| 1st Qtr.
| 12 Mo.
|10-yr Treas. yield||2.33%||1.51%||+1.18%||1.746%||+0.584%||+1.18%|
|Fed funds rate||0.25 – 0.5%||0 – 0.25%||+0.25%||0 – 0.25%||+0.25%||+0.25%|
(stock indices are before dividends; yield and rate changes are absolute changes)
The quarter can be summed up in two words – Ukraine and inflation. Concerns about the war in Ukraine expanding sent gold to an all-time high before retreating, and potential impact on Russian oil and gas (including a US ban) sent oil prices on a wild ride, spiking very near the 2008 level and then settling right at $100/barrel. Interest rates had a similar pattern, with the benchmark 10-year Treasury yield shooting up to just under 2.5% before settling at 2.33%. Those rate increases were felt in the bond market, with the investment-grade US bond index falling 6% for the quarter, a huge move for bonds. (The global aggregate bond index is down 11% from its January 2021 high.) The major market indices all hit “correction” declines of 10% or more at various times before recovering and while it certainly could have been much worse, investors breathed a sigh of relief for the time being.
All the various inflation measures hit 40-year highs, with the Fed’s preferred measure up 6.4% in March (the “core” figure, which excludes energy and food, was up 5.3%). The Fed has softened its claim that inflation is “transitory” and now projects the core figure at 4.1% by year-end, which would be a welcome easing but still double their 2% target. The Fed raised rates 0.25% and said it will raise rates more aggressively if necessary. The market expects an increase at each of the remaining six meetings this year, with a consensus rate of 1.9% by year-end and 2.8% by the end of 2023. The yield curve flattened and, in some areas, slightly inverted (see Looking Forward).
The hottest areas of the economy, jobs and real estate, stayed hot. Both weekly jobless claims and continuing claims hit 50-year lows even though the workforce is twice as large as 50 years ago. The March jobs report showed 431,000 jobs added, following February’s strong 678,000, and the unemployment rate fell to 3.6%. Total jobs are now just 1% below pre-pandemic February 2020. The labor participation rate has begun to go up, meaning that some people are returning to the workforce, and that rate is also 1% below pre-pandemic levels. Adding to inflation and offsetting the pain of inflation at the same time, average hourly earnings are up 5.6% over the last year.
New home sales were actually down 6.2% for the last 12 months as the median price jumped over 10% and has gone up 31% in the last three years. Inventory of existing homes for sale is only 1.7 months at current sales levels, and average 30-year mortgage rates are pushing 4.8%, the highest in over three years. (Phoenix has seen the highest prices increases in the country for quite a while.)
Consumers are being impacted in other ways. Gas prices jumped as high as $4.33/gallon, still below the inflation-adjusted 2008 peak of $5.24 but still painful. Auto sales are down 28% due to constrained supply but prices are up over 17% and used cars are even more pricey. Household debt increased by $1 trillion in 2021 with 87% of debt tied to homes, auto debt increasing and credit cards declining. Consumer confidence rebounded and the gauge of jobs being plentiful hit a record high, but consumers are not blind and inflation expectations jumped. The Fed reported that households had 36% more liquid assets than three years prior.
Fourth quarter GDP showed a 6.9% jump, triple the third quarter. For the full year 2021 GDP rose 5.7% after falling 3.4% in 2020.
Inflation and interest rates have both been topics in this section, but particular aspects of inflation and interest rates have been in the spotlight lately.
The first concern is an “inverted yield curve”. The yield curve is a graph of interest rates for various maturities of Treasury securities (90 days, 1, 2, 3, 5, 10, 20 and 30 years) which normally slopes upward from 90 days to 30 years. Remember that the Fed only sets short term rates, so the rest of the “curve” is determined by the market. The market has taken to heart the consensus projection that the Fed will raise short-term rates to 1.9% by year-end, pushing 1, 2 and 3-year rates higher.
An inverted curve occurs when short-term rates (specifically, the two-year rate) is greater than the benchmark 10-year rate. These two rates have been very close lately, with a slight inversion occurring during intraday trading and then on the closing rates on April 1. An inverted yield curve is seen as a reliable predictor of a coming recession, having occurred before the last seven recessions. And during the same period, it has only occurred once without a recession within the following two years.
Is an inverted yield curve really a near-perfect recession predictor? In a couple of cases, the recession was caused by events that had not been expected when the curve inverted (the 1973 oil embargo and the Covid pandemic). Europe is considered to be more likely to have a recession than the US, but their yield curves continue to steepen, not go flat or inverted. And in four of the last five inverted yield curves, the S&P 500 had strong returns of between +7.4% and +28.3% between the curve inversion and the start of the recession. It may be that a slight inversion is a sign that the economy is late in its growth cycle rather than headed into recession.
On the inflation front, the dreaded “stagflation” is a combination of slow or no growth, high inflation, and weak employment. Those factors can lead to higher costs for businesses but less room to raise prices, crimping earnings and hurting stock prices. Despite decent growth and strong employment right now, stagflation is a growing fear. As noted in Our Portfolios, better yields on bonds and a soft stock market can cause investors to reallocate their money, creating further downward pressure on stock prices. In theory stagflation is caused by some supply shock (the oil embargo in 1973, although we have been coping with supply problems due to the pandemic) or policies which hinder business while also growing the money supply too fast.
