Current Outlook & Portfolio Strategy
Posted on August 3, 2022
To say that investors experienced a roller-coaster ride in the markets during the second quarter was an understatement. We witnessed the S&P 500 close 20% down from the benchmark’s January highs to officially enter bear market territory in June. Meanwhile, yields on 10-Year U.S. Treasury bonds more than doubled from the beginning of the year, recently reaching 3.36%. To what can investors attribute this volatility? The biggest culprits are concerns and uncertainty over inflation, both in the U.S. and globally.
The June Consumer Price Index (CPI) report posted a headline inflation reading of 8.6%, which marked an increase over the prior months’ report and exceeded economists’ consensus estimates. While everyone may not purchase the exact basket of goods measured by the CPI survey, most of us have likely experienced the uptick in the price of gasoline and groceries. Even if we remove those volatile elements of gasoline (energy) and groceries (food) from the report, inflation still measured a 6% year-over-year increase. This level is well above the Federal Reserve Board’s inflation target of 2% and increases investors’ concerns that the Fed will have to take more aggressive measures that potentially result in a recession.
Pinpointing the exact origins and causes of current U.S. inflation generates significant debate and disagreement among economists. However, it is reasonable to consider some key drivers that likely explain most of the situation. First, the unprecedented shutdown of the global economy led to significant fiscal and monetary stimulus as governments and central banks worked to avoid a protracted global recession. Central banks have started to withdraw that monetary stimulus by raising short-term rates and reducing their balance sheets (quantitative tightening). Following higher-than anticipated inflation readings, our Fed raised interest rates by 0.75% June 15, and remarked that “ongoing increases…will be appropriate” to wrest inflation back to the Fed’s 2% target.
Second, the four-month long Ukraine war has cut global supplies of both wheat and oil. Europe recently implemented sanctions against some purchases of Russian oil, which will lead to less overall supply of oil available to the market and, hence, keep oil prices elevated. Although the U.S. does not import Russian oil, we are not immune to the marketplace dynamics. While a definitive conclusion to the war is not in sight, a relatively amicable solution will provide energy and food markets a much-needed reprieve and dampen inflation.
Finally, China’s President Xi continues to implement a zero-COVID policy forcing massive shutdowns of entire cities, especially those that are key to global supply chains. Such a policy can worsen inflation as fewer goods are produced and delivered relative to surging consumer demand. During the pandemic, many companies acknowledged the hard lessons learned in concentrating supply chains around China, yet moving manufacturing facilities and establishing new vendors in the supply chain take time. Unfortunately, China’s zero-COVID policy is unlikely to be rescinded and will continue to negatively impact supply chains and inflation.
We will likely continue to face uncertainty and volatility in the markets as the above variables shift over time. Naturally, this will lead investors to react positively or negatively to monthly data points as they try to glean a glimpse into the future. As in times past, we expect the roller coaster to bottom and begin its inevitable climb up. Long-term investors who allocate to high-quality companies will be rewarded during the recovery, but only if they stick with their long-term asset allocation. For clients who wish to reduce their risks, having modest allocations to short-term bonds or cash for upcoming lifestyle expenses may be prudent.
Andrew Vanderhorst, CFA, CAIA, CFP®
Chief Investment Officer
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