Summary, Second Quarter of 2022:
While 2022 started with headwinds of higher inflation, rising interest rates, tightening monetary policy, and slowing economic growth, the confluence of these headwinds as well as the outbreak of war between Russia and Ukraine pushed markets down and into undervalued territory. These moves came on the heels of the market’s recovery from Covid-19, which had pushed valuations upward and into overvalued territory. The U.S. Federal Reserve (the “Fed”) grew more hawkish as inflation was stronger than expected, testing their resolve and creating uncertainty as market participants changed their strategies depending on interest rate levels. A bear market took hold and recession rhetoric has gained popularity.
Inflation can be a complicated beast if it gets out of control. Higher inflation means lower purchasing power, which no one likes. And no central banker wants to let inflation get out of control. Deflation, which is when prices fall, sounds less harmful, but it can stall economic activity as consumers wait for lower future prices. This is why central banks have moderate inflation targets, such as the Fed’s 2% annual inflation target. Low and controlled inflation is a good thing: it helps businesses and consumers plan for the future and spurs economic activity because people expect higher prices in the future.
Current inflation levels need to come down to a more sustainable level, and this is why central banks are raising interest rates—their best weapon against inflation. It appears that the recent rate hikes are beginning to slow the economy down, perhaps beginning the “soft landing” that the Fed would love to achieve. We would love it, too, but history is not on the Fed’s side, and a recession is a real possibility.
During this interest rate hiking period, the bond market is suffering its worst two-year period in history. As rates rise, existing bonds are less attractive, so they tend to get sold in favor of newly issued and higher yielding bonds. As we get through the rate hiking period, bonds become more attractive.
An important point about the stock market is that it typically precedes the larger economy by a few quarters as investors shape their expectations of future earnings. In other words, economic expectations are reflected in the stock market before the general economy as stocks “price in” events like expansions or contractions before they happen. This could mean that we have already endured some of the eventual drawdown in stocks if we are indeed heading into a recession. Per Morningstar’s market valuations, stocks are currently strongly undervalued. In our view, this has provided an opportunity to purchase high-quality stocks that were previously overvalued, which we have done across our portfolios. We expect more opportunities to emerge and will act accordingly when appropriate.
Commodities, which have lagged other asset classes for years, are enjoying a solid year. It appears that commodity prices may stay elevated for the foreseeable future, and where appropriate, we have added some commodity exposure to client portfolios. Commodity prices behave differently than stocks and bonds, as they are more of a pure reflection of supply and demand. China is in the process of ending a recession and ramping up economic activity. As the second largest economy in the world, China will have an outsized impact on global demand for commodities.
Until next quarter,
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