It is difficult not to bemoan the complexities we all face as investors and willing participants in the markets as of late. As the economy at large seems to have just recently escaped the clutches of COVID, a new slate of challenges has been thrown into the system with little time to recover from the bruising of the past two years. The interconnectedness among global economies, trade systems, and financial markets is an ever-evolving beast, and we will highlight key concerns impacting portfolio volatility and driving future expectations. We understand the unsettling nature of difficult times; however, we have not strayed from our objectives of long-term wealth accumulation and prudent capital management through all stages of market cycles. To “win” the game of investing, one needs to avoid trying to fight this market beast, but more importantly, learn to play and understand that the rules of the game change over time, sometimes more rapidly than others.
Downside risks have seemingly accelerated in the month of April as the Russia-Ukraine conflict continues to unfold. Our prayers go out to those families devastated by the horrors of war, and we hope for a quick and peaceful resolution to curtail the loss of lives that have already impacted so many families. Inflation, interest rates, and corporate earnings are weighing heavily on Wall Street’s mind and have continued pushing market volatility to increasingly elevated levels. Extremely rare is the fact that what has historically been viewed as “conservative” assets – bonds – have provided virtually no insulation from the falling stock market. Difficult to digest as it may be, this is a much-needed course correction and well overdue from the days of pandemic policy intervention. From market index performance presented below, you will note that pullbacks have been experienced across virtually all major asset classes (first quarter and first three weeks of April, respectively):
Recent inflationary pressures have placed strain on American wallets to the likes of which have not been experienced for decades. As of March, the consumer price index increased at its fastest pace in 40 years (for the fifth month in a row), measuring an increase in prices of 8.5% over the previous year, up from February’s read of 7.9%. This has placed an unfortunate burden on millions of households simply looking to put food on the table. There is no certainty as to when we will see the rate of price increases slow and revert to lower historical averages; however, we are witnessing the policy activities in action in efforts to cool the effects. This process takes time to allow consumers and business to adjust expectations along with consumption and investment in general. The best-case scenario may expect a gradual decline in inflationary effects in early fall ’22. Some aspects of inflation are more “sticky” than others. Figure 1 provides a visual on key inflation drivers over the past year. For example, fuel, grains, and industrial metal prices tend to fluctuate more frequently due to seasonal effects and supply/demand imbalances. On the other hand, it is much harder for employers to reduce wages once pay is increased. Higher prices are likely here to stay, but the pace at which they increase will eventually slow.
Since our last writing, the Fed has begun what we expect to be a relatively aggressive economic tightening process by way of raising benchmark interest rates. These policy efforts are intended to slow inflation and may in turn impede economic growth. The Fed’s outlook to continue down the path of steadily increasing interest rates will likely lead consumers and businesses to reduce borrowing and spending, therefore reducing total output (GDP). It is important to understand that although upside growth in the underlying economy is expected, shifting expectations in the pace of growth compared to previous outlooks leads to volatile market conditions. These rapidly changing prospects for the post-COVID economy are exactly what we are experiencing at present.
As interest rates creep higher, consumers may delay or forego large purchases altogether as prices along with borrowing costs increase. According to the Bureau of Labor Statistics, wages recovered and grew at an accelerated pace during the second half of 2021. The March CPI figure of 8.5% compared to nominal year-over-year wage growth of 6.7% leaves the average American worse off, down 1.8% in “real” terms. This may have sweeping effects across the economy as consumer spending accounts for nearly 70% of economic output and even minor changes in spending behavior can have large effects on economic growth. For example, although there remains a shortage of supply in the housing market which has pushed prices ever higher, we expect the skyrocketing prices of homes to cool over the coming months as borrowing rates rise. As of April 21, the national average for fixed 30-year mortgage rates hit 5.11%, up from 2.97% just one year ago (Source: Freddie Mac). For a typical $250,000 mortgage, this increases the monthly payment by over $300, and a total of over $100,000 in interest paid over the life of the loan. Perhaps the silver lining is the fact that many Americans were able to take advantage and lock-in historically low interest rates over the past few years – either through purchasing or refinancing – meaning costs for existing borrowers will not change.
Businesses have been forced to increase wages to attract and retain employees during a very tight labor market. Like consumers, many businesses were able to borrow or refinance existing debt at very attractive interest rates in recent years, having a net positive effect on profitability. Uncertainty around higher future financing (borrowing) and operating (labor & materials) in general and the potential for slowing consumer demand creates a difficult backdrop for business conditions in general. In order to survive, businesses constantly need to balance the risks of raising prices to protect margins versus potentially driving away customers to seek lower-priced alternatives. Those that fail to maneuver these conditions appropriately will soon find themselves out of business. This ultimately weighs on near-term investment implications as conditions have become increasingly cloudy very quickly.
Further headwinds to growth and inflation due to the Russia-Ukraine conflict have exacerbated an already precarious economic picture. Ukraine is a major global exporter of corn, wheat, and seed oils – key foodstuffs especially for many in the developing world. Russia is also a major supplier of natural gas and petroleum – used for energy and many industrial/manufacturing components. Both countries produce raw materials needed in the production of fertilizer, further placing upward price pressures on food costs for all of us. Sanctions by the west against Russia and questionable output forecasts for much-needed materials is placing further stress on an already strained supply chain struggling to recover from government mandates and public health directives. There is the potential for these factors to spark protectionist trade policies, creating rippling effects and further choking global supplies (Indonesia largely banned the export of palm oil in late April, used in over half of all US consumer packaged products according to the World Wildlife Fund).
To summarize, we expect near-term uncertainty to continue driving market volatility and investors should temper return expectations compared to what we have delightedly experienced over the past few years. Equity (stocks) investors have been handsomely rewarded beyond expectations for most of the past decade and should be prepared for less attractive returns for 2022 as corporate profit outlooks face fairly strong headwinds. Fixed income (bonds) will continue along a rocky path ahead as interest rates will likely resume lifting off from all-time lows. Recall that as interest rates increase, bond prices typically fall. Further, we expect the Fed’s tightening process to begin once again moving us back toward normalcy in terms of financial market conditions. We may expect a gradual move toward positive returns on cash equivalent and money market vehicles for instance – a taste of which we last experienced briefly in 2019.
Although we believe it to be simply a matter of time to get through the challenges of today, we fully respect that people have finite lifespans and life’s expenses need to be met from asset bases that can uncomfortably fluctuate in value at times. We remind investors that patience is your best friend in finding success with any investment undertaking. More often than not, history has demonstrated some of the best investment opportunities have come when moods are most bleak. Financial markets are forward-looking and adjust based on changing future expectations. Figure 2 illustrates the general feeling of American consumers as measured by the University of Michigan Consumer Sentiment Index versus the subsequent 12-month return of the US stock market (S&P 500 Index). We are not suggesting that you should expect stocks to return 22% over the coming year as was the case from February 1975, but it is important to understand we have always pushed through the gloomy times to find brighter days. We believe this time will be no different.
On behalf of all of us at Sanford Advisory, we would like to express our deep appreciation for your continued trust and confidence. We appreciate the opportunity to continue building relationships with those we serve and their families alike. As we will officially be changing the name of our business and integrating with Mercer Advisors, we would like you all to be assured to expect the same personalized service and attention that you have become familiar with over the years at Sanford.
SANFORD ADVISORY SERVICES, LLC
● Todd Sanford, CFP® ● Scott Williams, CFP®
● Brent Kerstetter, MBA, CFP®
● Nick Bond, MBA, CFP® ● Kristen Cordell
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