Investment Commentary: October 2022

A brief review of the past two years helps set the stage for where things may be headed over the next several months:

What started as an isolated case of limited supplies of toilet paper, eventually, morphed into empty shelves for all sorts of goods. More frustrating was the knowledge that fleets of cargo-packed ships sat idly off California’s coast – unable to offload goods. These things were symbolic of the supply shocks to the economy resulting from the Covid pandemic.

Also symbolic of the pandemic were the haunting empty streets that were once bustling thoroughfares just weeks prior. The empty streets were an obvious sign of a sharp economic slowdown. The Federal government stepped in and flooded both businesses and consumers with stimulus money. These funds landed directly in bank accounts and helped pump up the demand for goods and services.

In economic terms, parked cargo ships represent a limited supply of goods, and spent stimulus money represents a pickup in demand. As these two things (limited supply and rising demand) intersected, prices on most goods and services began to rise rapidly at a pace we hadn’t seen since the inflation of the 1970s and early 1980s. Today, halting inflation is the generally accepted goal.

The widely accepted method to stabilize the rapid rise in prices is to increase the cost of borrowing money. In good fashion, the U.S. Federal Reserve (“Fed”) has committed itself to making this the top priority for the time being. Effectively, this means interest rates are being nudged up by the Fed. The Fed will continue to do so (and will keep rates higher) until it strongly believes price increases (i.e., inflation) have stabilized close to the Fed’s acceptable level of approximately 2%.

While rising rates have been a relief for those who would like to earn interest on cash, via higher money market rates, or put fresh cash to work in bonds, via higher bond yields, it has occurred at a time that has been rough for investors who already own bonds and stocks alike.

In our view, much of the carnage in the stock market this year is attributable to rising interest rates. Specifically, since the beginning of 2022, long-term treasury bonds have underperformed both stocks and high-yield (“HY”) bonds.

Quite often, the opposite is true. For example, in March 2020, when most people feared a deep recession, investors ran to the “safety” of treasury bonds while stocks and HY bonds plummeted.

Another example is during the Great Recession (2008-2009) when stocks and HY bonds crashed while treasury bonds went up in value.

The key difference between today’s and many difficult periods when treasury bonds do relatively well is that interest rates have gone up. Treasury bonds are interest-rate sensitive and go down in value when rates go up. HY bonds tend to decline if there is a fear that defaults will pick up; typical in recessions. However, like other fixed-rate securities, HY bonds will also decline as interest rates rise. The fact that HY bonds have gone down in 2022, but not nearly as much as treasury bonds, indicates much of their decline is seemingly attributable to rising interest rates and less so related to the fear of default.

The pertinent question then becomes, if the decline in stock prices is linked to the rise in interest rates, when will interest rates stop rising?

This takes us back to the inflation discussion. We believe interest rates will likely level off when inflation is back in check. If limited supply and rising demand cause inflation, then, in turn, supply improvements and lowered demand lead to lower inflation.

Many of the supply chain issues related to transportation, semiconductors, and yes, toilet paper, have been greatly reduced. However, many new supply chain issues have appeared related to energy and grain. While it’s difficult to say just how much things have recovered, signs generally point to improvement. For example, delivery times for manufacturing appear to be returning to pre-pandemic levels.

So, what’s the point? This year, riskier assets have not necessarily declined for fear of recession but instead due to a rise in interest rates. Consequently, the decline in stock prices is likely just as much related to a rise in interest rates as anything else in our opinion.

Regarding demand, the Fed’s raising of interest rates has the intended side-effect of restraining demand by making it more costly to borrow money for both consumers and businesses.

As both, the supply of goods and services seems to be improving and the Fed has already raised rates to above its 2% inflation target, it’s reasonable to assume we are well on the road to lower inflation and some sort of leveling-off of interest rates.\

We believe the good news lies on two fronts:

• The stock market seems to be quick at recognizing the sort of logic above and may well begin to recover before inflation is tamed.
• The valuation of the stock market seems to be at a relatively attractive level.

The big question that remains for the next 12 months is whether we will have a recession and how painful would it be. Our view is that the setup for a big recession is not there at this point given strong employment trends, a strong banking industry, and a reasonably priced stock market.

In the meantime, we believe investors should not be overly conservative as valuations appear to be quite reasonable for long-term investors. In fact, we believe investors should have exposure to the stock market in at least a similar range to their long-term asset allocation objectives.

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