Navigating the Markets
I make the 250-mile drive from my home in Ann Arbor to Cincinnati several times a year to visit family. Although I have no need for maps or directions, I still use the Google Maps, Apple Maps, or the Waze app on my smartphone to inform me of road closures, traffic, and collisions ahead. This allows me to know what to expect when I travel and provides me with the option to choose a different route if needed. As we discussed in last quarter’s market commentary, our Investment Committee at GreenUp uses several metrics to navigate the markets as we travel along the road of long-term investing. As is sometimes the case with the navigation app on my smartphone, it can be uncomfortable at first to see yellow and red traffic on the road ahead. In our current market forecast, we are seeing splashes of red and yellow on the map: we see a near-term slowdown in markets, followed by a stretch of green for the second half of 2022, and another potential slowdown ahead before traffic finally clears and the map turns green again.
Red in the Rearview: Causes of Near-Term Slowdown
Using our GPS analogy, we have been stuck at a standstill in traffic as we stare at a bright red bar impeding our progress. The good news is that the traffic is starting to flow, and we are moving again. The path ahead is no longer a deep red but instead trending towards yellow and followed soon after by stretches of green.
In our last commentary, we anticipated increased volatility in 2022, which has certainly held true in this first quarter. Major stock indexes dropped into correction territory with even fixed income indexes having a negative return year to date before partially recovering by the end of the March. Inflation levels, measured by the Consumer Price Index (CPI), continue to surpass economists’ expectations with the latest CPI measurement including food and energy registering at a year-over-year increase of 7.5%. This is the highest CPI reading since 1982. The conflict in Ukraine and current Federal Reserve actions are pairing with an already fractured supply chain to continue to impact inflation: here, we cover what that means for our investors.
The Russian Invasion of Ukraine
Inflation remains high due to continued supply chain issues which is now exacerbated by high oil, natural gas, and wheat prices, which are the main commodities exported from the Ukraine and Russia.
In 2021, according to the U.S. Energy Information Administration, Russia was the largest natural gas-exporting country in the world, the second-largest crude oil exporter, and third-largest coal-exporting country. Russia’s invasion of Ukraine drove the price of oil, already on the rise due to the economic recovery following the COVID pandemic lockdowns, to levels not seen since 2008.
The sanctions implemented by the Western World are attempting to cut off Russia and Russian oil from the world market. Suddenly decoupling from a major exporter of energy is easier said than done. Our expectation, based on the current geopolitical climate, is for oil prices to decrease through 2024 per the oil futures market. Unfortunately, inflation is the main byproduct of high energy costs across a wide array of goods, not just gasoline.
Another economic consequence of Russia’s invasion of Ukraine is exacerbating the rising price of food. Ukraine is the largest exporter of sunflower and sunflower oil, fourth largest barley exporter and corn exporter, and eighth largest wheat exporter in the world. The Black Sea region is known as the “breadbasket of the world.” Russia and Ukraine together account for 30% of the world’s wheat exports, supplying millions of tons of wheat to the Middle East, Africa, and South Asia. Because of Russia’s attack on Ukraine, Ukraine’s government has banned the export of wheat, oats, and other staples in order to feed its own citizens and prevent a humanitarian crisis within the country.
With more money being allocated toward gas, food, and all necessary goods from a family’s budget, less money may be available for consumers to spend on discretionary purchases. A potential for a decrease in consumer spending can be concerning since 68% of the United States’ Gross Domestic Product, commonly abbreviated as GDP, (the measurement of economic growth exhibited in a country) stems directly from the consumer.
If the geopolitical situation does not get worse from here, we may be able to get past the current near-term slowdown and see our smartphone maps turning green. As much as the situation in Ukraine pains us from a humanitarian standpoint, we will go back to our thesis from last quarter as we monitor the tug-of-war between strong corporate earnings and inflation.
