these effects, the “core” measure of inflation that the Federal Reserve often highlights as its preferred measurement is running at 6.5%.
The Federal Reserve did not act quickly enough in response to inflationary signals last year. They have now pivoted and are arguing for an aggressive series of interest rate increases. The bond market has spent the entirety of 2022 adjusting to this new narrative. Interest rates have climbed significantly higher this year and, critically, 30-year mortgage rates have risen from an average of around 3.3% to 5.3%. Rising mortgage rates will put pressure on housing prices at some point, which are the largest single input for the Consumer Price Index. The U.S. dollar has been strong this year, which in turn means that imported goods will be relatively cheaper going forward. Curbing inflation has always been a somewhat painful economic process and this time seems no different. There is now discussion among investors and pundits of a possible recession later this year or in 2023, and investors in both stocks and bonds are already suffering widespread losses as the markets digest higher interest rates and the potential for reduced economic activity. Looking forward, there are no easy and immediate fixes for high inflation. So far, each spurt of investor optimism seems immediately checked by another rise in interest rates, and discouraging (albeit necessary) rhetoric from the Federal Reserve.
Shares of technology companies, represented by the Nasdaq Index, have been hit hardest so far this year. There is a complicated calculus linking higher interest rates with lower valuations for tech companies, but it is simpler to state that these shares generally had risen tremendously in value in recent years, especially during the pandemic, and were due for a correction. In particular cases, like with Netflix, the companies are maturing and struggling with slowing growth at exactly the wrong time. But a long and growing list of companies has lost 40% or more of their value in just a few months. Strength in oil and gas, defense, and some consumer staples companies masks just how disastrous a year it has been for the shares of many other companies, particularly faster-growing, more richly-valued technology companies.
We entered the year with high levels of cash for many clients, and continue to hold a larger reserve. This strategic positioning has been helpful this year, but it has only served to mitigate, rather than offset, losses in other investments. The investment portfolio of stocks we own certainly has a higher representation of technology companies than consumer staples companies, and an obvious absence of oil and gas or defense companies. In challenging markets like this one, we must balance the need to preserve capital for clients while also eventually taking advantage of the improved future investment returns that come from lower prices on stocks. Cash is comfortable today (for the first time in many years, frankly), but it ultimately needs to be invested in productive assets, and we are plotting out how best to do that.
The losses for bond investors have been far more uniform, if only a bit more modest overall. Bonds as an entire asset class rise and fall in value at the same time, and in times of rising interest rates, an investor is only protected to some degree by owning shorter-maturity bonds. Bonds are also becoming more attractive as they decline, offering the potential for more income into the future than they did a year ago. We are already rebuilding bond portfolios for clients with fixed-income objectives, and will continue that process if yields rise further. A variety of bonds will mature or get called this year, so work remains to rebuild a bond portfolio. Some purchases will be premature in hindsight, but we trust that the overall effect will be to create a fixed income portfolio for clients that produces far more interest than in recent years.