This article brought to you in collaboration with our colleagues at Laird Norton Wealth Management. You can also find it on their website linked here.
The Long View on 2022
In Brief
- Market volatility is likely to continue amid higher uncertainty, including higher inflation, higher interest rates, geopolitical upheaval and continued challenges with the global supply chain.
- Market dislocations should continue to create opportunities.
- Bond exposures have been challenged by rising interest rates but look increasingly attractive.
- Our focus remains on combining portfolio allocations that together can effectively address risks and opportunities through active rebalancing.
Signal vs. Noise
Signal is the meaningful information you’re actually trying to detect; noise is the random, unwanted variation or fluctuation that interferes with the signal. As professional investors, part of our job is to dig beyond the headlines and the surface-level data often cited to look for meaningful and material “signals” derived from our broad range of sources. It has been a very “noisy” first quarter. By that we mean we’ve seen short-term market fluctuations that are driven primarily by the “noise” generated by financial and general media. We would argue that the market regime shift we have referenced in the past few quarters is likely now fully with us, accelerated by Russia’s invasion of Ukraine, a humanitarian crisis that is likely to have economic and geopolitical ramifications for many years to come.
While the fog of the war in Eastern Europe and the war against COVID cloud how the geopolitical and economic future may unfold, it is becoming increasingly clear that we may be entering a period of geopolitical instability unlike that which we have seen since the fall of the Soviet Union. In this commentary, we would like to frame what is happening by highlighting our broader market perspective and discussing the importance of third-order thinking to our understanding of what may lie ahead.
Q1 2022 Asset Class Performance: Mostly Negative
Source: Bloomberg; as of 3/31/2022.
In the first quarter of 2022, the U.S. stock market posted its worst performance in two years with good cause. COVID is still lurking if not as dangerous, Russia invaded Ukraine with no resolution in sight and global inflationary pressures are mounting.
Inflation Is a Real Concern But Must Be Taken in Larger Context
As troubling as inflation is today, this bout with inflation appears different than the experience of the 1970s. At that time, manufacturing was a material contributor to U.S. GDP, making our economy twice as dependent on oil as it is today. Additionally, inflation was not only being driven by a shortage of oil but very strong consumer demand, as millions of baby boomers in their 20s and 30s formed households.
It is important to remember that most of the world’s major industrialized economies were battling a number of long-term deflationary trends until 2021, including aging populations in Europe, North America and China, technology including automation driving down production costs and mounting debt. These trends remain in place. In addition, today we are facing ongoing shortages in many goods, materials and commodities due to the disruptions of the pandemic and the invasion of Ukraine, but it remains to be seen how the tug-of-war between inflationary and deflationary forces will end.
Russian Dominance in Energy and Agriculture Poses Challenges
Russia provides a large share of the European Union’s (EU) imports of critical goods: oil and natural gas, key metals used in a broad range of products, as well as fertilizers and wheat. Ukraine is also a substantial provider of rare earth elements, including nearly 50% of the world’s supply of semiconductor grade neon. Crucially, Ukraine is the “breadbasket” of Europe supplying much of their grain, vegetables, sunflower seeds, milk and meat.
Russia’s Outsized Share of Global Energy & Key Commodities
Source: IMF; Goldman Sachs Global Investment Research.
Considering that the EU is approximately 15% of global GDP1, the knock-on effects of its slowdown should not be underestimated. And with commodity prices remaining elevated for longer, stagflation risks (high inflation and weak growth) have increased, not just for Europe but for the world at large. The U.S. is relatively well positioned, given that we are a major energy and food producer, but is not entirely immune to stagflation or recession.
Is U.S. Consumer Demand Growth Sustainable?
A key question for the rest of 2022 is can U.S. consumer demand, responsible for nearly 2/3rds of GDP, continue to rise without support from fiscal or monetary stimulus? This year will likely see the largest one-year decline in the federal budget deficit in U.S. history, with a $1.3 trillion drop expected in 2022 as COVID relief lapses. At the same time, the Federal Reserve is raising interest rates and no longer buying billions in bonds and mortgages monthly. It is not surprising 30-year mortgage rates were recently at around 5.2%, up more than 60% since the start of 2022.2
U.S. wages that are rising, but not fast enough to keep up with inflation, present another challenge for consumers. Real wages (wages minus inflation) have been shrinking for five months running. Ultimately, inflation is determined not by what companies want to charge, but by the willingness of customers to accept the price hikes, and we are seeing customers balk for the first time in recent memory. This could be an inflection point — forcing businesses to either cut costs, improve productivity or reduce profit margins.
Fed Funds Rate and US Inflation: A Big Differential
Source: Federal Reserve.
While U.S. corporations reported record profits and profit margins for 2021, analysts are now revising corporate earnings forecasts downward. There may be more downside in the months ahead as analysts confront the reality of a challenging economic backdrop. With this in mind, volatility in the major equity indices could well continue.
