Happy Spring! In the midst of all the turmoil we find ourselves faced with of late we can still depend on Mother Nature to put on her usual stupendous display, reminding us that hope always springs anew after even the grimmest of winters.
This year started with apprehensions about inflation, rising interest rates and the Omicron surge. While the Omicron surge (thankfully) in the US slowed as quickly as it had begun, the worries about inflation and the interest rate increases designed to counter it have continued to figure prominently in the news and in the calculations of market participants and economists alike. Adding to and further exacerbating those concerns has been the onslaught of war in Ukraine, with all the terrible consequences and suffering inflicted on one nation by another.
The economic sanctions adopted by the US, Europe and others have punished the Putin regime through pressure on the Russian economy and will inevitably help influence the outcome of the Russian invasion. We’re heartened by the response of so many nations and hope for a speedy end to the bloodshed and suffering of the Ukrainian people.
The sanctions have also, not surprisingly, contributed to an increase in inflationary pressures through rising costs for oil, natural gas and other commodities found in abundance within Russia. That, in turn, could quicken the pace of interest rate increases by the Fed as they attempt to use higher rates to reduce inflationary pressures and bring inflation back to their targeted rate of 2 to 3%.
An increase in interest rates over time isn’t necessarily a negative thing. Higher rates reward savers, giving them a chance to receive meaningful income from their most conservative holdings like savings accounts and CDs. Further, if rates rise accompanied by healthy demand and a growing economy, stock investors will be happier accommodating higher rates, figuring higher quarterly profits will come along with them. Companies will also be better prepared for higher borrowing costs if their businesses are profitable and continue to grow. With the inflation horse already out of the barn however, rates can be seen as rising to fight inflation caused by supply constraints and other measures and those rising rates will be perceived differently by some who won’t feel nearly as comfortable.
Today we have both a growing economy and increased inflation from supply constraints and other factors. The Fed started a cycle of increasing interest rates with its recent .25% hike in the Federal-funds rate in March and so far, have penciled in 6 more increases for this year with perhaps additional in 2023. Will this pace of rate increases make a meaningful dent in inflation? Only time will tell and there are those who think it will and those who are sure it won’t. One nagging fear that can surface in the beginning of a rising rate regimen is that the Fed will go too fast and too far, eventually slowing the economy to a crawl or even tip it into recession.
While a recession in 2022 doesn’t appear to be the base case in the minds of many economists, it is possible that the economy could be moving towards characteristics more typical of ‘late cycle’, which has included higher inflation, strong commodity prices, and tight labor markets.
Stocks are not the only investments affected by rising rates, bonds are as well. When interest rates rise the value of many types of bonds decrease to make the bond yields competitive in the new higher rate environment. Bonds with short maturities aren’t as sensitive to interest rate increases and other types of bonds, those with yields that adjust as rates rise, are also not as sensitive to rising rates as conventional bonds are. In our clients' portfolios, we’ve had meaningful portions of both shorter maturity and “floating rate” bonds and this has been helpful so far this year.
Our economy has been resilient to the challenges posed by the pandemic and higher rates of inflation thus far. Corporate profits have expanded, and GDP has risen steadily from the dislocation of early 2020. Each of the last 3 years has been profitable for a diversified portfolio. Sooner or later, of course, we’ll have a year that isn’t positive. It’s important to remember that sort of result is part and parcel of a diversified approach to investing and a normal outcome over time.
We continue to take a disciplined approach to managing our clients' portfolios, paying particular attention to valuation changes within asset classes along with security selection for implementation. Periods of volatility can create opportunities as the markets in particular asset classes overshoot on both the upside and the down. While we cannot predict what the markets will do, we can certainly be cognizant of valuations, and we try to make good decisions both when particular asset classes look too expensive as well as when they go on sale.
We’re hopeful that the Fed is able, through judicious rate increases and by using some of their other monetary tools, to engineer a soft landing for the economy and a decrease in inflationary pressure. Most economists agree that the prospect for inflation to tail back over the next few years is highly probable.
While there is periodically the unexpected “black swan” (rare, unexpected event) to deal with, sooner or later they get swept up by the current of life and disappear downstream. In the meantime, we’ll hope for a cessation of hostilities in Europe and a return to a peaceful Europe.
We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.