Geopolitical Tensions Continue, Elevated Inflation and Tightening Financial Conditions
April proved challenging yet again for investors with the traditional 60/40 stock/bond portfolio falling 6.9%; its worst month since March of 2020. The tech-heavy NASDAQ index experienced its single worst month since 2008, dropping 13.3% as financial gravity seems to have found the previously untouchable growth stocks.
Thus far 2022 has been one of the most difficult investing environments on record as numerous macro factors have conspired to depress growth and risk appetites. The record fiscal stimulus following the COVID crisis has ended and it’s knock-on simulative effects likely fully digested by now. On the monetary side, the Federal Reserve appears committed to tightening policy through all available means; balance sheet run-off/quantitative tightening and well-telegraphed interest rate hikes. Lastly, structural upward pressure on the US Dollar, higher credit spreads, elevated commodity prices and a negative wealth effect all serve to further tighten financial conditions likely weighing on near term growth.
The tragic events in Ukraine viewed from a financial perspective will have a similar effect as COVID in accelerating a number of trends that were already well underway. Countries must now reconsider their food and energy security. Companies will need to further shift their supply chain priorities from “just in time” to “just in case”. This shift will likely involve reshoring production to higher cost domiciles, and holding higher inventories than previously considered necessary. The deflationary forces of globalization are abating as the world becomes more polarized and volatile. Deglobalization will mean higher input costs, product availability disruptions and more persistent inflation.
Higher costs and tightening conditions applies to all financial asset classes concurrently, causing correlations between stocks and bonds to increase sharply. With bonds failing to play defense in a tightening environment the overall risk of traditional portfolios increases leaving investors doubly exposed in a stagflation scenario where stocks and bonds fall together. This all-too-common blind spot in traditional portfolios to the scenario of rising inflation and falling growth is a major reason why Oxford believes in further diversification beyond traditional stocks and bonds.
Investors have been well rewarded in 2022 for diversifying portfolios into real assets and certain active strategies such as trend following and global macro. Prudent allocations to these areas has provided much needed ballast to portfolios, and provides a ready source of liquidity to rebalance into depressed financial assets, further improving long term returns. In periods where mentalities shift from “nominal” to “real”, investors remember the importance of holding non-financial assets and active strategies capable of profiting from volatility and downtrends.
While the macro backdrop appears challenging, we can take solace in a number of items. Firstly, while inflation is likely to remain elevated, the absolute level of CPI probably peaked in April as base effects from COVID begin to roll off and commodity prices come under some short term pressure. Additionally, asset valuations appear much more reasonable after a horrid start to 2022 as the market discounts the known challenges noted above. Much of the obvious froth in technology names has subsided, and both stocks and bonds valuations appear slightly more reasonable at current levels. The longer term prospects for diversified portfolios are stronger now than they were 6 months ago despite the challenging macro environment.
Squaring Strong Labor Market with Poor Consumer Sentiment
Headlines continue to tout tightness in the labor market and the apparent newfound bargaining power of workers. Overall nominal wages increased 5.5% year-over-year through the end of March; well above long-term trends.
Concurrently, consumer sentiment measures are low and trending negatively. The University of Michigan Consumer Sentiment Index is currently below 60; numbers not seen since the 2008 Global Financial Crisis. Employed workers are earning more than ever before, but consumers are increasingly dour? What gives?
While nominal wages have been increasing at 5.5%, headline CPI for the same period was 8.5%. Compounding the issue, prices of food, energy and rent, which comprise the majority of spending for lower wage cohorts, have all been increasing well above headline numbers. With inflation running this hot workers are earning less in “real” (inflation-adjusted) terms despite the above trend growth in nominal wages. Negative real wage growth means workers take home pay buys fewer goods and services thus reducing standards of living. Persistently high inflation is making Americans poorer and likely explains why consumer sentiment is low and trending negatively.
Yield Curve Inversion
The yield curve inverting is arguably the most famous recession indicator amongst professional investors. As such, inversions garner headlines when they infrequently occur. However, yield curve inversions tend to be a noisy and nuanced signal of impending recession.
What is a yield curve inversion?
An inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit quality (e.g. 2-Year yields exceeding 10-Year yields).
What does an inverted curve mean?
Curve inversions represent a strong market signal that bond investors believe higher short term rates will dampen economic growth and inflation resulting in lower interest rates in the future, and increasing the attractiveness of longer duration bonds. If the bond market is correct in this view, the economy is headed for disinflation, contracting economic growth and potentially a deflationary recession.
Recessions have historically occurred only after the majority of the yield curve inverts. Additionally, recessions typically coincide with the yield curve re-steepening as monetary policy maker’s sharply pivot towards looser policies, interest rates are cut and investors rush to the safety of cash and money markets.
The Federal Reserve claims to have the tools necessary to tame inflation without hurting employment or economic growth. The bond market doesn’t seem to be buying that narrative, but history suggests “don’t fight the Fed”. We are keeping a particularly close eye on the bond market for further signals.
The above commentary represents the opinions of the author as of 5.22.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2205-22.