S&P 500 Earnings Estimates Are Being Revised Downward
Percentage (%) of S&P 500 Companies with Q1 Positive and Negative Guidance
Source: FactSet as of Q2 2022.
Could We Be Heading For a Recession?
The short answer is yes. As painful as recessions are, they are a natural and necessary part of the economic cycle, despite the financial media making them sound like a death knell. For perspective, we look not to the stock market but to credit markets since in many ways they are the lifeblood of the economy, as borrowing decisions that are reflected by the credit markets affect investment and spending. In the past month, the credit markets have started to indicate higher risk of recession but if or when that might actually materialize is anyone’s guess. The charts below show two key indicators we monitor for signals related to the health of the economy and functioning of the capital markets.
The first is the OFR Financial Stress Index (OFR FSI). This is a daily, market-based snapshot of stress in global financial markets. It is constructed from 33 financial market variables, such as yield spreads, valuation measures and interest rates. Those indicators are starting to edge upward, although not to an alarming degree within the context of recent history.
OFR Financial Stress Index
Source: Office of Financial Research, St. Louis Fed, ICE.
Another indicator to watch is the yield spread between short- and long-term Treasury bonds. In the recent past, recessions have followed an “inverted yield curve”, in which 2-year yields are higher than 10-year yields. Currently, the yield on 2-year Treasuries is about the same as the yield on 10-year Treasuries. The Federal Reserve seldom raises interest rates when the yield curve is flat or inverted. One example of the Fed not raising rates at a time that they might have otherwise due to an inverted yield curve is 1999. We all know what the next year, in fact the next four years, looked like for the market: a sharp drop followed by stagnation. Still, over time there is a clear general pattern — the Fed over-eases (1988, 1999, 2002, 2008-2014) and then course corrects by overtightening (1989, 2000, 2004-06, 2018).
2 and 10 Treasury Spread
Source: Bloomberg LP.
Third-Order Thinking
Reporters on current events tend to apply first-order thinking: A is happening which will lead directly to outcome B. Readers are then drawn into making conclusions based on a very limited information set. For the invasion in Ukraine, first-order thinking might be: Russia is threatening not only Ukraine but Europe; the EU will respond by spending relatively more on defense and less on other priorities.
However, the world does not stand still when threats are on the rise; in fact, things can start moving faster. Second-order thinking attempts to look past the simplest cause-and-effect outcome by focusing on the various potential intermediate-term trajectories. EU defense spending can encompass more than just military spending and include an even stronger focus on developing renewable energy and sustainable, regenerative agriculture, both of which are in the interest of national security given the desire to eliminate reliance on Russia.
By the end of 2022, the EU is striving to reduce its dependence on Russian gas by 67.0% and be free of Russian gas by 2030 as it simultaneously works on developing renewable energy and new alternatives to natural gas such as bio gas and green hydrogen. Some major beneficiaries of EU self reliance could be U.S. infrastructure companies that liquify natural gas and transport it to Europe, where gas prices are 10 times what they are in the U.S.
Third-order thinking is strategic, long term and aligned with our focus on managing wealth over multiple generations. Applying third-order thinking to the potential transformational impacts from the pandemic, as further amplified by the Ukraine invasion, we see the potential for a shift from globalization to regionalization.
Necessity as the Mother of Invention
As was proved during the pandemic, companies in Europe, the U.S. and elsewhere can deal with challenges in a variety of ways (restructuring workforces, changing packaging, switching suppliers and leveraging technological innovation as well as automation). Some examples:
- Tesla tweaked power steering and removed lumbar support from some car models to lower semiconductor use.
- FedEx installed a robotic sorting system in its Queens, NYC facility to address increased demand and staffing shortages.
- Walmart created new “pop-up” e-commerce distribution centers to handle demand.
- Pepsico teamed up with Schneider Electric on “Pep+ Renew,“ an initiative to accelerate the use of electricity from renewable energy in food production.
Work-around efforts like these tend to give birth to new companies and industries, presenting new investment opportunities.
Pain and Gain of Regionalization
Countries and companies across a variety of industries, for example pharmaceuticals, semiconductors and electric battery manufacturers, are starting to rethink their supply chains. A major focus is diversifying production away from one or two main suppliers often located across the globe and either onshoring back to the U.S. or near shoring to Mexico or Canada.
A shift to regionalism has the potential to make goods more expensive in the short-to-intermediate term, contributing to inflation at a higher level than we have seen prior to 2021. Eventually, though, supply chains that are closer, more reliable and more secure could result in a resurgence in U.S. manufacturing, broader regional economic prosperity and possibly the offsetting of higher labor costs with lower shipping and transportation costs.
Portfolio Positioning
As we turned the calendar to 2022, we cited a greater-than-usual level of uncertainty, with many catalysts for higher volatility and a wide divergence in opinion on Wall Street as to market direction. We do not place much value on Wall Street or economic forecasts because they are often wrong, but the disparity in outlook was telling. We also know that prevailing opinion can be something of a market force in and of itself, with concerns raised by the media influencing investor action.
