Powell, Putin, and Probabilities
Dear Clients and Friends,
A string of unexpected events in the first quarter left investors scratching their heads and dramatically adjusting probabilities of potential market outcomes. Jay Powell and the Federal Reserve emerged from hibernation this winter with a roaring appetite for interest rate hikes that may cool the economy and create new uncertainties for the bond market. Vladimir Putin also surprised the free world by invading Ukraine, forcing decision-makers to re-think the odds of a global economic recovery, just as the Covid pandemic began to fade. This client letter will evaluate upside and downside probabilities for markets as investors grapple with emerging risks and opportunities.
A challenging quarter
Surging bond yields and geopolitics drove broad U.S. markets down as much as 13% in mid-March, although a late-quarter rally left the S&P500 down only 5%, the first quarterly decline since early 2020. Losses increased for growth and technology stocks, which suffered a 20% decline from early January to mid-March, though a similar St. Patty’s Day rally left the Nasdaq down only 9% for the quarter.
During the quarter we gradually accumulated shares of both growth and value companies trading at a discount, while modestly trimming energy positions that had reached new all-time highs. We also took advantage of rising rates to add attractive bonds to client portfolios.
Reflecting on the quarter, the late March rebound in equities may have stemmed from investors assigning a higher probability of improving fundamentals. The bullish move anticipated that the US economy and blue-chip companies can manage through the overlapping challenges of a pandemic, rising interest rates, and a land war in Europe.
The question for investors is what comes next. Are stocks a leading indicator, suggesting that many of these macro concerns will resolve? Or could the late March rally be a temporary blip as new challenges emerge? Let’s explore both sides of this debate, starting with the bear case.
Reasons to worry
Many cautious investors point out that we are in the middle of a polycrisis, with multiple, overlapping challenges facing markets, starting with pandemic-related lockdowns in China and new Covid strains emerging. Bears also stress that we are in the early innings of a multi-year period of Fed rate hikes, intended to hit the brakes on runaway inflation.
The unfolding crisis in Ukraine continues to harm innocent civilians, while also wreaking havoc with global commerce, triggering commodity shortages, and raising prices. The bearish argument worries that higher interest rates, surging inflation, and battered supply chains may trigger a recession, driving corporate earnings and stock prices lower. Probabilities for future stock market gains appear bleak in this scenario.
Reasons for optimism
Bulls might suggest that pandemic-related stress on the economy will continue to decline as governments, companies, and individuals adapt to emerging variants. Rising corporate profit margins indicate to us that companies are finding creative ways to grow amid the pandemic.
Bulls also anticipate a more contained situation in Ukraine, with a reasonable probability that the warring factions will find a compromise that reduces global tensions. The Federal Reserve is watching the Ukraine war intently, especially since the conflict impacts global economic growth and inflation. Optimists expect Jay Powell to support companies and investors more than his predecessors such as Paul Volcker whose prescriptive rate hikes jolted the economy in the 1980s.
Even with rising rates, bulls see the potential for a slowing economy and a soft landing for an overheated job market. A slowdown in hiring might balance out the supply and demand for workers, reducing wage pressure. In a gradual slowdown scenario, companies will continue to grow earnings above the rate of inflation, and stocks will continue to appreciate.
Is there a middle ground between the optimists and pessimists? We see a realistic probability that companies will find a way to manage through emerging threats, though the road may be bumpy at times. Looking through the current challenges, we expect long-term earnings growth, and we continue to favor equity ownership as a preferred way to compound wealth and offset inflation.
As many of us look forward to baseball’s opening day and warmer weather, we remain mindful of the headwinds and tailwinds that may push the economy, corporate profits, and equity valuations. We continue to monitor emerging trends in global capital markets and search for additional investment opportunities that meet our core investment principles and your goals and objectives.
We wish you all the best this spring.
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®
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