Investment Outlook, March 2022
March 25, 2022
After two blistering years, markets have had a difficult start to 2022. Investors are struggling to determine if inflation, interest rates, or geopolitical trauma may derail our economic growth. We see this past quarter’s market pull back as a correction that may be overdone given our potentially positive outlook for the remainder of the year.
In December, Federal Reserve Chairman Powell declared inflation more than “transitory” and vowed to use monetary policy to fight it. As we have noted before, our inflation spike can be tied to three distinct forces- COVID relief to consumers, COVID supply chain disruptions, and higher energy prices. Energy prices have now been further stoked by Russia’s assault on Ukraine. Investors who are struggling to understand the future of inflation in our economy should consider that most economists and our Federal Reserve expect inflation to be lower at the end of 2022. So, while the phrase “transitory” was dropped in communications after only six months, it does, indeed, appear that this cycle of inflation is likely to eventually recede going forward. In the meantime, today’s inflationary pressures are forcing companies to raise both wages and prices. If companies can successfully pass on price increases, then profit margins can often be maintained – even as wages increase. In this way, corporate earnings are often a hedge for inflation trends, encouraging stock market investments.
As widely foreshadowed, our Federal Reserve raised interest rates a couple of weeks ago by 0.25%. Originally, it was expected that rates would increase to about 1% by year end. At this recent meeting, the message changed dramatically. Now the Fed expects its benchmark rate to be closer to 2% by year end, perhaps made up of 6 interest rate increases. Much more telling is the range of disagreement among Federal Reserve governors in their outlook for interest rates in the future. The most “hawkish” participants forecast that the benchmark rate may be as high as 3.25% this year and 3.75% next year. This high forecast is not something to fear, but it is a sign of unusually wide disagreement among experts as to how monetary policy can manage inflation today. Given our very low interest rate starting point, many believe that monetary policy can only act as a “bully pulpit” for inflation and that even 2-3% rates are not sufficient to change capital decisions in our economy. If even higher rates are necessary, will the Fed go too far and cause a recession? With the latest announcement, it is reasonable to question, though, how likely it will be that the Fed will be able to raise rates six times this year, as the world and the economy have a way of throwing curve balls that can change plans. For investors, the most important consideration is likely the historical evidence that equity markets are not hampered by rising rates. Global equities have historically gone up in almost every one of the past 5-6 tightening cycles. Today, we believe that the market correction of the first quarter in both equities and bonds has already fully discounted the anticipated increases in interest rates. From here on there is more upside than downside potential.
And now we are witnessing the unexpected and unpredictable Russian invasion of Ukraine. In addition to the military and human stresses this has added to our world, the conflict has increased global inflation as sanctions on Russia have led to soaring prices for energy, metals, and grains. It also has caused global investors to seek safety once again in U.S. Treasury bonds, driving down long-maturity U.S. interest rates. The supply-side shock of the conflict creates a very real risk of a recession in Europe if this conflict drags on, and we do not know how this would affect demand in the rest of the world. No one can predict how or when this crisis will end. We can only monitor the situation and stay vigilant in our assessment of the U.S. and global economy in the wake of this tragedy.
For the U.S. markets, the first quarter was a time of rotation, correction, and rebalancing. The year started with a bias toward “flight”. High growth stocks had started retreating last fall and by this winter many strong companies saw their stocks down 30-50% from their summer highs. Investors were taking profits and fleeing these investments, thinking that higher interest rates would make these companies worth less. During the decline, earnings generally continued to grow, and the price deterioration was entirely due to lower market valuations. Our decision to take some profits last fall and invest in a broader portfolio earlier this year protected portfolios better than the market through this period. More recently, investors are choosing to “fight”, with buyers coming back to some of the largest U.S stocks that have shown in recent results their ability to raise prices and wages while maintaining earnings growth. We do not yet know how much longer this “fight” and “flight” struggle will continue in the markets, but we believe your portfolio is well positioned for the potential growth we still see for the U.S. through 2022. We believe it is still best to be fully invested in equity markets where growth has the potential to offset both inflation and rising interest rates. For bond allocations, we are focusing on bond opportunities that either vary with rising interest rates or can offer attractive yields at maturities that fit your time horizon.
We all look forward to the days of Spring and wish you more days of sunshine.