The first quarter of 2022 presented investors with a litany of new challenges. This missive will address some of those, while hazarding a guess as to possible future outcomes. In our eyes, the most impactful difference from last year is the rapidly changing interest rate landscape as the Fed embarks on a quantitative tightening program. Next, we would point to the more recent geopolitical turmoil triggered by Russia’s invasion of Ukraine. Lastly, we’ll assimilate those two changes and consider the impact these situations are having on global equities and risk assets in general.
To begin, the Federal Reserve has seriously miscalculated inflation, believing that rising prices were going to be “transitory”, and thus keeping their foot on the monetary accelerator for far too long. With consumer prices up +7.9% YoY and producer prices up +10% YoY, it’s clear to anyone that has tried to buy a home, groceries, gas or attempted to travel to Florida, that prices are rising dramatically and show little sign of abating. For all of 2021, the Fed, while insisting inflationary pressures would recede as the pandemic evolved, kept the short-term Federal Funds rate at 0%, all the while buying approximately $1.5 trillion in Treasury and mortgage-backed securities.
The persistence of these broad price increases has forced the Fed to sing a decidedly different tune here in 2022, sending both stock and bond markets into a tizzy (a technical term implying heightened volatility and large daily price swings). Since the start of the new year, the yield on the 2-year Treasury note has risen from .73% to 2.50%, while the Bloomberg Aggregate Bond Index recently suffered its worst quarter in 50 years, declining by -5.9%. The typical 30-year mortgage rate has surged from less than 3% a year ago, to over 5% today. All this due to the Fed’s miscalculation on inflation, and subsequent rush to “normalize” interest rates.
During the course of this normalization (a euphemism for more restrictive monetary policy), an interesting thing is happening. Short-term interest rates are rising rapidly, while longer-term interest rates (beyond 10 years) are climbing at a more measured pace. Hence, the yield curve, the slope between short and long rates, is flattening, and as we go to press, is nearly inverted (short-term bonds yield more than long-term bonds). This phenomenon is somewhat rare, but has preceded every recession here in the U.S. Market pundits like to joke that inverted yield curves have predicted 25 of the last 6 recessions. In fact, though, each recession has been preceded by an inverted curve. What to make of this?
It’s important to remember that a) recessions don’t happen overnight; b) they are actually calculated by the National Bureau of Economic Research by looking backwards (and are occasionally over before anyone knew they started) and c) they are a normal and healthy part of the business cycle. Today’s yield curve may portend a coming recession (defined by the NBER as a significant decline in economic activity spread across the economy, lasting more than a few months and visible in GDP, real income, employment and industrial production), or it may not. Only time will tell.
By our lights, any interest rate move off the zero bound is a good thing. Ultra-low rates, a necessary condition during the pandemic, no longer appear appropriate in light of an economy with 3.6% unemployment, over 10 million job openings, and an economic reawakening taking place (not to mention the above referenced double digit inflation). Savers have been punished enough. Higher interest rates, while disruptive to asset values of all types, will help limit the moral hazard associated with a free money economy (akin to every kid gets a trophy, regardless of winning or losing).
Year-to-date through February 23rd, the S&P 500 had declined -11.3% (largely due to the situation discussed above). On February 24th Russia invaded Ukraine. Since then, the S&P has rallied +8.5%, despite the ravages of war, commodity supply disruptions, and the awful humanitarian disaster that has ensued. Go figure – and another argument against market timing. Brent crude, which had been steadily moving higher throughout early 2022, closing at $98 per barrel pre-invasion, shot up to $134 in the initial aftermath of the invasion, before falling back to today’s level of $99 per barrel.
