Q2 2022

July 7th, 2022

As you already know, the stock market was not kind over the past quarter. Major stock market indices are now down for the year between 20% and 30%. Our stock strategies have held up fairly well relative to the market, but no one claims victory in tough markets.

Most of the decline for the year occurred this past quarter, which may lead you to believe that something has fundamentally changed over the past few months. Has it?

Before writing this letter, I reread my last letter to you as I covered a lot of ground in that letter. I wanted this discussion to put things in perspective relative to what was happening earlier this year. More important, I didn’t want to belabor points already made…. something I’m desperately working on!

One change we’ve seen is the Russian invasion of Ukraine has largely disappeared as an issue for markets. Replacing it is a renewed focus on our economy. Many investors now believe a recession is at hand. I believe this to be true.

Also fading since last quarter is the argument that the economy could weather the spike in inflation. If inflation was driven by a surge in post-pandemic demand for goods and services, the rise in prices could be seen as being both “transitory” and a signal of economic “strength”. That view has now been largely debunked.

Consumer demand has weakened considerably. You could clearly see it in the earnings reports of retailers over the past two quarters. I’ve been closely watching reported inventory levels as retailers report earnings.

Typically, we expect retail inventories to peak in the Fall quarter as merchants stock up for holiday season sales. Once the holidays are past, we expect lower reported inventories (4th quarter reports) and continued reductions through the Spring (1st quarter reports). This year we saw higher reported inventories after the holidays that continued to grow into the Spring quarter. This indicates consumer spending has failed to meet expectations.

Let me take a moment here to remind you that recessions are almost always caused by excess inventories. Since consumer spending is the main driver of U.S. economic activity, when you see retailers get caught with excess inventories, you can pretty much expect a slowdown in economic activity.

The transmission mechanism that rolls through the economy starts with retailers cutting their buying, then manufacturers respond to declining orders with layoffs, then rising unemployment exasperates the drop off in consumer demand. It’s not until inventories get back into balance that we see the economy bottom and things start picking up. I believe the downward spiral is underway.

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In this cycle though, the layoff/unemployment piece of the downturn may be muted. Most employers are having a very difficult time hiring. I suspect they’ll be hesitant to get too aggressive with layoffs given the shortage of workers; this is something to watch and, if true, would moderate the downward cycle.

So why has consumer demand tailed off? One reason was the stimulus spending during the pandemic: the money sent to people clearly helped sustain consumer spending during the shut-down. Because of this, there was no “pent up demand” for goods and services (as previously noted), with some notable exceptions like travel.

Which leads to the second reason consumer spending has tailed off: confidence. We have seen a sharp decline in consumer confidence over the past year. Business confidence has also taken a hit and they are also cutting back on spending. Where does this leave us? We are going into a recession. If it’s limited to an inventory correction, the outlook for stocks from here is actually quite good.

However, we continue to be concerned about longer term inflation. It is very important inflation be snuffed out as quickly as possible. I’ve harped for years about my displeasure with the Federal Reserve’s policies. I’ve worried that they may have “monetized” inflation. That remains the greatest risk to the longer-term outlook for stocks.

I was encouraged to see the Fed take more decisive action in June when they increased rates by 0.75%. That move helped assure the market that they may become aggressive in fighting inflation. The open question is whether, in the face of a weakening economy, the Fed will revert to short-term thinking and fail to remain diligent in addressing long-term inflation. The answer to that is the key.

So, what are we doing? In our fixed income (bond) accounts, we are taking advantage of higher interest rates by reinvesting maturities at much better yields. We are still keeping maturities relatively short- to intermediate-term reflecting our continued cautiousness regarding longer-term inflation.

In our stock strategies, we still hold significant cash that is available for investment in stocks. We’ve been cautious investing cash, but we have and will, add to positions we own or buy new stocks as prices justify. In short, you could say we are still looking at investing one stock at a time.

I hope you have a wonderful Summer!

Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com