28 Apr Bridge Perspective – April 2022
As we mentioned in our 2021 year end newsletter, it is important to look at investing as a marathon, not a sprint, and snapshots of any one year are nothing more than brief segments in time to be reviewed as part of a long-term investing process. Recent market volatility does not change our view nor impact this investment process. In this quarter’s newsletter, we will focus on important market and economic topics that are likely the cause of this volatility and our outlook going forward in 2022.
2022 – The Federal Reserve; Inflation and Interest Rates
The US Federal Reserve (FED) has been front and center for 2022, and the main cause of much of the market volatility experienced in Q1. The FED says it will move quickly to normalize their monetary policy with both interest rate hikes and potentially Quantitative Tightening (QT). QT is the policy of removing funds from the financial system, as opposed to increasing under the Quantitative Easing (QE) system that is ending. The interest rate increases were expected but recent commentary regarding QT has caused interest rates at the longer end of the yield curve to increase much higher and faster than expected. Interestingly, from 2017 – 2019 the Federal Reserve attempted the same strategy and were forced to end as both equity and fixed income markets experienced rapid declines coupled with a rapidly slowing economy in both the US and abroad. This time the stated reason for the change in policy in 2022 is that inflation has spiked dramatically to a rate now above 7%.
If history does rhyme, the current attempt by the FED to fight inflation with the tools mentioned above could be a repeat of 2017 – 2019. Rising rates and reduced liquidity in the financial system that will come from QT may strain elevated stock and real estate prices. In addition, weakened economic conditions both here and abroad may be worsened if the policies are implemented too fast. Specifically China, a big contributor to the global economy, is showing significant signs of slowing including sporadic factory closures and a weakened real estate sector. Add in the incursion into Ukraine to an already tight supply of commodities (food, grains, energy, oil, etc.) and the drag on economic growth increases.
Inflation and the Economy
The Consumer Price Index (CPI) reading of 7.9% as of February is the highest headline inflation level since 1982. Core CPI, which excludes volatile components such as food and energy, registered at 6.4%. This comes after core inflation has lingered around 2% or below since the Global Financial
|Crisis (GFC) of 2008. Many economists believe that the massive fiscal and monetary stimulus prompted by the pandemic, along with unprecedented supply chain disruptions have fueled this sharp uptick in inflation.|
Unlike other periods of rapidly rising inflation, global economic activity while strong in 2021 has shown significant signs of slowing in 2022. Consumer spending has been firm but not supported by other indicators such as Consumer Sentiment, with readings that are near 10-year lows. (Chart 1)
|Also, Real Weekly Earnings have been falling to near 14-year lows. (Chart 2)|
Intermittent factory closures around the world have upset global supply chains creating economic imbalances and conflicting data. So much so that the Blue-Chip economic forecasts and our own FED are expecting GDP growth to slow to about 1%.
(Chart 3 Source https://www.atlantafed.org/cqer/research/gdpnow)
Currently, many indicators are not supporting the long-term secular inflation theme. Slowing GDP, M2 Money Supply, Monetary Velocity, Loan-to-Deposit Ratio, and most importantly a flat yield curve are all indicators that point to an inflation cycle which may be short-lived. However, the ongoing failures in removing supply chain issues have not been resolved so temporarily we expect mid-to-high single digit inflation rates to continue in Q2.
Another factor that may come into play but has yet to arrive, is a weaker dollar. For now, the dollar has remained strong versus other global currencies. However, should this support change, a higher range of inflation may unfold.
Equity Markets and Inflation
The first quarter of 2022 ended with the US equity markets -5.28% (Russell 3000 index) International developed -4.81% (MSCI world minus US index) and the emerging markets -6.97% (MSCI index). Deeper analysis shows large company stocks and value stocks held up better than growth stocks and small company stocks. For example, the Russell 1000 Value index (Large US companies) returned -0.74% while the Russell 1000 growth index was -9.04%. The large value vs growth dispersion was also present in US small companies. The Russell 1000 index (growth and value combined) returned -5.13% while the Russell 2000 index (US small companies) returned -7.53%.
Historically, equities have performed well if inflation remains contained. However, a slowing economy combined with a tightening FED and elevated valuations may be headwinds to the markets that should not be taken lightly. Consequently, in certain portfolios we have rotated into value stocks, commodities and other investment asset classes that will benefit from higher inflation.
Do Value stocks or Growth stocks perform better during periods of heightened inflation?
If you think about investing time horizon, the expectation is that a value stock will return capital to shareholders faster than a growth stock. This is because, by definition, much of the expected cash flows from lower-multiple (value) stocks is front-end loaded. Conversely, growth stocks are considered longer-duration assets with expectations of greater cash flows further into the future. A higher proportion of the stock’s price comes from far-off cash flows, and that gets discounted by higher rates. This gives value stocks, with more stable near-term cash flows, and an upper hand
in an inflating environment. In an analysis of growth versus value using data since 1927, value has achieved greatest outperformance in periods of moderate to high inflation. It is only when inflation was extremely low that value performance paled. The chart below depicts the differential in return between value and growth stocks and not the actual return of value stocks.
Value outperformance by inflation regime, 1927-2020
Source: BlackRock, with data from the Kenneth R. French Data Library and from Robert J. Shiller. Fama/French data uses the CRSP universe, which includes all companies incorporated in the U.S. and listed on the NYSE, AMEX or NASDAQ exchanges. The level of annual inflation is defined as the year-over-year change in the Consumer Price Index (CPI). “Lowest inflation” represents the bottom 20 years of inflation readings; “highest inflation” represents the top 20 years; and “middling inflation” represents the remainder. The numbers below represent the range in inflation readings for each regime. Value outperformance is annualized and calculated across various inflation regimes using annual data from 1927 to 2020. Value outperformance represents the performance of value stocks minus growth stocks, as defined by the Fama/French HML research factor (i.e., “high valuation minus low valuation” using book to price).
Fixed Income Markets and Inflation
Consistent with the equity markets, the first quarter of 2022 was also difficult for the fixed income markets. The Bloomberg US Treasury Bond 3-7 year index returned -5.08% and the Bloomberg US Corporate Bond 3-7 year index returned -5.46% . The FTSE world government Bond index (hedged to USD) returned -4.79%. The Bloomberg US TIPS index returned -3.02%. The Bloomberg Municipal Bond index returned -6.23%.
Since interest rates are inverse to bond values, this means interest rates rose across most bond types for new bond purchases. The short-term US Treasury market was one of the greatest beneficiaries with the yield on the 2 – year US Treasury note rising from 0.73% to 2.28%.
While long-term US treasury yields also rose, they did not match the pace of the rise in short-term yields, resulting in a flattening of the yield curve. A flattened yield curve indicates expectations of slowing economic growth in the future and potentially higher bond prices (falling yields). This will be another challenge for the Federal reserve to navigate. We will be watching closely.
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BlackRock Fundamental Active Equity Investment Team
Antonio (Tony) DeSpirito, Managing Director.Bridge Advisory, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Information herein has been obtained from sources believed to be reliable, but Bridge Advisory, LLC. does not warrant its completeness or accuracy; opinions and estimates constitute our judgment as of this date and are subject to change without notice. This newsletter expresses the views of the authors as of the date indicated and such views are subject to change without notice.