“We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.” – Jerome Powell, Chairman of the Federal Reserve
After rallying through the summer months on hopes that the Federal Reserve could successfully engineer a soft landing for the economy, markets have reacted violently to the aggressive actions and rhetoric by the Federal Reserve on the heels of continued elevated levels of inflation.
Equity markets have fallen back into bear market territory. Bond markets have been similarly challenged by the sharp increase in interest rates across the yield curve resulting in the worst bond market returns in the post-World War II era.
Certainly, this has been a challenging environment for investors with cash representing the only safe-haven asset class, albeit still losing purchasing power versus inflation. As we assess the investment landscape going forward, we believe our words from last quarter resonate:
Ultimately, the last forty years have been highly supportive for investors as the combination of rising margins, falling inflation, and falling interest rates supported expanding values across asset classes. The challenge for investors is determining whether shifts in the economy are cyclical or represent secular changes. While our crystal ball remains cloudy, the evidence is building to suggest we may be in an environment where inflation and interest rates trend higher over the longer term with profound implication for portfolios.
Where do we go from here? While our crystal ball remains unclear given deep geopolitical uncertainty (Ukraine, Taiwan, European energy to name a few), Chairman Powell has been explicit that the Federal Reserve will take the necessary steps to rein in inflation.
The combination of rising interest rates coupled with Quantitative Tightening (to the tune of $95B per month) appears to be having an impact on economic activity. Housing activity has turned decidedly negative with existing home sales down 20% and new home sales down almost 30% from a year ago. Housing affordability has fallen to pre-financial crisis levels suggesting housing is unlikely to provide a tailwind to economic momentum. In the meantime, industrial activity is sending mixed signals while the consumer appears to be increasingly looking to credit to sustain spending levels. Overseas, the strength of the US dollar is creating inflationary pressures, limiting foreign central banks flexibility to react to slowing economic growth.
While stocks have declined sharply, we continue to position portfolios with a focus on quality and stability given a more challenging underlying fundamental backdrop. Earnings expectations for the broad market are being revised lower but remain optimistic given slowing economic activity and persistent cost pressures.
For equity markets to move sustainably higher in the near term, one of two scenarios will need to play out: either economic growth and earnings accelerate, or valuation multiples expand.
In the first scenario, it is difficult to paint a picture for accelerating earnings in the face of 1) the Federal Reserve committed to slowing growth 2) margins sitting at peak levels 3) unit labor costs rising resulting in overall costs rising faster than revenues.
In the second scenario, falling inflation could drive interest rates lower supporting multiple expansion. In this scenario, however, we would question the ultimate level of earnings power for the market given the underlying economic backdrop that would push interest rates lower.
Our base case remains that earnings expectations must come down. We continue to own businesses with durable competitive advantages competing in more stable end markets selling at reasonable valuations. While not immune to the overall volatility of the market, these businesses should ultimately deliver fair rates of return for investors.
As mentioned earlier, fixed income markets have generated the worst returns in the post WWII era as interest rates have risen in response to higher inflation and Federal Reserve policy. While the rise in interest rates has resulted in sharp declines in bond prices, there is a silver lining for investors and savers. As interest rates have risen across maturities to levels not seen since the 2008 financial crisis, future return expectations are becoming increasingly compelling.
For instance, a 2-year US Treasury Note yields 4.3% as of this writing while longer dated investment grade corporate bonds are yielding north of 5%. While we continue to maintain bond portfolios with relatively short maturities given the potential for inflation to stay higher for longer, fixed income markets are beginning to reflect improving value for the first time in a decade.
Given the deep level of uncertainty across the spectrum of variables affecting capital markets, we continue to position client portfolios cautiously with an eye to protect against continued market volatility. It is during these challenging periods that asset allocation and financial planning take on even greater importance. We continue to work with our clients to ensure that allocations align with the long-term objectives, liquidity needs and risk characteristics.
We thank you for the confidence that you and your family place in our firm!