There’s a lot going on in the world right now. If you’re trying to keep track of it all, you might feel a bit like the fellow on the Ed Sullivan show who ran around spinning plates and other kitchenware on sticks.
Understanding how all of today’s events intertwine, how they’re affecting the investment markets, and what it all means for future US economic direction requires a little patience. We already know what the three questions on investor’s mind are – because they don’t change much over time:
- What’s happening to the investment markets?
- What does it all mean for the U.S. economy going forward?
- What, if anything, should I do about it in my portfolio?
We’re going to do our best to unpack it for you in this analysis. Pour yourself a cup of your favorite beverage. Here we go:
The Ukraine Conflict
The toll of human suffering and the displacement of Ukraine’s citizens continues to worsen. Putin wants what he wants, and no one seems to be quite sure what that is. The coordinated sanctions are decimating Russia’s economy but will take more time to fully put the screws to Putin and his close circle of oligarchs and military leaders.
But it is working. One of the analysts we follow offers the following hopeful perspective:
Russia needs an out. The takeover of Ukraine did not go according to plan. The entire world has risen to oppose the invaders. The Russian economy is now looking at future double-digit declines in quarter over quarter GDP. Russians with financial means are considering leaving the country.
Blaine Rollins, CFA Hamilton Lane
Underneath the conflict, people are learning how important Ukraine is to the global supply chain. According to AgWEB Farm Journal, Ukraine ranks in the top ten countries for global export production of sunflower oil, corn, barley, wheat, rapeseed, soybeans, and iron and steel. The disruption of these commodities will translate into higher prices in the short and medium term.
Enter China
The world’s second largest economy has embraced a zero COVID policy, meaning one positive case in a factory of 700 people results in a complete shutdown of that facility for ten days. As of this writing, China’s in the midst of another large COVID spike. That means continued disruption in export goods to the world.
Takeaway #1: Wars – whether against countries or viruses – have economic consequences, not only on the combatants but on their trading partners as well. With global supply chains already snarled from COVID, the Ukraine conflict and China’s zero COVID policy will weigh on global economic growth as their respective export machines labor to meet demand.
Back at Home
If you were going to bake an inflation cake, you’d need the ingredients, right? Take wage growth, a tight labor market, rising commodity prices, and a healthy dose of cheap money injected into the economy by Washington, and, well, there’s your recipe.
The most recent numbers reflect year-over-year growth in inflation of 7.9%, the highest rate since 1982. To be sure, much of the inflation we’re seeing may end up being temporary due to the supply chain kinks, but inflation is back and is likely to be with us for a while. Even if we back out the temporary spikes in things like used cars and rent escalation, you’re still looking at long-term inflation in the 3%-4% range – meaningfully higher than we’ve experienced in the last decade.
It may be a year or more before we see inflation abate, but the Fed’s commitment to raising interest rates will help tamp down the current spike – if they get it right. Should the Fed raise rates too much or too quickly (or both), we run the risk of a recession. Indeed, the odds of a recession have increased. All eyes will be on the Fed and its actions in the coming months.
The performance of the stock market last year was largely attributed to the incredible growth in corporate earnings. The average quarterly growth rate in earnings exceeded 20 percent. As inflation has permeated the economy, the expectation for quarterly corporate earnings growth has been declining. The expectation for the first quarter of this year is about 5 percent. While that is a positive number, the rate of annual change is clearly decelerating.
Takeaway #2: Higher inflation and slowing economic growth due to supply chain issues are creating a headwind for corporate earnings.
Putting it all Together
Now that we’ve set the table, let’s answer the three burning questions:
- How is all this affecting the investment markets?
- What does it mean for future US economic growth?
- What, if anything, should investors do now?
How is all this affecting the investment markets?
Coming into this year, we reminded everyone we could that three years in a row of double-digit returns in the U.S. stock market was very rare, and they should expect more modest returns this year. We had no idea what the cause of the pullback would be, but statistics were on our side. Sure enough, as the quarter unfolded, stocks pulled back, and volatility increased. First, it was because of the uncertainty around the Fed raising interest rates, and then it was because Russia invaded Ukraine.
