Update - Inflation, Ukraine, and the stock market
You have undoubtedly noticed the continued volatility in the stock market this month after a rough first quarter. We want to explain what is happening and why, as well as our current investment strategy. The key factors leading to the market declines are listed below. Most importantly, we have made several moves to protect portfolios in this environment, and we will explain those as well at the bottom of this email.
Factors driving volatility
- Reduction in federal stimulus including
- Rising interest rates
- Reducing bonds held on the Federal Reserve balance sheet
- Reduction in federal spending
- Ongoing war in Ukraine
- Lockdowns in China
- Potentially slowing economic growth
Reduction in federal stimulus was expected, as the small businesses loans, unemployment payments and other stimulus programs were designed to cushion the immediate shock of Covid shutdowns but were never expected to be ongoing. Four types of stimuli have been layered into the economy since the 2008 Great Recession: (1) record low interest rates (more on that below), (2) federal bond purchases to increase levels of liquidity in the markets, (3) tax cuts, and (4) emergency spending. All four of those are being reduced now or scheduled to be reduced in the near future. All these stimuli achieved their purpose of fueling economic growth, but the stimuli cannot continue forever.
Rising interest rates are not a surprise. You may remember we have been discussing this in our client meetings for several years. In the stock market, rising interest rates negatively affect growth stocks far more than value stocks. Growth companies are those whose revenues grow faster than their profits, including many technology firms, e-commerce firms, and digital payment firms. Characteristics of growth stocks include the need to borrow heavily to invest in the future and promises of large profits many years down the road. When interest rates rise, the interest cost on the debt rises, and the profits far in the future are worth less, which reduces the current valuation of these growth stocks. Since 2009, interest rates have remained at record lows, fueling a very high valuation of growth stocks. However, with interest rate increases expected all year, growth stocks have lost 25% to 30% year-to-date. Conversely value stocks, especially dividend paying stock funds, have performed much better than growth stocks. Value and dividend paying funds have lost 5% to 6% this year, while the S&P 500 has lost almost 15%.
Bond prices also decline when interest rates go up, because everyone wants to buy only the newer bonds that pay higher interest rates. The total bond market index has declined 10% year-to-date. In preparation for interest rate increases, our portfolios currently do not include bond market index funds.
The war in Ukraine was the least expected event this year, with the greatest unknown in outcome. Its impact is clear in not only the human toll, but also the reduction in food and commodities being exported from Ukraine and Russia. This results in shortages and inflationary pressures on many fronts of the US economy.
Inflation is the result of a mismatch between supply and demand, and of course we know about the labor shortage, rising wages (which can also be helpful to the economy) and supply chain shortages exacerbated by the lockdowns in China. The Federal Reserve is raising interest rates to help fight inflation, and that always comes with a concern about a ‘policy mistake’ of too much too fast, resulting in a recession. When you see commodity prices dropping on some days, it is because the fear of a recession has increased at that time.
Potentially slowing economic growth is feared due to the combination of all the factors above. Federal spending fueled recovery, but its withdrawal can also slow growth, in addition to rising interest rates. Inflation from shortages of food, labor and raw materials can mean consumers have less disposable income. The probability of a recession has increased, but it is not here yet, and timing is very unpredictable.
On the bright side, there are counterpoints, which indicate that there could be a ‘soft landing’ in the future. Company profits have remained strong, houses have grown in value, wages are higher, consumer spending is strong, unemployment is low and interest rates remain at the low end of historical rates.
Actions we have taken to protect your portfolio
- We began the move from growth stocks to value stocks last year when the Federal Reserve announced an acceleration in the timing and amount of interest rate hikes. We don’t want to move out of growth stocks entirely, but the lower priced value stocks are getting their day to shine in portfolios now, and we expect that to continue for some time.
- We moved from traditional bond funds to Treasury Inflation Protected bonds (TIPS) and very short-term Treasury Bills (which show up as ‘cash’ in Morningstar) to significantly reduce the impact of interest rate hikes. The bond price issue will resolve itself quickly when interest rates stabilize, and we will be able to buy traditional bond funds again at lower prices and higher yields.
We do not see a need to move away from long-term portfolio allocations at this time. Current market movements are in the normal range, and many of them have been expected for years. This year has been another good reminder that trying to guess timing simply doesn’t pay off, and as you know, all the financial plans that we model for you incorporate the probability that there will be some years when the market declines.
In the meantime, we are watching the economic environment closely, and if you would like to discuss your portfolio, we are always available. We hope you and your families are well and enjoying this beautiful spring. If you have any other concerns or questions about the market or another part of your financial plan, please do not hesitate to reach out to us.