April 18, 2022

The winds of change blew strong this past quarter, with new trends emerging and others shifting. Specifically, global risks have increased, a move towards globalization is shifting to reshoring, and long-term disinflationary trends, as well as the age of quantitative easing, appear to be paused.

Just as the latest COVID-19 surge began to fade in early 2022, Russia’s invasion of Ukraine brought new global risks and uncertainty. While the financial market consequences of this war cannot compare to the suffering of Ukrainians, the conflict will still have meaningful economic effects, particularly in Europe. Immediate impacts include surging oil and gas prices and disruptions to supplies of critical materials (Ukraine supplies about half of the world’s neon gas, which is used to produce semiconductor chips, and Russia and Ukraine are major exporters of grains and fertilizer). Economists anticipate these disruptions will accelerate the shift from global to regional sourcing that has already been underway due to the China-U.S. trade war and pandemic-related supply chain issues. Underscoring this trend of reduced globalization, lockdowns of large Chinese cities in response to soaring infection rates of highly contagious Omicron strains will likely interrupt manufacturing and further hinder supply chains.

Despite these global risks, the U.S. economy continues its recovery from the pandemic-induced recession – although the pace of economic growth is slowing. Continuing trends from last quarter include a very tight labor market and rising inflation. We are closely monitoring both for their impacts on the economy and financial markets.

Inflation is becoming a problem. While retail spending is holding well above the pre-COVID trend, consumers are already altering spending behavior in response to surging prices. When asked about their spending intentions for the next 12 months, consumers reported planning to spend more on necessities like groceries and childcare and less on discretionary items like travel and entertainment.

Urged by continuing inflation and a tight labor market, the U.S. Federal Reserve is shifting from a regime of quantitative easing to quantitative tightening. At its March meeting, the Fed increased the federal funds rate by a quarter percent and signaled raising rates at each of the remaining six meetings this year (although the Fed may be forced to scale back interest rate hikes if the risk of recession becomes too likely). Additionally, they plan to reduce their huge bond holdings. The Fed is aiming for an economic “soft landing,” wherein they put the brakes on inflation via interest rate hikes, yet don’t cause the economy to roll over. Because rising interest rates will increase borrowing costs for companies and consumers, potentially suppressing economic growth, the Fed faces a delicate balancing act between controlling inflation and maintaining economic growth. One key component we’re watching is U.S. wage growth because, in the long run, real wages and productivity need to move together for a strong U.S. economy.

With short-term interest rates increasing quickly, the yield curve has flattened considerably, with yields for U.S. Treasuries almost identical across a range of maturities. This occurs rarely and may indicate upcoming economic challenges, possibly even a recession. We continue to opportunistically buy individual short and intermediate-term bonds at relatively attractive yields since investors are not compensated for the risk of holding longer-term issues.

The Fed’s more hawkish stance and the shock of the Russian invasion of Ukraine are resulting in much sharper price swings in the stock market. Despite increased volatility in the first quarter, recent U.S. stock market returns have been far above historical averages. We continue to trim overvalued equities while also selectively taking advantage of pockets of value in high-quality companies. We are also interested in companies poised to benefit from the trends identified in this letter. For example, reflecting the move towards reshoring, a U.S. semiconductor giant is ramping up capacity to produce sophisticated chips domestically. Companies with pricing power should also prevail in the face of inflation.

Going forward, we remind our clients to maintain a long-term focus through any additional market volatility – and to remember that investors can still find opportunity amid uncertainty – be it war, inflation, or recession.

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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