Russia supplies 10% of the world’s oil and roughly 17% of natural gas production. Moreover, Europe is heavily reliant on Russia for it energy needs. With high oil prices likely emboldening Putin’s Ukraine gambit, the long-term outcome may be disastrous for Russia, as western countries boycott Russian energy, and sources such as US LNG come to the fore. America’s energy independence has never been more valuable, and likely underappreciated. The global movement towards sustainable green energy has no doubt gained adherents following the invasion; however, the runway to viable, accessible, cost effective “alternative” energy is paved with oil and gas. (According to the US Energy Information Administration, renewables made up approximately 20% of electricity generation in 2020.)
Russia’s invasion of Ukraine may be the seminal event that marks the end of the globalization movement. Re-shoring, bringing back production to the U.S., was already underway; it is now being accelerated. Key goods such as semiconductors, pharmaceuticals, rare earth elements and other items critical to both manufacturing and the nation’s defense are now under the microscope with respect to country of origin and the risks that supply disruptions may render. We feel this is just the beginning of the movement away from “made in China”; and while countries with lower labor costs will still see interest for the supply of simple goods (clothing, textiles, consumer electronics etc.), other more critical supply chain components will likely, to the extent feasible, be made in the USA, or the country of a close ally.
Bad actors such as Russia, North Korea, Iran, and to a lesser extent China, will likely see a movement away from trade negotiations, towards one of isolation and economic boycott. While we don’t expect this to materially alter the economic landscape (and hence your portfolio) tomorrow, once underway, these are powerful trends which should benefit the US labor force and America in general.
The combination of the rising interest rate environment and growing geopolitical tensions/de-globalization, presents serious headwinds in our view for further near-term equity gains. While not exactly calling for the death of the bull market, we do think risk asset returns going forward may be materially lower than realized over the past half-decade. The main reason for this is the historical tendency for the market to assign a lower P/E multiple to earnings during periods of heightened inflation. Adding to this is the likelihood for increased pressure on margins resulting from higher labor costs and other raw material and input costs.
There’s been a bit of a buzz lately around the prospects for a 1970’s style “stagflation” scenario – slow/no growth along with high inflation – but thus far that is not our base case. The S&P 500 has compounded at nearly 15% per annum over the past decade on the heels of the greatest central bank largesse we may ever see. A decade+ worth of quantitative easing has sent asset values everywhere skyrocketing, greatly benefitting the “haves” over the “have-nots”. With the Fed adopting a more hawkish and restrictive monetary policy – taking the Funds rate off the zero-bound and unwinding $8+ trillion worth of Treasury and mortgage-backed securities from its balance sheet – the prospects for continued double-digit returns in equities have diminished.
Our hope is that we return to market-driven asset pricing, the Fed recedes into the background, and non-governmental actors such as private investors determine financial market prices. While we applaud the heroic efforts of the Fed during the credit crisis and more recently the pandemic, we also recognize the moral hazard associated with its extended QE regime, and wish for its speedy demise. The road to higher interest rates will likely be bumpy for asset prices, but in the end, healthier and more stable markets will likely ensue.
As investors, it’s important to acknowledge potential paradigm shifts and respond accordingly. More than anything, a recognition that the Fed is no longer pursuing an “easy money” policy must be taken into account. Return expectations should be ratcheted down, relative to recent years. Time horizons and asset allocations should be reassessed and considered in light of the new investment landscape we find ourselves in. Higher interest rates are a boon to savers, but can have deleterious effects on the prices of some longer duration risk assets. Leverage may become an anchor rather than a tailwind. Be careful.
As always, Nottingham stands ready to assist you through this process. Outside of death and taxes, nothing is certain and there are no guarantees in life. However, we promise all our clients we will always remain steadfast fiduciaries and principled stewards of your capital. Please reach out to us with your questions or concerns.
Larry Whistler, CFA
President
Larry joined Nottingham in 2006 and heads the Investment Policy Committee, along with portfolio and relationship management responsibilities. He brings over 32 years of investment experience to the team. Prior to joining Nottingham in 2006, Larry worked as an independent RIA for two years and, before that, spent a decade as a bond trader for Merrill Lynch Capital Markets in Los Angeles and New York City.
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