3.9k Share this
With the arrival of Spring this year, many investors are too concerned about their shrinking portfolios to get out and enjoy the greenery and flowers. Instead, they are hoping for a revival of the global economy.
The just-ended first quarter of 2022 was the worst three-month period the stock markets have experienced in two years, with the S&P 500 down almost 5%, the DJIA falling about the same amount, and Nasdaq down over 9%. Inflation is hitting levels we haven’t seen since the 1980s, while problems with an already disrupted global supply chain are being compounded by the Ukrainian war. And Covid just won’t go away.
There’s a lot going on right now, not much of it very good. There are also many unanswered questions, starting with what can the Fed do about inflation?
Chairman Powell is under tremendous pressure to navigate a soft landing, but doing the wrong thing could be as damaging as doing nothing. The Fed is trying to tamp down inflation by raising interest rates, but if it goes too far too fast, there’s a risk of slowing down the economy too much and potentially pushing it into recession. The first step was to raise the Fed funds rate by 25 basis points, which Powell did recently while indicating there would be a 50 basis point increase at the Fed’s next meeting. Those actions are likely to continue in the coming months, with an eventual reduction in the Fed’s balance sheet holdings coming as well.
The war in Ukraine and related sanctions are disrupting the flow of commodities from that part of the world, making things even more difficult for the Fed here at home. The direct impact will certainly be felt more strongly in Europe, which had become reliant on natural gas imports and other commodities from Russia and Ukraine.
Back in the US, inflation had already started climbing due to substantial amounts of monetary and fiscal stimulus. First, when the Covid pandemic hit and then when Biden entered office and passed legislation to send new stimulus checks to everyone. But some of the inflation we’re currently seeing results from aggressive governmental policies that date back to the great financial crisis. For example, interest rates have been low for a very, very long time, even as the US government has been spending much more than it has taken in for years.
MORE FOR YOU
The Fed’s move to start fighting inflation by slowly and steadily raising interest rates may be predictable. Still, there is only so much that can be done by reducing monetary stimulus. If you really want to combat inflation, you have to also reduce fiscal spending. However, the US government appears to be headed in the opposite direction as the Biden administration’s agenda calls for considerably more governmental outlays.
The president’s proposed $6 trillion budget includes numerous, expensive proposals to address issues around the social safety net, such as increased spending on education, the opioid epidemic, and housing assistance, as well as our crumbling infrastructure. These are the issues that got Biden elected, but he hasn’t yet explained how we will pay for all of these programs. The obvious answer is higher taxes, which can serve as a drag on economic growth.
Whatever the Fed does, it seems inevitable that we will see more inflation, which will directly affect investors. It’s still a terrible time to be a long-only fixed income investor for the simple reason that we’re in a rising interest rate environment, and fixed income securities pay at a fixed rate. As rates climb and inflation increase, the value of that fixed income security drops in most cases. Some securities, like leveraged loans, which reset depending on the current base rate of interest, offer some protection, as do Treasury Inflation Protected Securities (TIPS). However, according to Bloomberg, there are still ~$2.3 trillion in negative-yielding securities outstanding even though that number has dropped considerably in the last few months. So the obvious question is, why would any investor want to own a security that’s guaranteed to lose money? Presumably, they’re required to do so by mandate or because they’re afraid of the alternatives.
The current environment is also particularly challenging for all those investors who subscribe to the traditional 60%/40% stocks to fixed income portfolio model – such a large portion (60%) of that is subject to big risks of loss due to higher rates and inflation even though the fixed income portion had long been considered the “safe” part.
Companies involved in commodity production seem to offer a reasonable investment opportunity. That means companies that produce oil and gas, silver and other precious metals, and agricultural commodities. Of course, even as investors may benefit from investing in these commodities, which are appreciating in price, they may also suffer as consumers because higher prices will lead to inflation. The end products made with those commodities will all cost more.
Investors should be considering not just whether these are attractive investments, but also the follow-on effects those trends in inflation have on national economies and producing companies. Those companies with higher input costs that are unable to pass them through to their consumers will suffer. Companies that can pass costs on to their consumers should do well because their ability to make greater profits will likely exceed the extra costs incurred. We’re entering a period where there will be serious winners and losers depending on each actor’s ability to navigate the changing macroeconomic environment. Some firms and countries will do well, while others will do poorly. On the securities front, some types of securities will do poorly, and others will do better. Stocks may do well, but it depends entirely on which ones you select.
Seasoned fundamental security investors should fare much better in this environment since there will be opportunities to select clear winners and losers using a top-down and bottom-up approach. In contrast, if you’re blindly throwing capital at an ETF that passively tracks an index, can you really make money? That should become more and more challenging in this kind of dynamic environment.
The distressed securities market has been rather quiet, with default rates practically nil, although cracks are starting to develop. We’ve previously talked in this space about Chinese developer defaults, but now many of the largest firms in Russia are defaulting, and so may Russia as a country.
Big changes are happening, and there are signs of future turmoil on the horizon. I would caution investors to tread carefully, know what you’re buying, and make sure it has a rock-solid balance sheet if it’s a company with decent pricing power. Avoid passive ETFs or leveraged ETFs that sometimes blow up, and instead focus on investments that make sense after reasonable analytical scrutiny. The best advice for investors in this environment, and, really, all environments, is to do your homework and know what you’re buying. There are opportunities for those willing to do the work to find them.