2022 is shaping up to be close to what we outlined in our Outlook at the beginning of the year. The economy is returning to pre-covid levels, consumers are returning to travel and services, and corporations are still showing improved earnings. Market volatility has increased as we expected; we saw a -12% decline to begin the year, followed by an +11% rally in about 1 and a half weeks. Over the last 10 days, the market has pulled back and is close to the February lows. The jumpy moves – rocket rallies followed by air pockets – show that investors are unusually uncertain about the market trend and macro-outlook, which means prices must move far and fast as they search for buyers and sellers with any conviction.
We started the year with cash on hand and have been adopting a more defensive stance over the past few weeks. Market sentiment, expensive valuations, Ukraine, Chinese Covid and a hawkish Fed have turned market prospects more negative than we have seen in years. The Fed has turned far more hawkish than most investors anticipated, and they are expected to raise the Fed Fund rates from 0.5% currently (after the initial raise in March) to 3.0% at the end of this year, and even higher next year. They will also start reducing the size of their balance sheet. In anticipation of these actions, markets have already moved long-term rates from about 1.5% at the beginning of the year to almost 3% currently. On balance, monetary policy is no longer supportive of asset prices.
On the positive side of the ledger, the economy is still expanding enough to keep earnings growth on track. This is the key which will determine the path forward. Any deterioration in the economy will impact earnings, which is likely to further pressure equity markets for an extended period. Another possible positive is that investors have quickly become very pessimistic, factoring in many of the bearish trends in monetary policy and inflation that have evolved. As we have observed many times, the markets often peak when optimism reigns and markets often bottom when everyone is pessimistic.
We believe that the market will be range bound in the near term, with a possible negative bias, until the Fed tightening actions can demonstrate that inflation has peaked, and the economy is still on stable footing. While it is difficult to see extended upside from current levels, there already has been a significant amount of damage in many names, with a substantial percentage of the S&P down 20% year to date. It would not surprise us to see the market be more resilient than most expect as negativity is pervasive. The S&P 500 multiple has come down from about 21x earnings multiple to just below 18x currently. If we can get market multiples below 17x earnings it should provide some attractive long-term entry levels in stocks.
Interest Rates, The Fed, and the Economy
During the quarter, the yield curve inverted (short rates are higher than long rates). This action has been followed by siren calls for a recession from many pundits. While an inverted yield curve is indeed a warning sign that we are taking seriously, it is important to note that it is not always an immediately bearish sign. Often, the market and economy continue to do well for a while, after which, it later runs into trouble. The last 4 times the YC inverted, the market continued rallying for an average of 17 more months by an average amount of 28%. Before 1985, immediate subsequent returns were mostly negative.
The question is: can the Fed engineer a soft landing? Such an outcome would be a surprise and very bullish. The central bank tightened monetary policy significantly in 1965, 1984 and 1994 without precipitating a recession. However, in all these “soft landing” episodes the Fed did not tighten sufficiently to push up the unemployment rate.
Our current situation is quite different – the unemployment rate is much lower (at 3.8%), and inflation is far above the Fed’s 2% target. The Fed has made it clear that they intend to raise interest rates quickly and reduce the size of the balance sheet. In fact, they have directly warned that they need financial conditions to cool down and rein in inflation.
To create sufficient economic slack to restrain inflation, it is likely that the Fed will have to tighten enough to push the unemployment rate higher. The point here is that the Fed has never achieved a soft landing when it has had to push up unemployment significantly. So, the odds are not with the Fed to achieve a soft landing, but it is always possible.
In summary, history has shown that it is possible to achieve a soft landing – slowing the economy enough to cool inflation, but not causing a recession. Such an outcome would be very bullish but seems improbable. Right now, we do not have any economic signs that that a recession is imminent, but to be fair, it will be at best coincident, if not lagging the equity market.
Equity and Fixed Income Strategy
Interest rates have rocketed higher during the quarter, and this has had the result of reducing fixed income and equity values. YTD, Long Duration Fixed Income is down -18%, Small Cap Growth is down -21% and Speculative Growth (using the famous ARKK fund as an example) is down -47%. We have taken a very conservative fixed income posture for quite some time, and our equity exposure is defensive as well. We have been able to dodge the worst of the carnage and continue to adopt a modestly conservative position in both the bond and stock portions of our portfolios. While the macro environment does indeed look challenging, earnings are holding up and pessimism is rampant. While not a guarantee, this often is a harbinger of a wide trading range as the market digests large reductions in fiscal and monetary policy while the economy is still expanding – albeit modestly.
It is hard to see how the market rallies while the Fed is determined to lower inflation and warning they are open to reducing asset values to achieve their objectives. With a midterm election looming, they are compelled to cool inflationary pressures, or expectations for future inflation will set in. The war in Ukraine, recent Chinese economic results and lock downs will make this even more difficult. However, if the Fed can navigate through the uncertainty, and inflation does start to cool, there is meaningful upside to the market. As always, the future is very murky.
The global economic expansion is proving to be durable despite hits to sentiment. The cyclical bear market in bonds is not over, but a pause or at least a technical correction is likely. Equities need a pause in rising yields to make some headway. Corporate profit trends remain supportive, but rising rate yields will continue to pressure equities. Our current view is that the market is unlikely to make meaningful upside that will stick in the near term, so our base case scenario is a sideways market for most of this year. We also have less likely scenarios that are both more bullish and more bearish. The bullish scenario would be accompanied by lower inflation, a Fed that does not need to be as hawkish as it is warning, and a soft landing. The bearish scenario is that the Fed continues to tighten as inflation stays sticky and that eventually something breaks in the financial system. Neither bull nor bear can be ruled out, but our base case is volatility in a wide range. For now, we will keep an element of caution in the portfolios and adjust our positions as the trends emerge.