Investment Outlook, July 2022
July 1, 2022
Has 2022 only been six months? The S&P 500 has had its worst start to the year since 1970 and the traditional safety of bonds has been upended – U.S. Treasuries are down nearly 10% which is estimated to be their worst start since 1830! The markets, along with people who regularly pay no attention to the happenings on Wall Street, are fixated on inflation.
When we were writing here last June (and September), inflation talk centered around what has now become a four-letter word- transitory. Inflation was elevated due to circumstances surrounding the pandemic and the stop-start nature of the reopening of the economy. Once we got past that, as the economy worked out its kinks, inflationary pressures would subside. We’ll never know how that might have played out as Russia invaded Ukraine and China had a resurgence of COVID. For now, let’s take a deeper look into this current bout of inflation, how it may end, and what that means for portfolios.
Current inflation is a shortage story. Energy, food, industrial metals, housing, labor – these are inputs in every product or service we buy. Even if we did start pumping more crude and natural gas here in the U.S., oil companies don’t have the refining capacity in the U.S. to process it in a timely manner and turn it into gasoline, diesel, or jet fuel. Russian natural gas, a key ingredient in nitrogen fertilizer, came offline just in time for the North American planting season – leaving farmers to scramble to secure supplies which pushed crop prices up even higher than the existing supply-chain and weather-related issues. Higher airfares are the result of an industry responding to multiple supply factors – jet fuel is in short supply as well as qualified pilots. And airlines are not the only chronically understaffed workforce – many of the problem areas of our economy are directly tied to labor underinvestment.
Some of the “old-economy” related industries have struggled to attract both unskilled and skilled workers for years as workers have increasingly gone to more enticing and well compensated jobs in tech and finance. Why risk your job becoming obsolete in “dying” and “dirty” industries like oil exploration or copper mining when you could land a high-paying job in Silicon Valley that will likely be around, in some form, for the entirety of your career? That leaves a number of industries with an aging workforce that is increasingly deciding it’s a good time to call it a career – leaving companies scrambling to find workers with the appropriate skills to replace them. Airlines are the perfect example. Pilots are aging and the upcoming talent pipeline is limited, while support workers for all aspects of flying are preferring more reliable and stable employment in other industries. These labor shortages are pushing up wages, forcing many companies, both large and small, to pay up for qualified workers. Companies that have pricing power are passing on the cost increases to consumers for now and are maintaining profit margins despite these inflationary forces.
The Fed cannot control these ongoing supply issues. It can’t make investments or jobs more attractive for businesses to undertake, especially by raising rates. But it can bring supply and demand into balance – by choking off demand as it becomes more expensive to borrow with higher rates. The question then becomes, since consumer spending constitutes 70% of U.S. GDP, will the Fed overdo it and destroy demand, leading us into a recession? We may already be there – Europe almost certainly is, and China could be in comparison to their growth standards. One leading indicator, U.S. consumer sentiment, is at levels below those of the depths of the Great Financial Crisis (when the financial system was on the brink of collapse, with unemployment hovering near 10% for months, etc.). Perhaps this signals that we are in, or are on the verge of, a recession. But this sentiment decline could also just be our increasing inexperience living through more typical recessions. Millennials and Gen Z’s only know of recession from two of the deepest and most painful downturns in the last 40 years – 2008 and 2020. Few likely remember, or know, that the recessions we’ve experienced since 1960 have typically seen mild slowdowns and unemployment rise 3.0 percentage points on average. So when you use the word “recession” with someone born between 1985 and 2000, the first thing that comes to mind is likely some combination of double digit unemployment and financial system fracturing. That is not the likely outcome of this supply-driven recession; banks are well-capitalized and mass layoffs across all industries are not on the horizon. Thus, consumer recession fears, and the market reaction, may be overblown.
For portfolios, this means there is still market opportunity – the market is punishing companies for any type of negative economic data or company news from managements, even if it’s short-term in nature and doesn’t affect the long-term fundamentals of the business. This provides us with buying opportunities in many especially hard-hit areas of the market including the technology, communications, consumer, and healthcare sectors that we believe are worth owning for the long-run. Uncorrelated exposures, including ETFs tracking a basket of commodities and the U.S. Dollar, have supported performance through the broad market sell off. The silver-lining of the fixed income rout is that we’ve also been able to add some attractive, high-quality, long-term bonds to fixed-income allocations. We continue to stay vigilant and abreast in these volatile conditions, positioning portfolios for future growth to achieve long-term goals and objectives.
Vice President, Investment Strategist