After a brief rally at the end of January which lifted the S&P 500 out of correction territory, the market continued to move higher for the first two days of February. Thereafter and through the course of February, the S&P made a series of lower highs and lower lows, closing the month down 3.1%. While the S&P closed February off its low for the month, it is still down 8% YTD. The NASDAQ 100 (QQQ) declined 5% for the month, while small caps (IWM) and large cap value (RPV) bucked the trend, ending the month with a gain of less than 1%. The bond market was down 1%.
What’s driving the market – interest rates, inflation, Russia invasion of Ukraine
Ongoing concerns over higher inflation and how much the Fed would respond through its March 16th interest rate policy meeting was the continuing driver of the market during the first half of February but was quickly put on the back burner when Russia invaded Ukraine on the 24th. We touched on the Ukraine-Russia conflict in our 2022 outlook as a potential market moving event (https://thewestermangroup.com/2022/01/10/2021-year-end-summary-and-2022-outlook/). The market initially gapped down over 2% at the open, breaching the 1/27 lows, but quickly began clawing its way back to close the day with gains greater than 1%. This was a huge intra-day turnaround that appeared encouraging. A follow through on Friday increased the perception that the rumor of invasion had a greater adverse impact on the markets than the invasion itself, particularly when Ukraine was able to stand its ground and impede Russia’s expectation of a swift victory. However, as the conflict escalated over the weekend, the final day of the month was down, but still well off the intra-day low. In our opinion, the conflict is simply headline news, and the Fed will likely have a far greater impact on the market over the upcoming months.
An effect of the conflict is a spike in food and energy process, stoking inflationary concerns yet again. Though Russia is a small percentage of global GDP, its largest two exports are oil and wheat, which commodity prices spiked as the invasion took hold. The conflict is creating another layer of uncertainty, to which the market typically does not respond positively. A flight to quality pushed treasury yields down (and prices up), and dragged down cyclical, economically sensitive sectors, particularly financials. Ironically, as the Fed wants to normalize and raise rates, the conflict in Ukraine is causing treasury yields to buckle, doing the exact opposite of what the Fed is trying to accomplish. The broader market moves are putting Fed Chair Powell in an even more challenging position. Any impact that the conflict may have on their upcoming policy meeting is currently being voted on by market participants, causing volatility and price spikes. Furthermore, the cycle of lower treasury rates is making those growth names that have been beaten up due to an anticipation of higher rates seem more attractive to market speculators. For the time being, growth stocks have rallied from February 23rd as treasury yields have fallen.
As a result, it is our opinion that inflation is still the primary driver of the market, and the geopolitical events only serve to muddy the outlook and cause even more uncertainty. This conflict is inherently inflationary due to Russia’s main exports, which food and energy prices are the biggest inflationary metrics that the Fed is trying to stabilize. What may be ironic, is that war often causes citizens and businesses to take pause, slow down, and reduce spending which may slow down the demand side of inflation equation. At some point, extremely high gas prices may result in people opting to drive less. This “demand destruction” may partially take care of the inflationary spike on its own and thus require less Fed tightening than without. As supply chains normalize, the natural forces that are causing inflation may very well moderate on their own.
On a positive note, U.S. fourth quarter GDP grew at a 6.9% annualized growth rate, beating consensus estimates of 5.5%. This points to the strength of the U.S. economy, which should very well be able to handle several Fed Funds rate increases. The Fed has been very clear of its intent to be “data dependent” in its rate policy decisions and increasing the fed funds rate is a vote of confidence that the economy is strong enough to support higher rates. Perhaps the sell the rumor buy the news trend will continue in March, when the Fed pivots from talking about raising rates to raising rates. This perhaps may reduce the uncertainty that is challenging the direction of the market. But with a likely extended period of conflict in the east, only so much uncertainly can be removed for the time being. Thus, we anticipate ongoing volatility as the market sorts out these two significant forces, which it likely will in time.
PORTFOLIO ADJUSTMENTS:
On January 14th, we evacuated our sizable position in QQQ and repositioned the proceeds to RPV, a pure large cap value fund. Since this move, QQQ has shed 7.8% whereas RPV has declined 2.9% through 2/28.
During the end of Januarys relief rally, we also moved profits from XLG, SPLG and SPTM to cash, paring those positions back down to target to further reduce exposure to volatile risk assets. Through February our process still has not recommended reducing exposure below target, except for a 5% trim of XLG, now amounting to 95% of target.
We also rotated our fixed income model from preferred stock (PFF) to High yield bonds (HYG) on 2/16, paring some risk in the fixed income side of the model portfolios as well.
Collectively, these adjustments have reduced the overall risk profile and moved the allocation away from being overweight large cap growth to being overweight large cap value. The value space has held up much better YTD, as RPV is up 2% as of 2/28 where the growth complex (RPG) is down 15% YTD. The largest period of dispersion of returns occurred during the first two weeks of the year, when RPV was up 6.9% and RPG was down 8%. Our process has moved us to greater relative strength, for now, and we remain flexible to change that allocation as our process continues to evaluate the market based on objective price discovery.
LOOKING AHEAD
As we’ve been very clear about the expectation of heightened volatility as we move from a highly accommodative Fed policy to a policy designed to reduce inflation, it is more important than ever to maintain a long-term view on the financial markets. While no one likes to see their portfolios decline in value, the reality of investing is that the stock market goes up AND down. Over a long enough time horizon, those investors that stick to their long-term plan have been rewarded by higher values. The current situation is no different. While uncomfortable, and likely to play out over a longer duration than the prior two market challenges (December 2018 and February 2020), we remain committed to our process to systematically reduce risk when appropriate and to maintain sufficient exposure to growth assets, as one knows when the market will bottom, and sunny skies appear again. For the time being, we are adjusting the risk profile to stay invested, at least until the market deteriorates to a level that statistically indicates further downside ahead. For now, the market remains down but rangebound and the S&P is still holding above correction territory, which is defined as a 10% decline from a recent all-time high.
The effects of higher inflation, higher rates, less Fed induced liquidity measures, and the geopolitical considerations are likely to slow down the economy for the time being, which will help ease inflation over time so that the economy can be on more solid footing and better prepared for the next cycle of expansion. It is important to be realistic about future return expectations, particularly when coming off a decade of higher-than-average results. Reducing return expectations relative to the past calendar years is warranted, as is exercising patience. The two aforementioned corrections (as well as the recession during the financial crisis) were resolved by the Fed injecting sizable liquidity into the markets as well as reducing rates to zero, which are not viable measures right now. The Fed must allow the economy to stand on its own two feet, akin to what parents know is necessary to enable their children to do the same at the appropriate age. The time is now, while the economy is still showing signs of strength vis a vis earnings growth, almost full employment, and rising GDP. A reduction to the longer-term trend line of all those metrics will take time, and will often be unpleasant, but necessary to maintain the long-term growth trajectory of which our great economy is capable. Without reducing the excess liquidity, highly accommodative rate policy, and heightened speculation in the markets because of the great recession and the COVID induced pandemic emergency measures taken on by the Fed, then inflation will likely be persistent for much longer than anyone would desire. Inflation is a nasty tax on all our standards of living with much deeper impact than a reduction in future investment returns.
We’ll get thought this together, and we will continue to proactively guide you to ensure that your long-term financial plans will be met.