Don’t Fight the Fed
One reason we experienced high traffic in the first quarter of 2022 was the fear of how quickly the Federal Reserve would raise interest rates. Just like in everyday life, the fear of an event is often worse than the actual event itself. Unfortunately, in finance, fear is akin to uncertainty and uncertainty manifests itself in market pullbacks, which is exactly what we saw.
Why is something that happens in every economic market cycle, and is the consequence an economy which is growing at a faster pace than expected, scary? In short, this fear is unfounded because the stock market tends to increase after the first interest rate hike in an economic market cycle.
Historically, the fear of interest rate increases is greater than the pain of the actual interest rate increase. This was the case on March 15, 2022, when the Federal Reserve raised the Intraday Lending Rate to .25%-.50%. The market absorbed the Federal Reserve’s action with grace, and we emerged from our traffic jam.
Green Ahead: The Second Half of 2022
There is reason for optimism in the US Stock Market. As we look through the near-term volatility and into the remainder of 2022, our GPS app shows green roads ahead.
Although inflation is starting to dampen consumer sentiment, it is not yet keeping consumers from spending money. Consumer spending in February grew year over year at a rate of 17.6%. In comparison, the average annual growth rate of consumer spending is 4.8%.
It is easy to see why consumers are spending money. The current unemployment rate is 3.8% and wage growth was at 6.7% in February. With consumers employed and seeing raises (which may or may not keep up with inflation), it does not appear that retail spending is going to meaningfully decrease through 2022 without a significant change in the labor market.
Paired with strong consumer spending, corporate balances sheets and earnings growth look strong. Corporate earnings growth exhibited a year-over-year increase of 42.5% as of March 22, 2022, while average yearly earnings growth clocked in at 7.5%. Looking forward, corporate earnings growth is forecasted to be greater in mid cap and small cap companies versus Large Cap with an additional overweight being recommended in value style securities over growth style securities. The growth stems from the continued adoption of technology by these firms over the past 10 years, which has not only increased profit margins, but also improved the end product/experience for consumers.
Also, we should not forget about the $1.2 trillion in increased infrastructure spending allocated in the 2021 Infrastructure and Jobs Act.
Traffic Jam 100 Miles Ahead?
Despite the market’s recent ability to absorb interest rate hikes, it has not fully digested the Federal Reserve’s plan for tackling inflation. The Fed’s plan is to increase interest rates at each of the six remaining Federal Reserve meetings. This is akin to closing two lanes of a four-lane highway, and thus forcing cars to merge. But the extent of the lane closure is not yet clear: traffic could be either significantly impeded or be simply slowed for a time.
With inflation at its highest rate since 1982 and a booming US economy which grew by 7% at the end of 2021, the Federal Reserve has a predicament: In short, the Fed needs to keep the economy’s engine running optimally, neither allowing the economy to run too hot (and thus raising inflation), nor too cold (which would put a damper on employment). From 2020-2022 the balance sheet of the Federal Reserve increased dramatically by $4.75 trillion to $9 trillion. Meanwhile, the Federal Funds intraday banking rate stayed between 0-0.25%. To solve their problem, the Fed must now decrease its balance sheet, while increasing interest rates.
This solution will put pressure on the long-term growth prospects of stocks and the economy. Monitoring credit spreads and the US Treasury Yield Curve, which is a measurement of the interest rate of US Treasury Bonds for a specific maturity, will tell us if the pressure becomes unbearable.
One indicator of pressure is a flat yield curve, which occurs when the interest rate paid is not significantly different between short-term and long-term bonds. For example, if a 2-year Treasury bond pays an interest rate of 2.35% and a 30-year Treasury bond pays 2.53%, what is the incentive to invest for 30 years versus two years? I do not know about you, but it takes more than 0.18% in interest for me to lock my money up for 28 more years. In other words, we are seeing a traffic jam in the US Treasury Market, the most liquid market in the world.
