June 20, 2022

The past few weeks in market has caught many by surprise. We suspected a pullback and adjusted portfolios accordingly, but to what degree was the unknown. We still don’t know what could lie ahead. After a better-than-expected ISM Manufacturing release at the start of the month, the eye-popping US CPI figure of 8.6% has resulted in an upward spike in short term interest rates. It seems undeniable now that the Federal Reserve is faced with a stark choice – induce a recession by aggressively raising rates or allow persistent inflation.  Furthermore, the narrative of the current bear market (now in its sixth month) seems to be on an accelerated timetable this time. 

As we cautioned in earlier market reports, we continue to believe that now is one of the more challenging market outlooks during our careers, as essentially all four drivers of stock market return [1) earnings growth; 2) change in the valuation of stocks; 3) dividend yield; with 4) a strong dollar have become significant headwinds after being tailwinds for the past decade.  In the short term especially, the significant increase in the cost of capital due to higher Treasury rates and increased risk aversion (higher risk) is impacting the valuation of stocks negatively and sharply.  This has now moved from being concentrated within technology to becoming widespread.  Also, fears that the Fed might actually raise rates to choke off consumer demand has increased dramatically as market interest rates have spiked higher over the last two weeks.  Our thesis has been that the Fed would raise rates in 2022 but, when faced with political pressures, would “take a knee” at the first opportunity of signs of economic and market weakness, and allow negative real interest rates in an attempt to avoid recession.  Our thesis remains intact but, with inflation being the political issue, we think the Fed may actually tighten faster and to a higher level before reversing, but only after the political pressures do a 180 degree turn and the highly political Fed recognizes that a recession is worse than high inflation. Moreover, unemployment is on the rise and so are late mortgages and higher credit card balances.  These implications are suggesting that we’re likely to witness further stress across the consumer discretionary and financials sectors, as earnings growth rates contract, as well as across many industries that lack pricing power.  In recent months and as discussed in our weekly reports, our portfolio has seen an increased shift towards higher quality blue-chip companies in consumer staples, healthcare, and other dominant industries barbelled against our existing inflation-hedge type companies in energy and materials where reported earnings have handily topped expectations and earnings projections have drifted higher, offsetting the stock market’s multiple contraction.

To be fair, we know that we have clients that want to take additional risk, but we feel being too aggressive could be a head-wind. We are not advising to refrain from the market. Instead minimize risk given the lack of safe harbor nearly everywhere. Thus, we have raised our cash levels and defensive positions in most if not all of our client holdings. Once we can learn how the strengthening dollar will fair in this environment along with the aforementioned concerns then should we be better positioned.