A Challenging Time
It has been a tough year, so far, for all of us as investors. From the year’s start, the stock market has undergone a continuing selloff, and bonds have also fallen in value as interest rates have risen. As investment advisors, we are frequently asked what is driving the weakness, and when will things get better. We thought it a good time to frame the moment, and also to remind our friends and clients of our investing principles.
First, why the weakness. In brief, our paramount problem is the current inflation, how to address it, and what the resulting impacts to the economy might be.
Inflation is commonly defined as “too much money chasing too few goods,” and that’s a good starting point for understanding. If we consider the policy tools utilized by the government and the Federal Reserve over the last two years to address the pandemic, we threw an unprecedented wave of money at households, businesses, and governments. There were multiple rounds of stimulus checks to the large majority of households; PPP loans to businesses that were subsequently forgiven in most cases; payroll tax credits to eligible businesses; and direct support to state and local governments, and to schools. On top of this historic emergency spending, the Fed cut interest rates to zero and greatly increased the money supply through Quantitative Easing. In short, we lent new meaning to the idea of “too much money.”
Throughout the pandemic era, meanwhile, the supply of goods and services has remained challenged. The global supply chain has been disrupted repeatedly from covid-related shutdowns, and even today, many goods remain in short supply, particularly semiconductors and other electronics, and the things they power, such as new cars. Energy markets remain tight, also, sharply driving up the price of oil and gas.
Amid an economic reopening, fueled by strong household balance sheets and pent-up demand, we have dealt ourselves almost a perfect storm of inflation. The Fed is now playing catch-up, reversing its easy money policies by raising interest rates and, soon, reducing the money supply. Its goal is to dampen consumer demand to cool inflation, but not dampen so much as to tip the economy into recession.
Not surprisingly, given these uncertainties, investors have reduced their risk exposure, driving down stock prices, while the bond market has sold off on the expectation of higher interest rates. In contrast to a jittery market, corporate earnings remain firm, with little signs of an imminent economic slowdown. The market’s decline, so far, is almost entirely due to lower stock prices, not tied to lower earnings. Profit levels, and profit margins, are high. Businesses, and households, remain on a strong footing.
We believe this storm, like so many others before it, shall pass. The economy will work through a rising rate environment. In particular, we expect the inflation story to improve organically as the extraordinary money growth of the past two years abates, while supply chains improve. Higher rates are already having an effect on the demand side—mortgage rates have surged to over 5%, weakening mortgage and refinancing originations. We expect to see some further dampening of demand, too, from the negative wealth effect, as investors are feeling less flush. In sum, given the economy’s present strength, our expectation is for moderating growth in the economy, with inflation coming off the boil, likely to a slightly higher level than the 2% of recent years, perhaps closer to 4-5%. We see the greatest continuing risk in energy and food costs remaining volatile.
A Word on Process
Long-time clients will know that our investment process is a disciplined one, and not prone to chasing fads. We seek to take investment risk responsibly, investing in companies with strong positions in attractive end markets, capable management teams, and financial strength. We want to remind our newer clients of the same. This process forms the bedrock of our investment philosophy, and it is time-tested. There are sometimes trying times, such as now, that seem intended to test that process, when emotions and herd movement can overtake the market. We believe that, in time, quality will out itself, as it invariably does. (As a reminder, investment outcomes can never be guaranteed or assured.)
Among our several equity strategies which blend into client portfolios, we have undertaken multiple investment moves to position for the road ahead. Specifically, we have reduced or eliminated several stakes in equities that benefitted greatly through the stay-at-home or work-from-home era of the pandemic, but whose moment has passed. Likewise, as overall market valuations have been pressured, we have lightened our exposure to higher-multiple growth stocks; while their businesses may be intact, the simple fact is that investors are not willing to pay as much for these companies in a time of higher interest rates. We have added to our energy exposure meaningfully; we expect carbon-based energy prices to remain firm, due to restraint from US producers, OPEC discipline, and the partial loss to the market of Russian barrels. In keeping with our view of a slower economy, we have reduced exposure to consumer cyclicals and have added to certain defensive positions. Last, we remain intrigued by the situation in the semiconductor industry, beyond its present shortages. We expect significant growth in new plant and equipment in coming years, and believe equipment names to be more than fairly priced at present.
For suitable and qualified investors, we have continued to invest in a diversified portfolio of non-public “alternative” investments, usually on a direct basis with a project sponsor. We believe these investments to offer diversification benefits away from the public markets, combined with an attractive return profile.
Our fixed income strategies have remained focused on investment-grade taxable and municipal securities, including allocations to inflation-protected securities. We have been very well-positioned for the current rate climate by keeping most client portfolios very modest in their duration (a concept similar to average maturity). In most client cases, we have a bond “sleeve” that is offering up near-term maturities that we are able to reinvest at stronger yields such as are now present. We do not expect a major run-up in interest rates from here, absent highly adverse inflation trends, and we believe our reinvestments will prove wise in the fullness of time.
The current market pullback won’t be the last we’ll see. Process and discipline, combined with insight, help us to navigate on your behalf. We thank you for your continued confidence.