Battening Down the Hatches
Published on June 13th, 2022
A few weeks ago, the stock market appeared to have put in a near-term bottom, as there were signs that inflation may have been in the process of peaking. Interest rates also had peaked and were in the process of declining. A peak in inflation would take pressure off the Fed to hike rates as aggressively as might be needed otherwise, to bring inflation back to its preferred target range in the low single digits vs. the current high single digit level. It would also bring some relief to stock and bond investors who have been living with higher volatility and declining portfolios to date in 2022.
Year to date, your portfolio managers have largely been adopting a more cautious approach to the market given what we saw as the higher than usual amount of uncertainty in the financial markets brought about by the unwelcome spike in inflation, the Federal Reserve, the Ukraine invasion, and the lockdowns in China. Earlier in the year, the investment team increased its assessment that a recession is likely within the next 18-24 months. In equities, for the most part the team has been shifting the portfolio gradually in the direction of what we consider to be ‘recession resistant’ companies, or those who in past recessions demonstrated an ability to outperform in a weaker economic environment. We hold more cash than is typical for our portfolio, and we have also gradually increased our energy positions to try and hedge against the risk of even higher oil prices than we are now seeing. In fixed income, the team has incrementally been adding higher coupon securities (which are more attractive in higher interest rate environments), and securities with higher credit ratings (which tend to hold up better in recessionary periods).
Last Friday, the latest reading of the consumer price index, or CPI, negatively surprised investors, indicating that for the time being inflation has not peaked, and a separate survey from Friday (the University of Michigan Consumer Inflation Expectations) showed that for the first time since 2008, investors are now expecting inflation 5-10 years from now in the range of 3.3%, well above the Federal Reserve’s target of 2%. It is important for the Federal Reserve to keep expectations of inflation anchored near its target, in addition to actually achieving a target CPI in the range of 2%.1 Relatedly, the average national price of unleaded gasoline has reached $5 per gallon, after starting the year under about $3.30.2 Such dramatic increases in the price of gasoline in the past have typically been precursors to recessions.
The negative surprises Friday have increased the odds, in our view, that the Federal Reserve will have to hike interest rates more aggressively than previously estimated, which is why the market declined sharply on Friday and again on Monday. In turn, we believe that this has increased the odds of the U.S. economy experiencing a recession, because interest rate policy tends to have a lagged effect on economic fundamentals. The Federal Reserve and the administration appear to be in a bind, because they have limited tools to bring inflation under control other than to tighten monetary policy. Further, the Federal Reserve needs to tighten policy until the economy slows, and the resultant slowdown in demand often helps bring about lower prices for goods and services. While we do not have a crystal ball that tells us a recession is around the corner, we are battening down the hatches in the event that conditions deteriorate, as seems more likely today.
The stock and bond markets are discounting mechanisms; they represent the collective investment community’s views on what will be happening with the economy a year from now – and in future years. With the stock market having already declined 20% so far this year, a lot of negativity has already been incorporated into security prices. However, our concern is that a potential reduction in earnings expectations by investors may not be fully baked into prices. While to date corporate fundamentals have been quite strong, and Wall Street analysts have been raising their estimates of corporate earnings overall for 2022 and 2023, we now believe it is likely that companies and perhaps consumers will start to act more cautiously in their levels of spending. In our view corporations now seem more likely, in the face of growing uncertainty, to slow hiring and be more guarded when they provide guidance for the rest of the year. As a result, analysts may start to cut their earnings estimates, which serve as a barometer for the level of the stock market that is based upon those future earnings. We therefore believe it is appropriate to assume a more conservative stance as it pertains to the nature of the portfolio, trimming and selling a few positions we hold which carry higher valuations and/or more cyclical exposure that would likely be hurt by a recessionary environment.
What might cause us to change our more cautious views? Anything that could represent a dramatic shift downward in the current drivers of inflation. One of the most pernicious drivers of today’s high inflationary readings has been the price of crude oil. While changes in the price of crude oil do are not included in the so-called “core” CPI, these prices do feed through into the core because the cost of shipping goods – everything from groceries to TV sets to coal – has increased as producers of those goods have had to pay more for transportation. So, anything that might bring about a dramatic reduction in the cost of oil would be a positive. Housing costs have also been contributing to higher CPI, and unfortunately the primary way the Federal Reserve can impact housing costs is through higher interest rates feeding through to make mortgage rates so costly that the housing market has to cool off.
We could also be wrong about a coming deterioration in spending patterns by consumers and companies. Consumers saved a great deal of money during the pandemic period when they were at home and unable to get out and spend. Corporate balance sheets are strong and companies with debt generally used the low interest rate environment of the last few years to refinance expensive debt and also extend the maturity structure of their debt farther into the future. But we have already seen evidence of lower-end consumers pulling back on spending because their discretionary budgets have been nicked by gasoline prices. And there are some concerns that corporate inventory levels may be too high (we have seen this at Walmart and Target in recent weeks), particularly if sales come in lower than anticipated. In the end though, we believe the Federal Reserve wants to see a deterioration in spending patterns to help reduce inflation.
While we have recently changed our view to reflect a higher likelihood of recession in the coming year, we also maintain our steadfast belief that investments in well-managed companies with strong competitive advantages and great businesses should provide attractive returns over time, and we continue to hold a portfolio of such companies. Our team will continue to manage the portfolio in a way that we believe provides a good balance of protection against downside risk but at the same time, maintaining the ability to participate in a rising market.
As of June 13th, 2022