“Whenever we consider an investment, we think just as much or more about what can go wrong as about what can go right, and we put the avoidance of losses on a high pedestal. That’s not the only thing we consider, but we put it first.”
– Howard Marks
We have now reached the halfway point of the year with equity markets sustaining the narrowly focused momentum of the first quarter. Against the backdrop of stresses in the banking system, rising tensions between the US and China, the ongoing conflict in Ukraine, and continued increases in interest rates, the seemingly limitless potential of artificial intelligence (AI) has driven a narrow group of stocks to extraordinary valuation levels. While we are skeptical of some of the hyperbolic near-term forecasts related to AI-specific capital spending, the ultimate impact on productivity and the economy is likely to be material and broad-based. This performance has masked quite pedestrian returns for the balance of the market. This broad market weakness is consistent with the continued deterioration in earnings expectations as investors wrestle with the potential path of the economy.
We wrote last quarter:
After the sharpest and swiftest tightening in Federal Reserve monetary policy since the late 1970s, history would suggest investors remain patient as businesses acclimate to higher interest rates. The lagged effect of sharply rising interest rates inevitably leads to cracks, if not outright breaks, in the economy… We anticipated a more challenging economy at this point in the year, although we respect the lagged effect of tightening monetary policy on economic activity.
Three months later, little has changed. The economy has remained resilient, buoyed by continued job growth while pockets of speculation in the market (read AI) have grown more extreme. There are, however, potential storm clouds that give pause to a more optimistic outlook for the economy. To list a few:
- Inflation, while moderating from last summer’s levels, remains higher than the Federal Reserve’s mandated target of 2%, suggesting rates stay higher for longer.
- Stresses in the banking system, including commercial real estate exposures as well as the potential for increasing regulation, will continue to constrain credit availability.
- The excess savings associated with pandemic stimulus appears to be largely exhausted.
- The yield curve remains inverted, forecasting a recession.
- Globally, the acceleration in economic activity in China associated with reopening has stalled.
When we weigh the evidence, our base case remains that a recession is increasingly likely. Markets are priced for a more positive outcome with earnings growth expected to reaccelerate in the second half of the year while credit spreads remain tight. Importantly, in an environment where risks appear to be rising, investors have the luxury of “being paid” to be patient. TINA (“there is no alternative”) is dead as equities must now compete with short term Treasuries yielding over 5%. We continue to position client portfolios to reflect our assessment of the imbalance between risk and reward in both equity and fixed income markets.
Philosophically, we strive to invest client assets with a bias towards quality and a focus on protecting capital in challenging market environments. “Participate but protect” will remain our mantra as we manage client portfolios.
We thank you for the confidence that you and your family have placed in our firm. Please do not hesitate to reach out to your wealth advisor or a member of the Investment Advisory team with any questions.