Quarterly Update: The Battles of Inflation & Ukraine

Investors Should Approach with Caution

After two years of low volatility and above average returns, global stocks and bonds have run into significant headwinds during the first quarter of 2022. Most of this turmoil has been caused by ever-increasing inflation data combined with the Russian invasion of Ukraine. Left on their own, we would suggest that either of these factors might be a challenge that financial markets could digest. However, together they pose risks that we feel investors should be cautious of, and prepared for, by making appropriate adjustments to their portfolios. Let’s take a look at the effects of the current state of affairs and some changes we have implemented on your behalf.

Strong Economic Growth = InflationIt has been a long time since we’ve had global and domestic economies growing at such a strong rate. One really has to go back to the 80s to recall such strong economic and profit growth. Most of this "Arnold Schwarzenegger-style" strength is the result of the central bank and vaccine induced recovery from the Covid crisis in 2020. It has created tremendous demand for goods for which there is little supply, hence driving prices of everything from steel to a loaf of bread ever-higher – what is known as inflation. Left unmanaged, inflation can be an insidious detriment to economies and their citizens since personal incomes cannot keep up with rising prices thereby squeezing all consumers, particularly those in low and middle-income households – the majority of the world.

The Best Way to Knock Out Inflation – Reduce Economic GrowthThe best and possibly only way to reduce inflation is to reduce an economy’s growth rate, which lowers demand and allows supply to "catch up." In essence, we need to throw central bank policy in reverse by significantly raising interest rates, slowing the global economy, and bringing the rate of inflation down to a more normal and healthy level. The Federal Reserve, along with the world’s other central banks, have already begun this mandate in their dialogue and action – and interest rates are on the rise! Ideally, interest rates will rise just enough to slow the economy to a lower, less inflationary cruising speed – possibly 3-4% annually.

The Challenge – Combined with Another ChallengeReducing economic growth to a level that is "just right" is no easy task, mainly because each rate increase takes 3-6 months to affect economic growth, as well as several other factors that are just difficult to measure accurately. This is probably why in the past central banks have unknowingly raised rates too much and induced recessionary times. When we combine this challenge with the war in Ukraine, the odds of success become more blurred. As we know, the war has created tremendous supply issues for oil, wheat, and other commodities, further stoking inflation. It has also reduced, and may continue to reduce, the growth of many economies and businesses that are negatively affected by sanctions. This added challenge makes the efforts of central banks and our Federal Reserve extremely challenging, which we believe warrants a more cautious approach to investment strategy.

Equity Exposure – What’s working and What’s ImmuneIn terms of your stock exposure, it has been temporarily reduced given these challenges. Reducing our allocation to the equity markets is the easiest form of managing downside risk. In addition, we have been actively rotating your portfolio of stocks into two areas of interest. The first is companies that are benefiting from the current trends of inflation and higher interest rates – think raw materials, energy, and financials. The second is companies that are immune to most of what is going on today and tend to thrive in periods of slower economic growth or even recession – think consumer staples, healthcare, and utilities. We believe this combination of less-than-normal stock exposure along with a more defensive group of companies should successfully get us through this challenging period. In the event that the current challenges dissipate, we stand ready to become more growth oriented.

Fixed Income Exposure – Silver LiningThe significant rise in interest rates is punishing long-term bonds and bond funds, many of which have fallen further than equities. We have escaped much of this carnage by owning individual bonds with less duration risk. That said, some of our high-quality preferred shares – of which we have a small exposure – have taken some of the heat from rising rates. While they have been a good source of income, we are in the process of rotating your exposure into individual bonds now that we are in a much more favorable yield environment. The silver lining in these interest rate trends is likely to lead us from here to a much more accommodating bond market. As interest rates continue to rise, it will allow us to capture yields that we have not seen in recent years. If rates continue this trajectory, we could see money market rates above 2%, and may even see yields on some high-quality bonds reaching 4-5% at some point in this cycle. This would be a tremendous benefit for those of us who might want to have less stock exposure, thus allowing the bond market to do some of the heavy lifting when it comes to total investment return.

Active Risk ManagementWe are facing some significant changes ahead and we are hopeful that policymakers can guide us through successfully. However, in the event that the outcomes are worse than expected, remember that we continue to apply our Active Risk Management process that allows for us to be flexible with your asset allocation, carefully manage the sectors to which you are exposed, and use carefully placed stop-loss orders on your stock holdings. All of these tools are intended to mitigate the risk of a catastrophic decline in your portfolio.

We hope you find this update helpful and if you have experienced a change in your financial situation, or would like to discuss your portfolio, please let us know.

From all of us on the team, we thank you for your vote of confidence in our work!

If you know of friends or family that can benefit from a no-cost portfolio review, please do not hesitate to reach out.