Getting out of stagflation presents difficult choices for policy makers. The actions to lower inflation can exacerbate unemployment, at least in the near term. Likewise, the solutions to unemployment and slow growth can fuel more inflation. Paul Volcker broke the stagflation of the late 1970’s by raising interest rates and after high unemployment in the early 1980’s a robust recovery took hold. In any case, the remedy for stagflation can be painful and the cure can temporarily be worse than the disease; it’s hard to tell how the public would react if it comes to that.
We spent a lot of time talking to clients around the last two presidential elections and we fully expect to do it again in 2024. The conclusion, well supported by economic and market data, is that the impact of presidential elections on the market is unpredictable, if not almost random, so it is futile to make significant changes based on some anticipated result.
Now we have a real shooting war in Europe, and even though there have been military actions of various sizes around the world over the last 50 years, this one feels different because it is on the doorstep of a direct conflict between Russia and the rest of Europe. That creates a new reason to worry and a new temptation to “do something” to protect yourself financially. What do the data and market experience tell us?
An analysis of 25 significant geopolitical events since 1962 is quite telling. These events range from the Cuban missile crisis, both Iraq wars, September 11, and the eruption of Covid to less remembered but still consequential situations like the Russian invasion of Georgia, German reunification and a number of major trade developments.
The worst 6-month performance of the S&P 500 following these events was -33% after the Russian invasion of Georgia in August 2008 but we know that market decline was caused by the housing bust and the ensuing recession; the impact of the invasion was coincidental. The next worse decline was -13% following the oil embargo in 1973, and the worst one-month declines were -20% due to Covid (we know how that has turned out) and -10% after the bombings of US embassies in Africa in 1998. The median one-month market change across these 25 events was +1.5% while the median six-month change was +8.4%. Once again, these events have generally not resulted in major market declines.
Presidential elections and major geopolitical are unquestionably important and we should be aware and concerned about them. But if they don’t move the stock market, what does? Despite all the crazy stuff in the world, and despite the sensationalist speculative trading that goes on, the market ultimately depends on economic activity and the creation of a return that is commensurate with the risk assumed by investors. Those returns are either earnings or the creation of an asset that has value. That does not mean that investors won’t make long-term bets that a company that loses money will eventually generate earnings (for example, Amazon lost money for the first six years after it went public and it was another 12 years before earnings really took off, while revenues grew steadily, and of course patient investors have been rewarded) but at some point, all investments find their true underlying value.
Another cornerstone of the market is that investors will weigh the risk and return profiles of various investments when deciding how to allocate their capital; that’s why borrowers with poor credit pay higher interest, among other things. With interest rates so low for the last couple of years (and historically low since the 2008 recession), both the income and potential price change for bonds has been dismal. It was an easy decision for investors to choose stocks, which may pay a dividend (the S&P 500 had a dividend yield around 2% for 15 years before it slid to its current 1.3%) and which have the potential for significant growth.
If interest rates continue to rise as expected, then the income from bonds and their relative stability may become a more attractive alternative for investors. Rising interest rates will cause bond prices to fall but that decline would be far less than the potential decline in stocks.
So, our investment thesis remains the same – a balanced, disciplined portfolio is best able to withstand market volatility, and will benefit from long-term growth in the global economy.
Fool Me Once, Shame On You, Fool Me Twice . . .
A disclaimer is in order here – the following is a practical discussion from a skeptical investor’s perspective and is neither an in-depth economic nor legal analysis.
Like it or not, we live in a world filled with “puffery”, loosely defined as exaggerated or false praise. Our former president has made puffery an art form and social media certainly encourages hyperbole and selective facts to create click bait and entice followers.
But puffery is not necessarily illegal. From legaldictionary.net, puffery in advertising is legal because it is assumed that most reasonable people do not take such statements literally – that they understand that the burger being advertised is not literally “the best burger in the world” – which is a classic example of puffery. In other words, puffery is another version of caveat emptor, buyer beware.
In Silicon Valley, puffery is known as “fake it ‘til you make it”. Start-ups sell their grand plans and vision to attract funding and then spend that money to hopefully realize that vision. Part of that pitch is often creative “metrics”, useless data that looks good but does not represent or correlate to real success. There are often several rounds of funding before there is a real product or service, and most start-ups either fail or linger in relative obscurity for a long time. There are big, visible successes but also a LOT of money lost.
Currently there are documentaries and docudramas on two very visible companies that both relied on puffery – Theranos and WeWork. The founder of Theranos, Elizabeth Holmes, has been disgraced and convicted of fraud while the head of WeWork, Adam Neumann, was paid hundreds of millions to go away. What’s the difference? (No, it’s not sexism.)
WeWork’s business model was not new or “disruptive”; they leased large office spaces and created coworking spaces that were used by individuals or small businesses. They never misrepresented that they were losing money and accurately reported their leases and occupancy. But their pitch was a bit cosmic, describing WeWork as a model of togetherness and community, and sophisticated investors bought it, eventually valuing WeWork at more than 10 times the value of comparable, more established firms.
Theranos, on the other hand, claimed to be revolutionary from the start, and was based on the idea of conducting numerous blood tests from only a couple drops of blood rather than the vials that are normally required. Ms. Holmes was also charismatic and celebrated as a visionary entrepreneur by many, including Pres. Obama. Plenty of influential and sophisticated people also bought this pitch; the only problem was that their technology never worked and most of the blood tests they conducted were done on conventional machines even while they said they used their new technology. The charade crashed when insiders with a conscience blew the whistle.
There are plenty of brilliant, creative and driven people behind many start-ups and new businesses. You should never be swayed, however, just because these people live in a different world and speak a different lingo. Be like people from Missouri – the Show-Me State.