Q1 2022 Market Update: A Fragile Market Meets War and Inflation

War in Ukraine’s Impact on Investment Markets

Does the upending of the post-World War II geopolitical order alter our investment strategy? Yes, but not how you might think. We’re still extraordinarily negative toward global stock markets but much more enthusiastic about the U.S. bond market. We still advocate record cash reserves for better buying opportunities than we generally see now.

Pre-War Conditions

The first global pandemic in a century and widespread shutdowns caused plunging spending, excess supply, and falling consumer prices. Soon after, businesses cut production to match the reduced demand. Then, the rapid development of vaccines and the enormous financial assistance by the federal government led to a surge in spending—while supply was constrained. Consumer spending on durable goods over a year and a half, for example, was almost equal to that of six years of normal spending. And as we learned in Econ 101, rising demand without a rise in supply of goods results in higher inflation.

Amid political and investor alarm over inflation, the Federal Reserve pivoted from its very stimulative COVID-era policies of near-zero interest rates and aggressive bond purchases to a campaign to sharply raise interest rates and to begin reducing its bond holdings, draining liquidity from the financial system.

As for the stock market, instead of the long-term average return of 8-10%, the average annual return over the decade ending in 2021 was close to 20%. The Federal Reserve’s “loose”—we’d say irresponsible—policies during that time led to exuberance across various markets, including stocks and real estate. By many measures, the U.S. stock market had become perhaps the greatest financial bubble in the last century. And you know what happens to bubbles, sooner or later. There were early signs in 2021 of the bubble bursting, first in the most-speculative stocks, then early in 2022 with more-established technology stocks. We think there’s more to come.

Current Conventional Wisdom

The expectation of the Federal Reserve and of most market observers is that the Fed will increase the Federal Funds (overnight) interest rate from nearly 0% to well over 2%, and that inflation will remain elevated. Despite the usual negative that higher rates mean for the stock market (more expensive borrowing slows economic growth, and higher bond yields provide a more attractive alternative to stocks), after a weak start to the year, the investing public has piled back into stocks. Most investors seem to be confident in the Fed’s ability to achieve a “soft landing,” where inflation eases without the economy’s falling into recession. The historical record, however, does not support this.

Clean Yield’s Thoughts

Even before the war, the U.S. economy was slowing noticeably, as real (after-inflation) consumer incomes and spending have declined for months. Consumer sentiment is depressed, and demand for big-ticket items, after the binge during the pandemic, has fallen sharply. This is now being exacerbated by surging energy and food prices, which leave less money for other purchases. Furthermore, the overall level of debt in the U.S. is at a record high relative to U.S. economic output. Rising interest rates will cause interest payments to grow, further sapping spending potential.

The recently high level of inflation has centered on supply constraints rather than excess demand. Unfortunately, the Fed’s primary tool to curtail inflation, interest rate hikes, can  address only the demand side of the equation. Given that, the Fed’s plan to sharply increase interest rates is unlikely to have the intended effect. Instead, it will put further downward pressure on consumer spending and will likely tip the economy into recession.

We expect that the Fed will be unable to follow through with more than a few increases in interest rates, either because of a large drop in the stock market or because of weakening economic growth and slowing inflation. This would cause another reversal in policy by the Fed that would result in increased demand for bonds, driving their prices higher—and bond yields lower.

The consensus view of investors regarding inflation overlooks the fact that high prices lead to both reduced demand and increased supply. As demand falls and supply rises, prices also fall.

Take oil. There have been several examples of price spikes over the years, accompanied by a compelling rationale at the time for continued increases, only to be followed by plunging prices a year later. In this cycle, the price of oil was recently $110, up from a low of $10 in 2020. But will it continue to rise at its current 40% pace compared to last year, which is what would be necessary (along with a 35% increase in agricultural prices) to sustain an 8% rate of consumer inflation? Unlikely.

The futures market expects oil prices to decline by about 15% a year from now. If that materializes, the rate of consumer inflation will fall sharply. Furthermore, oil and food price spikes have historically preceded an economic recession (which would further reduce inflationary pressures). We think that the rate of inflation by year-end could fall to the 2-3% range, which would be quite bullish for the bond market.

With the economy close to a recession already (the Atlanta Federal Reserve Bank estimates that GDP grew just 1% in the first quarter of 2022), we think that high-quality bonds are much more attractive than stocks. Note that U.S. government bonds have never lost money in a recession—not so for stocks.

We think the best, lowest-risk opportunity is to buy short- to intermediate-term U.S. government agency notes and high-quality municipal bonds. The yield on a 2-year note, for example, has risen from 0.7% to 2.6% over just the last six months. With a government-implied guarantee of full payment on maturity and little fluctuation in market value in the interim, this is very attractive. Laddering maturities over several years spreads the risk of having to reinvest maturing bond proceeds at unfavorably low rates over several years. We expect this approach also to provide portfolio diversification and more stability amid stock market volatility.

Overall risk for the stock market remains exceedingly high. While volatility in prices can be unsettling, we consider the true risk to be the risk of a permanent loss in value. We continually weigh that versus the opportunities for higher stock prices. Probabilities now favor an overall extreme risk-averse position. We always advocate maintaining some cash reserves, especially when stocks are substantially overpriced. Then, when better opportunities arise, we have the flexibility to seize them. Patience is a crucial part of the mix.

By sectors and themes, we favor the relatively stable sectors of telecommunications, consumer staples, health care, and real estate investment trusts (REITs). Our thematic emphases are to favor stocks with high dividend yields (since capital gains will be scarce) and international stocks, which are much more reasonably priced than is the U.S. market.

Our international stock holdings are primarily European. That means there are obvious risks to many of them amid the disruptions associated with the war in Ukraine. Nevertheless, they are in our favored sectors (noted above) that should be less vulnerable to a recession and equity bear market than are the U.S. stocks that dominate the popular market indexes (such as Apple, Amazon, etc.). In addition, the European stocks are undervalued relative to their history, and even more so relative to market leaders like Apple that are held in almost all portfolios—large and small—in the U.S. Every investment has some risk, but this is an area, perhaps counterintuitively, where we think the odds favor outperformance.