Q1 2022
April 4, 2022
I left off my last quarterly letter expressing my concerns about the stock market. I expressed this opinion noting several years of strong performance now facing tough headwinds. Chief among those headwinds was to be rising interest rates.
During this past quarter, interest rates have risen significantly. As an example, a 2-year maturity bond from the Tri-state Generation and Transmission Association (a high-quality electric cooperative) rose from 1.78% at the end of last year to 3.28% on 3/31/2022. A 10-year bond issued by Nucor rose from 3.00% to 3.58% over the same timeframe. {Yields provided by Bloomberg.}
These numbers show a material increase in yields paid on both short and long-term bonds. The shorter 2-year rate was up 1.50% over three months, while longer-term 10-year rates moved up 0.58%.
We believe the disparity between the increase in short vs long rates is because the Federal Reserve is still supporting longer-term bond prices. They have not yet stopped buying longer-maturity Treasury bonds. Once they stop, we believe longer-term rates will move even higher.
You may have been hearing or reading that the yield curve “inverted” during the last quarter. An inverted yield curve means shorter-term interest rates are higher than longer-term rates. When this happens, it generally gets a lot of press as it is both unusual and has tended to signal a recession is likely.
We’re not entirely embracing the idea that this yield curve’s inversion signals a recession. Too much of today’s bond market is still subject to unprecedented Fed manipulation, rendering historic economic indicators less meaningful. The sooner the Fed stops buying bonds, artificially supporting lower interest rates, the better for the long-term health of the economy and the markets. They are still committed to ending all bond buying soon.
The Fed also raised its short-term borrowing rate by 0.25% in March. More important, they clearly stated that they will continue to raise that rate over the balance of the year. The current expectation is they will raise that rate another 1% to 1.5% over the course of this year.
As you might expect me to say, I view all this as good news. I’ve continually viewed the unprecedented intervention of the Fed into the bond market as akin to the “cure, being worse than the disease”, a temporary fix that creates more serious longer-term problems.
What’s not good news is the reason the Fed is doing this now. Had they done this 12 to 18- months ago, when the economy was opening and demand for goods and services surging, we might have avoided some of the inflation we are now seeing. Unfortunately, much like in 2011 when the economy was recovering from the Great Recession, the Fed chose not to unwind its policy when the economic numbers supported unwinding. They instead delayed to avoid political fallout.
This brings me to inflation; inflation forced the Fed to act. They could no longer hold interest rates down while inflation surged throughout the economy. When inflation first reared its head last year, many felt it was transitory. That the post-reopening surge in demand was pushing prices higher. All indications were that this was true.
Then we started to realize you can’t shut the world’s economy down and expect it to seamlessly reopen. Logistics failed, bottlenecks emerged, and shortages were experienced. Consequently, inflationary expectations were extended to cover a longer period for normalization.
That whole narrative was starting to fall apart well in advance of Russia’s invasion of Ukraine.
By the 4th quarter, many were starting to wonder whether the massive stimulus spending during and after the pandemic had set in place “monetized inflation”. In other words, we’d printed so much money that the value of the dollar had declined. This is the most insidious type of inflation as it results in a direct loss of wealth.
I’m not going to weigh in with an opinion on the type of inflation we now face. It’s safe to say that the U.S. still has standing in the world as an economic power. Whether the lasting effects of the pandemic shutdowns and massive fiscal spending have lasting inflationary effects has nothing to do with what has already happened. It has everything to do with how policymakers respond going forward.
Here again, I see the Fed’s exiting quantitative easing as a good first step. Next, we’ll need action on the part of the legislative branch of government. As an optimist I see hope here too, we might be on the precipice of the most hopeful news.... gridlock.
This brings me to the stock market. After the New Year, the stock market started running into trouble. Prices fell in the face of worsening inflation, pending interest rate hikes, and concerns about the effect of labor shortages. Many of the high-flying growth stocks were hit as expected; higher interest rates tend to impact premium priced stocks the most. Valuations of companies most vulnerable to input inflation were also sent lower. All in all, it was a logical sell-off in light of conditions.
Then the Russians invaded Ukraine and the economic issues were compounded.
Before I go on, I feel compelled to remind you that this letter is intended to give you a sense of the markets and things related to investing. Geopolitical events have a bearing, but my assessment centers on the effects on markets.
With that said, I will depart to express my utter contempt for the Russian government and its criminal behavior. I hope each day that the Ukrainians, in spite of the odds, vanquish the Russian military. I hope the rest of the world holds Russia responsible for this action long after it ends. The world needs to unite against this sort of behavior.
From a market perspective, the invasion consumed everyone’s attention. The performance of the market became linked to the war.
Going into the end of the quarter, the Ukrainians showed a surprising capacity and the news focused on a potential negotiated settlement. The stock market responded with strong performance.
For the quarter, what were double-digit market losses during the quarter, became mid-single-digit losses by the quarter’s end. A somewhat surprising result given all that is going on, but as I said, the market has become tied to the war.
Neither Russia nor Ukraine are particularly significant to the earnings of U.S. companies. Their influence is more closely tied to the energy and agricultural markets, which means this war will increase the risk of prolonged inflation. But again, the overall effect cannot be assessed until we see how governments respond.
As for our investing in the stock market, we do view this as a time to be cautious. That does not mean we will sit on the sidelines as all this unfolds. Periods of economic turmoil provide opportunities for investment. So long as the money we are committing to stocks is truly long-term money, then our job is to buy well-positioned companies when the market gives us the chance to buy them at good prices.
As I said at the outset, please call if you have any questions. My Very Best!
Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com