Market Volatility is Normal:
At the beginning of the year, the S&P500 index started to fall on the heels of central bank interest rate increases. Central banks will decrease interest rates to help jump start the economy (usually during recessions) and will increase rates in an attempt to slow the economy and curb inflation
If we look at the chart below, we can see that the target rate was at an all time low and that increases were expected. Our portfolio managers were prepared for the market volatility by ensuring these rate increases were taken into consideration when valuing companies long before the hikes started.
From January 1st, 2022, to March 14th, the S&P500 index fell roughly 13%. This is quite normal, especially during a rising rate environment. When investors do not understand or value the companies they own, they indiscriminately sell everything. The good and the bad. From a short term, perspective, broad index selloffs can create a sense of unease, but our portfolio managers were hard at work buying these great companies that became very attractive from a price perspective. These periods are the times that allow our portfolio managers to outperform over full business cycles. On our end, it is our job to ensure that we understand the investment philosophy and allow them to do their job.
Here are a few stats of the S&P500 market selloffs over the past few years:
- Fall 2020 tech sell off: -10%
- Covid Recession: -34%
- Interest rate hike of late 2018: -20%
- Interest rate hikes of early 2018: -10%
- 2015 Commodity Crisis part 1: -12%
- 2015 Commodity crisis part 2: -13%
It’s important to note, that even though the S&P500 has pulled back, it doesn’t mean your actual portfolio has pulled back that much. It is just an index that we use to gauge the market as a whole. Now here’s the long-term performance of that S&P500 index relative to my most utilized US Equity portfolio manager:
To summarize, market sell offs are normal. Owning quality companies and not overpaying for them will help keep your mind at ease while also providing the bonus of better risk/return metrics into future years
Recessions, Inflation, and the impacts on our investments:
With all the above said, it’s important to also touch on some of the “headwinds” that the economy and market will be facing as we move through 2022 and beyond.
When I look at the inflation data, I see the same 8% that everyone else sees (chart above). However, when I dive into what is driving inflation, I see slightly different perspectives as well. Much of the inflation pre 2022 was due to demand pull. Consumers were stuck at home with large influxes of cash that they were spending on physical goods such as computers, vehicles, and other “toys”. Add in the supply chain issues that occurred due to the many shutdowns and increased shipping costs, this exacerbated price increases.
As consumers start to shift more of their spending back to services, I would expect supply chains to start to see relief and these price increase will relax.
However, there are aspects of the inflation story that are presenting new problems. Mainly the War in Ukraine. Ukraine and Russia provide one third of the worlds wheat and Russia is the second largest producer of potash (fertilizer). Depending on how long this war drags on, the global supply of different wheat products will see fault lines. Other foods may see price increases as well due to greater demand and higher fertilizer costs.
To add to the issue, we are also seeing other commodities such as precious metals and natural gas increase in price. Due to Russia’s large involvement/market share of these commodities, further global supply problems may present themselves.
Purchasing Manager Indexes and Yield curve spread:
The PMI is a leading indicator that we watch. When used in combination with other indicators, it can be a great tool to help give us an idea of where we are in the economic cycle. The chart below shows the last few economic crisis. We can see that the PMI always goes below the target level of 50 before the recession hits. Although it is a reliable indicator, it is important to use it in combination with other indicators as it can also give false positives.
The PMI index indicates that a recession may be looming when it dips below 50. Today, we are still at very healthy levels, but it is declining. My interpretation is that we are definitely out of the early section of the economic cycle and are likely mid cycle.
The yield curve is another indicator we watch. Normally lenders receive a better return when their loan is extended further into the future. It inverts when short term interest rates become greater than long term interest rates usually due to increased demand pulling medium and long term bond yields downwards. The increased demand for these medium and long term bonds comes from the increased sentiment of a looming recession.
As for the 10-2 yield curve, just today (04-01-2022) we have seen it invert indicating that a recession could come within 22 months (the average length of time since 1900). Just like with the PMI, this must be used in combination with other indicators for proper validation. However, I think this is further proof for saying that we are in the middle of this economic cycle and that we will need to become ever more diligent in making sure that the companies we own are not overly indebted and that we do not overpay for them.
Just like in 2018, we are going through a period of interest rate hikes, and we are seeing market volatility similar to what we saw during that period.
If you are invested within your risk tolerance with portfolio managers that have a strong investment philosophy of only purchasing quality companies at attractive prices, this market volatility (although uncomfortable) is absolutely normal and can be taken advantage of. With that said I also feel it important to reiterate that we do not advocate market timing, rather stay the course and invest based upon your strategic asset allocation using diversified portfolios.
We will likely see further headwinds on the inflation front due to the war in Ukraine. Many of the indicators that we follow are suggesting that we are in the middle of this economic cycle and that we will need to remain diligent as we progress through it.
As always, please reach out if you have any questions at all!