April 2022 Economic Commentary:  Geopolitical Conflict & Higher Interest Rates Galore

Those hoping the world would return to relative normalcy following the omicron variant’s peak in January were left disappointed, as Russia invaded Ukraine in February.  In addition to stirring geopolitical tensions, the invasion strained global oil supplies, which added to the existing forces causing the highest inflation in forty years.

Source:  St. Louis Federal Reserve

To counter this, the Federal Reserve took measures to tighten monetary conditions (reduce the amount of money in circulation), increasing the Federal Funds Rate (a benchmark for short-term interest rates) for the first time since December 2018.  Various officials have concurred inflation is too high, and that the currently robust economy could easily withstand several interest rate hikes this year.  Accordingly, market participants are currently expecting the Federal Reserve to increase its target range for the Federal Funds Rate from 0.25%–0.50% to 2.50%–2.75% through year end.

Naturally, the stock market reacted unfavorably to the specter of higher interest rates (increased borrowing costs for companies) and the uncertainty surrounding Russia and Ukraine, but stocks have since recovered much of their losses.  As of this writing, global stock market indices are now down just single digits year to date.

Implications For Investment Portfolios:  Higher Returns?

Core to our investment process is creating return forecasts for each asset class.  We then use these forecasts to create portfolios with the highest expected returns and lowest degrees of risk.  Our most recent forecasts suggest stocks and bonds should deliver higher returns (versus prior years’ forecasts) over a multi-year timeframe.

Why?  For bonds, it’s straightforward.  Though the process of adjusting to higher interest rates over the past couple of months has led to many bond funds posting negative year-to-date returns, bonds are now paying more interest, which should lead to higher expected returns.  A simple example:  A newly issued 10-year Treasury bond yielded 1.20% last August.  Buying and holding that bond to maturity would guarantee a 1.20% annual return (not adjusting for inflation).  A newly issued 10-year Treasury bond yields close to 2.50% today, indicating a substantially higher “hold-till-maturity” return versus last year.

Higher returns for stocks are largely a result of continued earnings growth and stock prices generally slumping through the start of the year.  In other words, the “price” to buy a dollar of corporate earnings has decreased.  Even so, that “price” remains relatively high for stocks of large companies domiciled in the United States versus other classes of stocks.  For this reason, we still have a general preference for stocks of smaller companies and international companies, which is reflected in our investment selections.

For those who are interested, our return/risk forecasts are below.  Asset classes are forecasted to be riskier as they move to the right side of the x-axis and higher-returning as they move up along the y-axis.  Ideally, we want to create a portfolio as close to the northwest quadrant of the scatter plot as possible.

Thoughts On Inflation:  How Gasoline Is Special

While consumers have been dealing with increasing gas prices since mid-2020, the Ukraine invasion has taken consumer frustrations to a new level. 

Out of all the kinds of inflation, gasoline inflation is, in my opinion, the worst.  First, the use of gasoline is ubiquitous in all products (via transportation) and many services.  Therefore, higher gasoline prices may cause the prices of other goods to increase.  Secondly, there are no readily available substitutes for gasoline.  An older car can be substituted for a newer car, chuck roast can be substituted for steak, and Walmart apparel can be substituted for Bloomingdale’s.  Unfortunately, we can’t fill our cars with anything but gasoline (unless you own an electric vehicle), making higher gas prices especially damaging to a consumer’s wallet.

High gas prices for a prolonged period may cause or exacerbate overall pessimism among consumers.  This pessimism is already being reflected in the University of Michigan Consumer Sentiment Index, which has continued to weaken through the start of 2022.

Source:  University of Michigan, St. Louis Federal Reserve

The problem with this is that pessimistic consumers tend to save their money instead of spending it.  This is because consumers become fearful of a poor economy, losing their jobs, etc.  This can cause trouble for the largest consumer-driven economy in the world, and can eventually lead to slower economic growth.  In other words, fear of a weak economy can potentially create a weak economy.  Despite current pessimism, however, there is no sign consumers are reducing spending yet—but this will be something we’ll be monitoring extra closely going forward.

Final Thought:  Late-Cycle Behavior, But No Recession Yet

Many pundits have been calling for a recession to develop soon, citing higher interest rates, rampant inflation, and inverted yield curves (short-term interest rates exceeding long-term rates).  The evidence indicates these proclamations are likely wrong or early.  However, the current economic environment is exhibiting typical “late-cycle” behavior (rising interest rates, high general inflation, rising commodity prices, strong economic and labor market growth).  If one follows an economic cycle template, then some sort of economic slowdown should come next.  The ultimate timing between late-cycle and slowdown varies widely, but here are some signs which would point to the economy transitioning from late-cycle to slowdown.

  • Growth rates for durable goods orders becomes negative
  • Initial claims for unemployment benefits increase
  • Growth rates for new housing building permits weaken
  • Average weekly hours worked falls substantially
  • Business inventories rise in the face of fewer orders

None of these signs have appeared year, suggesting continued economic growth and stock market gains over at least the next several months.  Please note, however, that stocks often become volatile in late-cycle economies, but there are still plenty of opportunities in volatile markets.  We’re prepared to take advantage of these opportunities, but also ready to adjust portfolios should the threat of economic malaise increase.

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