As of March 31, the above chart shows a flat US Treasury Yield Curve. While short term interest rates are set by the Federal Reserve, long term interest rates such as the 10-year, 20-year and 30-year Treasury bonds are seen as indicators of future inflation and economic growth. Ideally, the longer we lock up our money in a security the more interest we should earn. A flat yield curve is a sign of slowing economic growth and possibly a contraction. Although we do not expect this pain to matriculate into 2022, we are cautiously monitoring the conditions for 2023.
In other words, after a long stretch of green through 2022, we may start to see some yellow and red conditions on our GPS. Just like with traffic, macroeconomic events are fluid and can easily change over time. At GreenUp Wealth Management, we prefer to err on the side of caution with our investors’ retirement and financial plans. Should a choppy market present itself in 2023, we will be positioned to usher our clients through the turmoil and pick up some investments at a discount along the way.
How We Navigate Slowdowns
In our 2021 Q3 Market Commentary we discussed how the U.S. stock market seemed expensive, but strong corporate earnings would likely bring P/E ratios back to the historical average. This process has and continues to play out. Interestingly, while large U.S. stocks remain expensive on a relative basis, other asset classes such as small U.S. companies and emerging markets are relatively inexpensive. In this environment we are buying investments that have promising growth potential and are inexpensive. If the Fed deleverages by cutting its balance sheet in half, the U.S. stock market is approximately 9% overvalued. However, we do not believe all assets will react the same to a Fed balance sheet reduction. Companies that have not produced profits and/or are overvalued may be the first stocks investors are going to sell in a contraction and will likely drop the most in value. We will look for opportunities to buy growth investments at attractive prices.
We are shortening duration in GreenUp’s fixed income portfolio to reduce risk in a flattening yield curve environment. At the same time, we are increasing our overweight to US investment grade and government bonds to decrease credit risk while maintaining a reasonable interest rate.
In summary, our smartphone map shows a mix of green, yellow and red. Although we may get stuck in an unexpected slowdown, GreenUp will help you adjust the route depending on traffic conditions. Just like every road trip, proper investing starts with a plan. At GreenUp we believe your financial plan is the foundation of your journey. While unforeseen traffic may arise, through proper diversification we try to make your trip as smooth as possible, and GreenUp will be your navigator on your road to financial success.
- In our last commentary, we anticipated increased volatility in 2022, which has certainly held true in this first quarter.
- Inflation remains high due to continued supply chain issues which is now exacerbated by high oil, natural gas, and wheat prices, which are the main commodities exported from the Ukraine and Russia.
- With more money being allocated toward gas, food, and all necessary goods from a family’s budget, less money may be available for consumers to spend on discretionary purchases.
- If the geopolitical situation does not get worse from here, we may be able to get past the current near-term slowdown.
- Although inflation is starting to dampen consumer sentiment, consumer spending and corporate earnings are strong and there will be $1.2 trillion in infrastructure spending.
- Should a choppy market present itself in 2023, we will be positioned to usher our clients through the turmoil and pick up some investments at a discount along the way.
GreenUp Investment Models Update
Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation) We continue to believe that equities offer a better risk/reward relationship than fixed income. We are maintaining a risk budget of 105% in our active allocation models, overweighting small cap stocks and tilting from growth to value across market caps with equities. For our fixed income investments, we are shortening duration while utilizing investment grade corporate bonds to increase yield.
Large Cap Stock Model We are increasing Financial Services (adding MA, JPM, BK, and WFC) and Healthcare (adding CVS). We are decreasing Technology (selling TCEHY), Energy (selling ENB), and Industrials (selling ABC).
Tactical Equity Model The Bull-Bear Indicator entered bear status on March 4 and we moved out of the market. Until the indicator returns to bull status, we will maintain a defensive posture with periodic trades in and out of the market.
Tactical Income Model We sold PIMCO Income Fund to avoid any potential losses from a possible Russian debt default.
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The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.
GreenUp Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.