The S&P 500 has officially closed in “bear market territory” (20% down from the most recent all-time high of January 3rd). After a brief rally, the market has posted multiple bruising down days. Interest rates have moved swiftly over the last few trading cycles with the 5 year U.S. Treasury bond now yielding 3.25%. Markets are reacting to the June 10, 2022 inflation reading which showed an acceleration in the inflation rate. The risk of high inflation persisting has justifiably rattled markets.
The purpose of this post is to provide a quick update on the current situation:
- Inflation is running hot in the United States. The latest reading indicated that inflation increased at 8.6% year over year and core inflation (excluding energy and food prices) increased at 6%. Inflation levels have not been this high in many decades.
- Since the Great Financial Crisis (“GFC”), the Federal Reserve (“Fed”) has used the same playbook: as risks to the economy arise they loosen monetary conditions by increasing the monetary base through lowering key interest rates and buying bonds. These activities have generally provided support for stocks and bonds.
- The economic recovery from the GFC was slow and painful. The Fed used very aggressive strategies to grow the economy and to achieve their target of 2% inflation. Inflation remained persistently low for many years but asset prices, namely stocks and real estate, appreciated tremendously (partly in response to low interest rates).
- The COVID crisis led to the largest monetary expansion in world history with every major central bank aggressively pursuing easy money policies. Further, unlike the GFC, the United States government delivered multiple rounds of unprecedented stimulus by injecting capital directly into the hands of business owners and the labor force. Businesses and individuals increased their savings at a record pace during the lockdowns.
- The confluence of these events (more saving, government stimulus arriving in bank accounts, and low interest rates) has sparked a demand-driven inflation event. Both businesses and individuals have made up for lost time and have increased spending dramatically. As the economy reopened, much of the stimulus has found its way to corporate profits. Margins are at or near all time high levels.
- The demand-driven inflation event received a major supply shock in the form of the Russian invasion of Ukraine (and from various supply chain events related to COVID shutdowns).
- COVID’s impacts are also being felt in the labor market where the unemployment rate hovers at 3.6%. At these levels, some would argue the economy is at full employment. However, businesses in nearly every industry (but most acutely in the hospitality, restaurant, child care, and healthcare industries) report severe shortages in workers. This issue deserves its own essay but, in short, the workforce has failed to grow due to growing retirements, halted immigration, and a variety of other reasons.
- With inflation running hot in 2022, markets have begun to react. Interest rates have increased meaningfully as markets have priced in Federal Reserve rate hikes intended to combat inflation.
- Bonds have experienced substantial declines in value. Bonds of all maturities and quality have endured a difficult environment in 2022, however bonds with intermediate- and long-term maturities have been punished most severely. Further, until recently, high quality bonds have been battered more than low quality bonds because the sell off was related to interest rates and not creditworthiness.
- Stocks have also rolled over, with stocks that tend to be “longer duration” performing worse than the market. “Longer duration” generally refers to stocks with negative or low profitability. In general, value stocks have held up better than growth stocks because the market is, for the first time in many years, rewarding current cash flow and profitability over top line growth and a promise of profitability many years into the future.
- After nearly a decade of underperformance, commodities have emerged as the best performing asset class of 2022. Commodities have been led by energy but are seeing meaningful increases in agriculture prices as well.
- In a recent poll, inflation is the top concern for Americans. Our hearts go out to those who do not have the ability to pay for needed goods and services. Inflation hurts the consumer, it hurts small businesses as costs increase, and it ultimately hurts financial assets that benefit from moderate- to low-inflation. The Fed likely didn’t act as fast as they should have and it is very clear from their statements that they now realize the severity of this issue. For many years, the Fed has tended to offer support to financial markets during times of distress. This situation, is likely very different. The Fed may be willing to aggressively act to stop inflation, even if they harm financial asset prices.
- Verum Partners’ Investment Committee is continuing to focus on these issues. We do not believe that predicting inflation or interest rates is a time-tested way to invest money. Our investment philosophy revolves around a valuations-focused framework for capital allocation. While we did not predict inflation to remain this high for this long, we have owned many of the outperforming market segments across stocks, bonds, and commodities by focusing on an expected return framework that is driven by valuations.
- Similarly, we do not know the future path of inflation or interest rates. We do not know whether we will see a recession this year. However, we are continuing to respond to the current environment by asking a fundamental question: is this investment paying us adequately to take this risk?
- In times like these it is very important to have an investment plan and to adhere to it. A well-built investment plan outlines a playbook for how the investor will approach a situation. We believe that investors should look for opportunities to tax loss harvest, rebalance their portfolios back to intended weights, and re-evaluate their overall risk tolerance to ensure their investment portfolio is in line with both their risk capacity and tolerance.
- While we can’t predict what’s next for the markets, history tells us that those who are willing to buy stocks during periods of distress have been handsomely rewarded over longer time periods. We don’t know what the next 1 year or 3 years will bring, but we do believe investors will be rewarded for buying investments that trade at reasonable valuations. The current market is starting to provide more and more entry points into these types of investments.