May 20, 2022

The financial markets have exhibited higher than usual price volatility thus far in 2022. Daily swings in the stock market of over 1% have been frequent, and the trading range for interest rates has been wide as well. On the other hand, the selling in the stock market is not panic selling. Rather, the market appears to be repricing relative to the evolving fundamental investment and business backdrop. It is our view that the stock market got ahead of itself last year as investors extrapolated the low interest rate regime and strong corporate earnings growth dynamic well into the future, paying too much for even the best companies. Towards the end of last summer, the most popular stocks began to sell off. In November, the U.S. Federal Reserve began to pivot toward a policy of tighter monetary conditions. The broader stock market stayed strong through December. Investor risk appetite then began to shift in January as higher interest rates combined with the severe losses being experienced in the most popular stocks.

The positive economic and business conditions that drove stocks higher and higher after the initial COVID-19 lockdowns are changing, and the markets are looking for clues as to what to expect. Riskier assets like stocks (particularly the popular growth companies) and high yield bonds have experienced large selloffs. At the time of this writing, the S&P 500 Index is down about 18% year-to-date and down slightly on a year-over-year basis. The NASDAQ (mostly growth/tech stocks) has experienced a bear market this year, selling off about 27%. It is critical to remember that for the five-year period leading up to year-end 2021, the S&P 500 Index averaged an 18.5% annual return and the NASDAQ 25% per year. Those levels of returns were simply not sustainable and far above the longer-term return of stocks of approximately 9% per year. Accordingly, you could characterize the current selloff as a healthy event, benefitting long-term business owners and investors. We recognize that the selloff does not feel “healthy” to our clients and that investor psychology can play an important swing factor when markets decline in price.

As mentioned, interest rates have been moving up and down within a wide range this year, and riskier (higher yield) bonds have been selling off significantly. While our economy is expected to grow into the near future at a reasonable pace, investors have become increasingly concerned about the risk of recession. If the U.S. Federal Reserve remains resolute to tighten monetary conditions, there is a fair chance a recession will occur, eventually. Tighter money conditions are specifically aimed at slowing the demand for goods and services in the U.S. economy for the purpose of reversing the currently high levels of price inflation. We think it is safe to say that the U.S. Treasury market has displayed a fair level of skepticism as to whether the Fed will remain resolute, as do we at this juncture.

Economic conditions around the globe have deteriorated with the recent lockdowns in China and the tangential effects of the Ukraine conflict. We believe higher levels of inflation may be with us for some time. Supply chains are not functioning well, and there is no near-term fix for this conundrum. In fact, there is a good chance that our multi-decade experience of economic cooperation and the globalization of trade may be on the wane. For the last 40 years, interest rates have generally declined as globalization fostered disinflationary forces upon the global economy. Investors are looking for clues as to whether the higher inflation levels will be transitory or sticky. There are countervailing disinflationary forces still in place: aging populations in developed economies, high levels of government debt, and the deflationary influence of technological advances.

As we have mentioned in past communications, government involvement in business activities and especially the financial markets has been ascendant. Investors prefer stability in economies and currencies. Volatile politics and geopolitics cause higher levels of uncertainty, making it more difficult to think, plan, and invest for the long term. Yet, these are the conditions with which we must now deal. Our investment process, which has proven successful over past political and economic cycles, provides us with a level of confidence to execute our investment strategies. Moreover, during turbulent times or even recessionary periods, we know that investors tend to direct investment toward higher-quality companies and issuers. Higher inflation levels make investing in bonds challenging but can also open opportunities. As for stocks, higher inflation is not a death knell. Companies will learn to adjust to the new environment, and some will do so better than others. The markets are repricing from very speculative levels to adjust for the changing economic and business backdrop. Stock valuations are generally becoming more reasonable but are not yet bargains. A level of caution is advisable, as the risk of recession is real. We will continue to communicate our views and strategies as they evolve. Please let us know if you have any questions or concerns.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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