If you were yearning for more volatility, you certainly got it in the first quarter of 2022. Unfortunately, all the volatility led to negative returns across stocks, bonds, and most other liquid investment categories. The only one that recorded a positive return this quarter was gold. The specifics of the decline among asset classes are noted below. Broadly speaking, in the U.S., growth stocks underperformed value stocks and longer maturities underperformed shorter maturities. On a worldwide basis, domestic stocks continued to fare better than non-U.S. stocks, a trend that has been prevalent for some 15 years now.
What we find interesting and challenging these days is managing portfolios with some key secular changes afoot. Four key changes are noted below:
The End of the Era of Quantitative Easing in the U.S.
The Federal Reserve has been aggressive in growing its balance sheet since the Great Recession of 2008-09. Initially it was designed to pull us out of the aforementioned recession but then it took another leg up to help get us through the pandemic and its impact across many sectors when our economy came to a standstill in the second quarter of 2020. The chart below should give you a graphic picture of just how expansive the increase in money supply has been in our country over the past 14 years. This accommodative policy has kept our economy as well as our financial markets in good shape despite the various challenges.
In truth we are aware that, over the past 2+ years, there have been shortages of toilet paper, automobiles, and labor. There has not been a shortage of capital (money), however.
This is changing as the Fed will be reducing its balance sheet, effectively reducing the money supply out there.
Inflation is back and Pretty Pervasive Throughout Our Economy.
Over the 30 years of 1991-20 the consumer price index (CPI) never wandered much above 3.5% and was generally far lower actually averaging about 2.2%. But during 2021, in April specifically, we began to see a pickup in inflation. Led by energy prices, the 12-month increase of 8.5% (March 2021-March 2022) has also been fueled by higher prices for food, used cars, and non-durables (housewares, for example). We are also seeing the beginning of a commodities cycle after chronic under-investment in many resource industries.
The question today seems to be, “Are we at peak inflation today (8.5%)?” We believe that we are, however, the bigger question is where will inflation settle in as comparisons get easier in some categories such as energy and some overheated areas (like used cars) come back down to earth. We believe that the Fed’s target of 2% for inflation is too optimistic. Our belief is that a 3-4% annual CPI number is a more realistic expectation for inflation over the next 3-5 years. Our reasons for this are largely three-fold: Labor, Housing, and Environmental Policy. We all know that there is a labor shortage in our country and not all of it is pandemic-related. The upper hand today is probably leaning toward labor. Just ask Starbucks, Amazon, and Kroger. We can see labor costs rising at well above-average rates for several years, increasing the cost structure for many industries, and in turn, forcing many to raise prices.
Housing, in terms of the CPI is really rental rates. Over the past year, housing is up 6.4%, nicely below the overall rate of 8.5% of the CPI. But given the shortage of housing and rent control restrictions in many cities going away, the ability of landlords to raise rents has been constrained. We expect that these factors will keep housing cost inflation (rents) high for several years. Housing is about a 41% weighting in the CPI so it is a critical area.
Finally, environmental policy in the US has made it costlier for companies to operate their businesses as compliance only adds additional layers of costs.
Artificially Low Interest Rates Appear to be a Thing of the Past
We have been in a bond bull market for 40 years now. The chart below shows that the 10-year U.S. Treasury yield peaked at 15.84% in September of 1981 (after 40 years of increases) and has steadily worked its way down. For perspective, in September of 1981 the 12-month CPI increase was 11.0% (vs 8.5% now). The Federal Funds rate was 15.50% (it’s only 0.50% today). The 10-years U.S. Treasury was 15.84% at September 1981 versus 2.34% at March 31, 2022. In short, even if inflation settles in at our 3-4% number, we believe that interest rates are still way too low to give investors any real rate of return on bonds. Interest rates have to go up to reflect reality.
The Peacetime Dividend That the World has Enjoyed for a Number of Years Appears to be in the Rear-view Mirror
With Russia’s invasion of Ukraine, it appears that all bets are off, particularly with the lingering question of China’s position toward Taiwan. It would appear that the world is going to have to live with more uncertainty in terms of the world order (and increase their defense spending).
Related to the Point Above, a Trend Toward De-Globalization is Probably Ahead As a friend recently observed, “the general assumption that greater economic ties and greater trade would lead to more adoption of Western values has, in retrospect, been misguided.” Plans to bring production on shore in the U.S. are well underway. Our country’s self-sufficiency in terms of energy and food is a huge advantage so now it is a matter of bringing more production of product (technology, consumer products, etc) back on shore. Should this come to pass we believe that it will add to our higher inflation argument as labor is costlier here versus virtually every country we import from.