I hope this letter finds you well and celebrating life. One of the many blessings of having younger children is that there is always cause to celebrate, often things or occasions I might have overlooked or missed. Butterflies, snails, warm pools, and pizza topped the celebratory list this weekend.
Since the beginning of the year, the financial markets have certainly not found occasion to celebrate. They have been on tenterhooks lately for two main reasons: rate hikes and Russia. The invasion of Ukraine by Russia is a humanitarian tragedy and not to be marginalized in any aspect. The initial news of the invasion set off a flight to lower-risk assets, although the capital markets have subsequently recovered from the initial shock. This situation is very fluid, although I do not believe it affects the macro economic landscape or corporate earnings materially. Russia and Ukraine combine for well under 1% of U.S. imports and exports and account for less than 1% of revenue exposure to S&P 500 companies. Impacts to our domestic economy would likely come from higher global oil and commodity prices. I believe any material downdraft in equities would likely be temporary and a buying opportunity.
Raising interest rates to battle inflation can put pressure on equities in the short term, especially secular growth stocks with higher valuations. The Federal Reserve (Fed) is in a delicate position: how quickly can it tighten policy to curb inflation without triggering a recession?
No matter where you turn, you can see significant evidence of inflation. This is due to the both the massive money supply and stimulus provided by global governments coupled with the speed at which the global economy was halted and the subsequent strength of the rebound. You quite simply can't put 40% more money into the system and expect there not to be consequences. I found it odd in 2021 that the Fed described inflation as transitory, and they have since ceased using the word.
Despite Russia and interest rates, I do not want to paint a dour picture of our current economy. Economic and earnings growth are expected to continue throughout the year, and I would describe the post-lockdown recovery as transitioning from energetic youthfulness to awkward adolescence. It’s still growing, albeit at a slower pace, and there are worries about what happens next. The next leg of the economic cycle is typically driven by the quality of earnings rather than an expansion of the valuation multiple investors are willing to pay. For 2022, the key to which sectors and stocks perform well likely falls back to the historic quote from John Houseman, “they make money the old fashioned way… they earn it.”
Through all of the volatility and uncertainty, we have a tendency to focus on the short term and the news cycle narratives. As an investor and a financial advisor, I find it critical to approach the capital markets from a more strategic vantagepoint. What I have been observing lately are some interesting structural trends.
The U.S. economy and financial markets have been in a distinct cycle for the last forty years or so. We seem to have accepted these conditions as “normal,” however, I do not believe that holds true in absolute sense nor when you examine economic history through a longer historical lens. I believe economic and political conditions have led to this longer-term cycle, and as these conditions change, this cycle will end and evolve. This intrinsic view and character of what is ‘normal’ over the last forty years - moderate to low inflation, moderate to low interest rates, and rising earnings is all that most 45 years olds have ever personally known. Experientially, it is entirely normal and ordinary, but only within the context of this forty year time frame. Consider:
When you consider the current geopolitical climate, inflation expectations, and rising interest rates, I believe we may need to consider a different portfolio playbook now, one that battles both inflation and rising interest rates. Asset classes that have historically worked well in similar environments include commodities, equities with consistently growing dividends, real estate, and floating rate or fixed-to-float fixed income securities.
Dealing with all of these changes is challenging, and not for the faint of heart. Thank you for your business and your continued confidence. If we may be of service in any capacity or answer any questions that you may have, please do not hesitate to reach out to us.
Best personal regards,
Erik Melville, CFP®
Senior Vice President/Investments
(772) 672-5125 | [email protected]
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