In this piece, we are going to touch on a handful of topics that markets are encountering and express our current views on them. We feel that investors with a sharper understanding of the issues may be able to make more rational investment decisions, and hopefully avoid some of the mistakes that others make in volatile times.
THE SECULAR CHANGE IN THE DIRECTION OF INTEREST RATES
Since the early 1980s, we have been in an environment of steadily declining interest rates. For context, the Fed funds rate stood at 21% in June of 1981. Currently the Fed is targeting that rate in a range of 0.75%-1.00%.
For over 40 years the declining interest rate environment has been a tailwind for bond investors. As rates have declined… bond values have increased. Today, however, we face the prospect of a headwind for bond investors that may wish to speculate in fixed income instruments. Despite recent bond market declines, we continue to think that for investors seeking relative stability of principal, quality bonds continue to make sense in an otherwise diversified portfolio.
As a bit of trivia, historically, the word “inflation” in economics referred to the increase in the money supply. At present, “Inflation” has come to describe the actual increase in prices itself. Regardless of the semantics, we all are feeling the result – too many dollars chasing too few goods.
In recent history beginning with the financial crisis in 2007, we have seen the U.S. Fed and other global central banks inject copious amounts of capital into the economy to keep economies on the growth track. Since the Financial Crisis, the Fed has lowered the overnight lending rate and used quantitative easing several times to inject capital into the economy to support growth of the economy.
When Covid hit and global supply channels were impacted, the rise in prices resulting from too much money chasing too few goods was intensified. Currently, given China’s Zero-COVID strategy and the resulting lockdown in that country, the flow of goods from China to the US is almost certain to be interrupted again.
Given this, along with energy prices at inflated levels, we are not convinced that inflation will ease to past levels in the foreseeable future.
As described in a recent communication, we continue to think that this is truly the year of the Fed. Fed actions in 2022 could meaningfully affect the course of both the economy and capital markets into 2023 and beyond. So, market participants are paying particular attention to their proceedings.
Currently, the Fed is attempting to fight inflation by raising lending rates and is set to begin tapering their open market bond purchases (a.k.a. quantitative easing) this year – for all intents and purposes slowing the flow of new capital into the economy. By slowing the flow of capital into the economy, they hope to slow the pace of inflation. It is important to recognize that these moves have the possibility of slowing demand too much and in turn could send the economy into recession.
For the last several years, companies with global relationships with suppliers and customers that had spent decades perfecting their “just in time” inventory control systems, have been grappling with disruptions. While cost efficiencies were attained by relocating production to lower cost areas, and the U.S. became an enormous importer of cheap goods, we have become quite reliant on those foreign economies.
Political issues have also entered the conversation. Consequently, many countries are experiencing a groundswell of support for protectionist policies that mean abandoning some of the values of global interdependence and economic cooperation.
Some of the specific issues we see affecting deglobalization and its impact in inflationary terms include reshoring of manufacturing, Covid related supply chain disruptions (i.e. China shutdown), labor supply, social sentiment around nationalism, Ukraine war and its impact on the supply of oil, natural gas, and agricultural commodities.
PRICE EARNINGS RATIO (p/e) – 22.7 to 16
One of the key measures of valuation for stocks is the p/e ratio. If the price of a stock increases at an exceptional pace for a period, then the p/e increases. But sometimes that can be a temporary phenomenon, and it returns to its old p/e by either falling in price or having the earnings “catch up” to the new price.
Given the disruption of COVID, at times over the last several years, p/e’s have been difficult to assess. But as we have started to move away from COVID and earnings/profits became slightly simpler to forecast, p/e’s for the S&P 500 were estimated at around 22 to 23 times earnings. This is above the historical averages for S&P companies.
With the recent decline in stock averages, p/e’s have returned closer to the historical average of around 16. Some might call this a true “correction,” while others see doom. We think that the future direction of stock prices will depend largely on the progression of profits, rather than rampant speculation.
A RETURN TO VALUE
For years, the growth style of investing has outpaced the value style. Companies that have invested profits in growing their offerings and expanding operations have had the attention of investors. With an environment of easy money and fertile end markets, times have been good and prices for growth companies were driven ever higher. Meanwhile, those companies that represented less growth potential have been somewhat ignored.
This seems to have changed thus far in 2022. Growth companies have underperformed value. Many of the issues discussed above have played a part in this shift. While we do not think that growth investing has ended, we are heartened that we have maintained a healthy allocation to value throughout our strategies. We think that price and value will prove to be more crucial factors going forward than they have been, and simply focusing on growth will be more difficult as a means of generating returns.
As always, we continue to monitor the data and seek to make prudent and informed adjustments to our portfolios. If you have any questions about this, or any other financial concern, please feel free to contact your Atlas Wealth Management Advisor. We remain ready to assist you in your journey toward achieving your financial goals.
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