Market Letter Q2’22

By Ryan Ross on April 12, 2022

The March inflation report was released this morning and the headline number was eye-popping.  Consumer prices rose 8.5% year-over-year, the most since 1982[1].^.  While extremely elevated (and painful), we believe this will be the high water mark for this cycle.  Our expectation is that year-over-year increases will begin to decline and end the year between 3.5% and 4%; still too high for comfort, but within striking distance of the Federal Reserve’s target of around 2%. 

There are many pillars supporting our belief: easing pandemic supply chain disruptions boosting supply, rising interest rates cooling demand, and an active Biden administration fighting for its legislative majorities in a mid-term election year.  Nothing harms an in-office administration like high inflation, especially in food and energy.  Another important theme we are expecting is the shift from spending on goods to spending on services and experiences, as the pandemic eases and the weather warms, releasing pressure on goods inflation. 

Housing, an important inflationary input, has been flirting with bubble territory as supply hasn’t kept up with demand, spurred on by low mortgage rates.  We expect prices to remain elevated throughout the summer, but to plateau as affordability declines with higher mortgage rates.  One area of concern, however, is the persistence of low inventory for sale.  Because so many people took advantage of low mortgage rates, they may be reluctant to move if that means acquiring a higher cost loan.  The housing market requires a constant stream of movers — either upsizing or downsizing – and any frictions in the process have an impact.

What does all this mean for the markets?  Bond markets have been pricing in a significant series of interest rate hikes by the Federal Reserve as they attempt to slow demand growth to cool inflation.  As interest rates increase, prices for existing bonds decrease because investors demand the current market rate of yield.  Bond math 101 has leapt from the textbook to client statements, with bond investments turning in their worst quarter since 1980[2].  Stocks also fell in the first quarter on many of the same concerns, with an added curveball of a war in Eastern Europe throwing a wet blanket on risk appetite.  Normally bonds act as a shock absorber during tumultuous equity markets, but not this time around.  In fact, both categories finished in the red together for the first time since the first quarter of 2018[3]. 

Though painful, we feel the current correction is healthy, normal, and necessary for well-functioning financial markets.  Conservative investors can finally earn a decent yield on high quality bonds again.  Maybe not yet reflected in savings account rates, but short-term government bonds are not zero for the first time in 25 months.  The drop in equities has reminded investors that there are risks to owning stocks, washing away a lot of the speculative excess that had been building.

Going forward we expect continued volatility as bears and bulls wrestle for control.  There are almost equal numbers of entries on our pro’s and con’s sheet, foreshadowing a directionless, volatile market.  A few negatives include slower earnings growth, the elimination of monetary and fiscal stimulus, and company margins falling due to inflation.  On the positive side, uncertainty is high, but falling; most professional investors are already bearish, reducing selling pressure; and individual investors are flush with savings and continue to invest.  There has been a nice recovery off the March lows which feels a little like a “Sell the fear, buy the news” condition.  Investors are getting some clarity around the current situation and are stepping back in.

What we cannot forget, as we were constantly reminded of during the past two challenging years, is to not bet against Corporate America.  The resilience of our companies is incredible, and we are confident that they can manage through this inflationary period as well as they managed through the pandemic.  It pays to be optimistic in our capitalistic system despite the media’s fascination with pointing out its flaws. 

We cannot stand still, though, as volatile markets create opportunities.  Our precious metal hedges have worked exactly as anticipated, providing a positive return in an otherwise down market.  We’ve rotated out of stocks that are negatively impacted by a drop in consumer spending, and added stocks that have higher cash flow generation and visibility.  We have added energy, materials, and commodity exposure, which have worked thus far.  Structured notes are a category that we believe can be a hybrid stock/bond investment, and buffered ETFs remain attractive. 

As many of you heard from us last year during review calls, we let the equity allocation of portfolios run higher than target given the negative outlook for bonds.  We are excited to rebalance back toward target soon – replenishing the bond category – as interest rates rise to more attractive levels.  While running higher equity levels was profitable for clients, returning to a more balanced posture is prudent given the uncertainties.  Stable, but nimble – That’s HMA!

[1]  https://www.morningstar.com/news/marketwatch/20220412169/us-inflation-rate-leaps-to-85-cpi-shows-as-higher-gas-prices-slam-consumers

[2] https://www.barrons.com/articles/corporate-bond-losses-recession-yields-51649362040

³https://www.morningstar.com/articles/1087132/13-charts-on-the-markets-first-quarter-performance