With inflationary and deflationary forces in a tug-of-war, and potential outcomes especially wide, we spend our time and energy building and managing well-diversified portfolios that can navigate through periods of higher uncertainty and stress-testing them for a variety of market scenarios. At this time, we have populated portfolios with ingredients that we think can mitigate many of the risks, including higher inflation, interest rates and market volatility, as well as taking advantage of opportunities. On this latter point, it is important to recognize that the flipside of risk is opportunity—when the general market tone is marked by risk aversion, that’s when our allocations to active managers (vs. index funds) in various parts of the portfolio can take advantage of the discrepancy between current asset prices and fundamental value.
Risks and Opportunities: Exposures Covering Multiple Outcomes
Do we see any third-order effect opportunities? Possibly. For example, investments related to sustainable agriculture and climate solutions each presented opportunities prior to the Russian invasion of Ukraine. The knock-on effects we are seeing from the conflict, including the impacts on markets for both food and energy, only strengthen the case for each of those opportunities.
Total Asset Strategies
In times of higher market volatility, extra care is warranted when it comes to investing or divesting and diversification. If you just had or are about to have a liquidity event resulting in a significant amount of capital to reinvest, your Wetherby team can advise you about the optimal way to do that, perhaps in increments. If, on the other hand, you need to raise cash for a major purchase or other need, market volatility can wreak havoc with how much you will net, not to mention taxes. In any such case, your Wetherby team is always available to help you find the most effective way to achieve your goals under the current market conditions.
We work to keep your investment portfolio appropriately diversified and are focused on actively rebalancing as necessary. If you have holdings which your Wetherby team is currently not monitoring – such as real estate, company RSUs/RSAs/stock options, etc. – that are not diversified and could increase risk in a volatile market, we encourage you to discuss them with your Wetherby team to ensure that your complete financial picture is taken into account when managing your portfolio. As always, please feel free to reach out with any issues or concerns.
In Closing
The Russian invasion of Ukraine is a good reminder that geopolitics can lay waste to the best laid plans. History is rife with examples of participants and observers who have misjudged the duration of war, its course, the ultimate victors and the ramifications. As such, we will continue to monitor rapidly evolving market and economic conditions relative to our clients’ objectives and portfolios. In the meantime, we continue to hope for a speedy resolution and healing for the millions of families living in mourning and in fear.
Sources:
1Statista. “European Union: Share in global gross domestic product based on purchasing-power-parity from 2016 to 2026.” As of April 2022.
2Bankrate. “Today’s 30-year mortgage rates.” As of April 28, 2022.
Index Definitions:
U.S. BONDS: Barclays Capital U.S. Aggregate Bond Index – Covers the U.S. Dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, Government-Related, Corporate, MBS, ABS, and CMBS sectors.
COMMODITIES: Bloomberg Commodity Index – A broadly diversified index of futures contracts intended to be representative of the commodities market. It currently includes 19 commodity futures in seven sectors.
MUNICIPAL BONDS: Barclays Capital Municipal 1-10 Year Index – Tracks the broad market performance of tax-exempt bonds with 1 to 12 years remaining to maturity.
10-YEAR U.S. TREASURY BONDS: BofAML U.S. Treasury Current 10 Year Index – The market value weighted index of public obligations of the U.S. Treasury with maturities of 10 years.
INT’L DEVELOPED EQUITIES: MSCI EAFE Index – A free float-adjusted market-capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
EMERGING MARKETS EQUITIES: MSCI Emerging Markets Index – A free float-adjusted market-capitalization index that is designed to measure equity market performance in the global emerging markets. Consists of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. LARGE CAP EQUITIES: Russell 1000 Index – Measures the performance of the large-cap segment of the U.S. equity universe and represents approximately 92% of the U.S. market.
U.S. SMALL CAP EQUITIES: Russell 2000 Index – Measures the performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small-capitalization securities market.
LIQUID HEDGE FUNDS: HFRX Global Hedge Fund Index – A daily-valued index designed to be representative of the overall liquid hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.
ILLIQUID HEDGE FUNDS: HFRI Fund Weighted Composite Index – A global, monthly-valued, equal-weighted index of over 2,000 single-manager funds that is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies. Constituent funds report monthly net of all fees performance in U.S. dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.
GLOBAL REITS: FTSE EPRA/NAREIT Developed Real Estate Index – A measure that tracks the performance of listed real estate companies and REITs worldwide.
DIVERSIFIED PORTFOLIO: 10% U.S. Municipal Bonds; 10% U.S. Core Bonds; 25% U.S. Large Cap Equities; 5% U.S. Small-Cap Equities; 22% Int’l Developed Equities; 9% Emerging Markets Equities; 4% Global Infrastructure; 13% Illiquid Hedge Funds; 2% Commodities.