Rising Prices
It’s all about rising prices.
The markets never really like surprises and things that are new or not seen in a long time. This time it is about quickly rising prices on almost everything. It’s the “I” word, inflation. Interesting part is it seems like the markets were surprised in general. This has been building for the last several years and the top was blown off with all of the COVID era free money that was injected into the system.
This has created the most challenging equity and fixed income markets we have seen in 50 years. It is also the first time in that time frame that asset allocation has not helped cushion the blow. At a time when normally you could count on bonds, they were all down 10 – 15% YTD. So there has only been one sector that has had a positive return: energy. We own energy and we are overweight for the most part. Energy is currently only 4.6% of the S&P 500. Here is the other bright spot. Money markets actually pay you something on your cash. For the first time in over 10 years cash accounts earn over 2% yields.
The difficult thing to understand about this market downturn is that it is caused by too much of a good thing. This is the hangover following the party. The economy bounced significantly faster following COVID than anyone would have guessed. A demand shock was created, and we have experienced quickly rising prices on almost all goods and services. So, how do we fix it? The Fed’s primary weapon is fiscal policy and interest rates. Here is where it gets strange. The Fed wants to make credit more expensive, slow down spending and get unemployment to go up to slow down inflation. So is the Fed trying to make the economy worse? The answer is yes. This is a balancing act because the Fed does need to get the timing right or they could overshoot this and send things from bad to worse.
So, what is our outlook? Inflation does concern me and there is potential for 70’s – 80’s type economy killing inflation. I don’t think that is likely. Our base case is a short and shallow recession taking us into 2023. I do believe the Fed plan makes sense and will work. The Fed has been very successful going on this path in past economic challenges. I believe we will get inflation down from the current 8.2% year over year down to 3 – 4% in the next 4 – 6 months. But I do believe we will not be able to get under 3%. I think we will be in an era of higher interest rates and inflation for longer.
This means that what has worked the last 10 plus years will not lead the way the next 10 years. We think asset classes like commodities, in particular, agriculture, forest and precious metals will be much more of a contributor to a portfolio. Bonds are also much more attractive than they have been in many years. We like municipal bonds in particular, both investment grade and high yield. I also like intermediate bonds more than short and becoming more interested in corporate high yield. While we have seen significant pressure on all equities, corporate profits are still up 5% in 2022. The difference is valuation. The markets are concerned about inflation and are not willing to pay the higher P/E that existed coming into 2022. This means we still have a strong U.S. economy even if it will slightly weaken. We love our current portfolio of companies we own and managers we use and are confident we own quality. This becomes a patience game as we continue to get a bounce, you will see us transition parts of the portfolio to areas of the market which we believe will lead the way. This will mean more exposure to commodities, real estate, infrastructure, intermediate and high yield fixed income and small and mid-corporate equity. This will take time and will occur between now and mid-year 2023.
We realize seeing your portfolios drop like it has is always concerning but caution and patience is needed now to avoid mistakes. As always, we value your trust in us to be guardians of your assets. We work hard every day to protect what you have worked so hard to build.
Reach out to us with any questions or concerns.
All my best.
Regards,
Gregory B. Pierce, JD
President and CIO