1Q22 Letter: "Navigating Through Uncertainty"
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Economic & Geopolitical Update
Since my last quarterly letter, the global geopolitical and economic outlook has deteriorated considerably. Russia’s invasion of Ukraine in late February exacerbated already-elevated inflation concerns, as both countries are large producers of energy, precious and base metals, and agricultural goods. This event led to a large selloff in stocks and other risk assets and increased the likelihood of an economic slowdown.
Today’s environment is often compared to the 1970’s, when an oil supply shock sent energy prices rising, and the U.S. was faced with higher prices, increasing unemployment, and muted economic activity. This combination of slowing economic growth and higher inflation is known as stagflation, a possibility that is particularly concerning today because the Federal Reserve has limited options to stimulate a weakening economy without further eroding consumers’ purchasing power.
When history seems to be repeating itself, the natural question to ask is “How is it different today?” A few considerations:
1) Compared to the 1970’s, the global economy is far less reliant on oil. Oil intensity, measured as barrels of oil required to produce $1,000 worth of GDP, is 56% lower today than it was at its peak in 1973. This is due in part to the growth of renewable energy, as well increased use of natural gas. Moreover, the 1973 oil price shock was triggered by a detrimental oil embargo put into place by certain OPEC members, all of whom have far lesser power to control oil prices than they did in the past.
Primary Energy Generation by Fuel, 1965-Present
2) The U.S. consumer is much stronger. As a percentage of overall Disposable Personal Income (DPI), household balance sheets in the U.S. are well better positioned than they were prior to the economic contraction in the 1970’s. This is important because in the U.S., consumer spending accounts for roughly 70% of economic output, or gross domestic product (GDP).
Assets, Liabilities, and Net Worth as a % of Disposable Personal Income (DPI)
Source: https://www.federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/chart/
3) The labor market in the U.S. is much stronger. A key underlying driver of consumer spending in the U.S. is the labor market. As shown in the graph below, the most recent unemployment rate of 3.6% is well below the 5%+ rate experienced prior to the early 1970’s oil shock, and is also below the pre-pandemic rate. The jobs picture has improved dramatically over the last year, and the prime age labor force participation rate has consistently increased since its pandemic low.
4) A wage-price spiral appears less likely today. During the 1970’s, inflation was worsened by a wage-price spiral, which occurs when workers anticipating higher inflation demand higher wages. Companies meet these demands, and in turn raise the prices they charge for goods and services to their customers.
Today, the percentage of unionized workers in the U.S. is considerably lower than it was in the 1970’s, suggesting that workers have less bargaining power today. As unionization has declined, we’ve seen lower correlations between wages and prices.
Private Sector Union Membership Has Steadily Fallen in the United States
Source: https://www.nytimes.com/interactive/2022/01/25/business/unions-amazon-starbucks.html
As I consider the above factors, I can understand why the Federal Reserve has signaled six more interest rate hikes in 2022, some of which may exceed 0.50%. Federal Reserve Chair Jerome Powell believes that – in light of a solid employment picture and generally strong consumer demand – the U.S. economy is able to withstand a faster pace of rate increases. According to the Fed’s recent median forecast, U.S. economic growth (GDP) slows to 2.8% in 2022 and 2.2% in 2023 from 5.7% last year, while the unemployment rate remains at 3.5%.
On the other hand, we have several indicators suggesting that a recession is imminent. Last week we saw an inversion of the yield curve, which is traditionally an indicator that a recession is coming over the next 12 months. Based on Goldman Sachs’ research, a 35% chance of recession is now reasonable, and recent research by Harvard economists Alex Domash and Larry Summers suggests a high chance of recession over the next 1-2 years.
It’s hard for me to imagine a near-term 2-2.5% increase in the Federal funds rate not meaningfully impacting economic growth, particularly among more interest-rate-sensitive sectors. As an example, rising interest rates are already starting to impact housing demand, as surging mortgage rates are driving down affordability. The likely scenario, in my view, is a harder landing than the Federal Reserve anticipates, resulting in slowing economic growth or a mild recession.
Market Update
In the weeks following the Russia’s invasion of Ukraine, the S&P 500 entered correction territory (a 10%+ decline) and the Nasdaq 100 fell into a bear market (a 20%+ decline) as the risks of higher inflation and a possible recession were priced into stocks. Even after a nice relief rally in March, which added more than 3% to both the S&P 500 and Nasdaq, the indices still ended the quarter down 5% and 9%, respectively.
While it’s impossible to predict when and how the Russia-Ukraine conflict will end, the most likely scenario in my view is a prolonged conflict. Putin appears determined to take the key southern Ukrainian ports of Mariupol and Odessa, which could take at least several months. I anticipate that the risk of conflict escalation will continue to weigh on markets, and that volatility will remain elevated at least into the middle of the year.
Meanwhile, the hawkish shift from the Federal Reserve and other central banks in response to higher inflation is meaningfully changing the investment landscape overall. The low interest rate environment that characterized the 12-year period following the financial crisis is over, and investors are now adapting to higher real yields and nominal yields.
As I take these factors into consideration, below are three themes that I am taking into consideration for my clients’ portfolios:
1) I prefer U.S. stocks to European stocks. Roughly 40% of Europe’s natural gas and 27% of its oil come from Russia, and 30% of that energy is transported through Ukrainian territory. In the U.S. roughly 1-3% of oil and gas is imported from Russia. I expect the U.S. companies to remain more resilient when compared to European companies in the near-term, and have eliminated European stocks from my clients’ portfolios for the time being.
2) I prefer higher-quality value stocks to growth stocks. In my previous letters, I’ve indicated a preference for value stocks over growth stocks in a rising interest rate environment, and accordingly most of my clients’ portfolios were positioned with a preference toward value entering the year. More recently, I’ve rebalanced several portfolios to include a larger proportion of high-quality companies that generate significant cash flow, which can in turn be used to fund share repurchases and dividends
3) I prefer diversified commodities as a portfolio hedge. In several portfolios I’ve increased exposure to various commodities in the energy, agriculture, precious and base metals sectors. Not only are commodities traditionally an effective inflation hedge overall, agricultural commodities may work as a hedge to today’s geopolitical conflict because Russia and Ukraine together export more than 25% of the world’s wheat.
Summary
Following a multiyear bull market, investors are now facing a more challenging, less certain geopolitical and economic environment. A number of new risks have surfaced over the last several months, and these risks – including a 35% chance of a near-term recession - have largely been priced into stocks and other risk assets.
With respect to asset allocation, I have positioned my clients’ portfolios to take into the account the risks facing the market, while also considering each investor's risk tolerance, cash needs, and investment horizon. As I said in my note from late February, in all cases I recommend that we stay calm, patient, and diversified.
As always, if you’d like to discuss any of the above themes and how your portfolio is positioned, you’re welcome to reach out anytime. Thank you for your continued support and confidence in Evolve Investing.
Best,
Peter Hughes, CFA