At its worst (as of this writing), the S&P 500 index was down 12.5 percent. On March 16th Federal Reserve Chair Powell provided the financial markets with some of the certainty it had been longing for, and since then the stock market has rebounded.
We’ve talked a little bit about inflation, and we’ll be talking about it in more depth at our upcoming April 21st webinar. Companies have an uncanny knack at being able to pass increased costs on to you and me as consumers. As a result, they have historically been able to maintain corporate earnings at least in line with the annual rate of inflation. (That’s why stocks are the best defense against inflation.) Provided that holds true this time around, we still expect stocks to provide investors with returns in the 5 to 9 percent range this year.
We knew interest rates were going to continue going up this year and the Fed confirmed that at their recent meeting. The rest of the market knew it too and that’s why we’ve seen the yield on bonds increase so dramatically this quarter. Remember, when interest rates increase, the value of existing bonds decline. The Bloomberg US Aggregate bond index is down 5.4 percent as of this writing. By the time we get to the end of the year and include the interest earned on the bonds, we expect this asset class to breakeven.
With that background as context, we expect the typical balanced asset allocation to end the year with returns in the range of 3 to 5 percent, slightly below our long-term expectations.
What does it mean for future US economic growth?
Coming out of the Covid experience, the U.S. economy has experienced year-over-year growth at a breakneck pace. Unemployment is 3.5 percent. It took more than a decade for unemployment to reach this level after the Financial Crisis of 2008. There are 1.7 jobs open for every unemployed person.
Wages grew 5 percent over the last twelve months as employers have been willing to pay even more to fill open positions.
Consumers have, until recently, had more money in their pocket than ever before because they weren’t having to drive to the office. They’ve been using that extra money to buy more stuff. And a Google Trends search for terms like “cheap”, “coupon” and “discount” show that they have yet to change their behavior – despite the inflation they’re complaining about.
This is all contributing to the inflation we’re experiencing, and the Federal Reserve is finally stepping in to cool the economy. The Fed has a dual mandate to maintain full employment (check mark on that one) and maintain stable prices (x next to that one). Raising interest rates will increase the cost of borrowing. Whether it’s a business or a consumer, rising interest rates will reduce spending. That will translate into slowing the economy. And that will slow inflation.
Inflation is a hard battle to fight once it becomes entrenched. Looking back to 1980, the only way inflation fell once it exceeded the 5 percent level (7.9 percent at present) was due to a recession. We’re not suggesting a recession is eminent, but the risks of one occurring grow with each successive increase in rates by the Fed. If you’re in the market for a big-ticket item, you might want to wait nine to twelve months if you can. It will likely be on sale.
What, if anything, should investors do now?
As we’ve said numerous times before, markets dislike uncertainty. The result is elevated volatility. Investors don’t have to like the daily gyrations, but they need to understand it’s normal and natural. As the future becomes more certain, markets tend to settle down and start their advances again. We’d advise investors to look for signs of increasing certainty about the Ukraine conflict, Fed policy to fight inflation, and corporate earnings strength.
If you need a bit more comfort, here’s a historical perspective: Bank of America looked at each time the markets have been down 8 percent or more the first couple of months of the year since 1960, and what happened in the remaining time that calendar year.
We have no idea whether this historical record is indicative of how 2022 will end up. That’s not our point. It’s simply a record of history that suggests time is on our side. As of this writing, the S&P 500 index has rallied off the March 14th low and is only down 4.7 percent for the year.
Investors can’t control dictators, interest rates, or corporate earnings. But they do control their emotions, time horizon and diversification across assets. If you plan to be around for a while, and we hope that you do, today’s crises will be in the rear-view mirror at some point – just like all past cataclysms. Remember: The world is always ending… it just never ends.
See you on April 21st for our quarterly webinar update.
Your First Coast Wealth Advisors Team
The S&P 500 index is an unmanaged group of securities generally considered representative of large U.S. publicly traded companies. The index is owned and compiled by Standard and Poors. Individuals cannot directly invest in unmanaged indices.