The first half of 2022 was certainly an eventful one, as headlines both at home and abroad weighed upon asset prices. The S&P 500 and MSCI EAFE indices each lost roughly 20% of their values, making this one of the worst first halves of a year in decades for equities. At the same time, fixed income markets offered less in the way of a safe haven than would typically be expected, with the Bloomberg U.S. Aggregate Bond Index shedding about 10.4% over the same timeframe. Undoubtedly, the past six months have been quite volatile for markets, and there has been a plethora of factors to explain why this has been the case. Yet overall, we believe many such factors are merely variations of the same reality: the global economy is likely facing several important, and interconnected, “regime changes” that will certainly impact markets in the near term, and most likely over the long term.
To start, let us consider the trajectory of globalization. While Sino-American tensions beginning late last decade led some to discuss the prospect of further declines in global trade, the supply chain disruptions brought on by the pandemic made those conversations louder. Increasing uncertainties around trade routes and labor sources previously taken for granted have caused many companies to reconsider where they locate manufacturing facilities, valuing stability over cost. Such considerations took on a more urgent tone at the beginning of this year, with the Russian invasion of Ukraine in late February. Ukraine is a major global producer of industrial and agricultural inputs, and the war quickly led to new disruptions and price spikes in goods ranging from wheat to neon. In response to the invasion, Western nations placed a series of economic sanctions on Russia. Given the country’s status as a major exporter of food and energy to the world, the price of many commodities rose as a result. Further sanctions severely limited Russia’s ability to transact within the global financial system, renewing concerns that geopolitical rifts may eventually translate to splintered financial markets and reduced global trade. Unfortunately, as things stand now, we fear that may indeed be the case, and as the world’s major economies seek to adapt, we believe there will be greater volatility for sovereigns, corporates, consumers and of course, financial markets.
Building new facilities, holding contingency inventories and securing additional sources of supply all have the potential to drive the price of goods higher. As such, we believe that this increase in geopolitical instability not only impacts supply chains but acts as a contributing factor to another major “regime change” we have seen impact markets recently: inflation. We have discussed the issue for quite some time now and continue to be of the view that inflation may persist for longer and at a higher level than many expect. While we have no interest in pronouncing any kind of “top” in CPI or PCE data, we do believe there is a distinct possibility that while inflation numbers may come down somewhat from their recent highs, they may settle at a level greater than that seen in the last several decades. From December 1989 to December 2019, US CPI averaged 2.5%. By contrast, in the three decades prior, that average was 5.0%. Let us assume for a moment that inflation comes to persist around 3.75% (the average of the two periods): that is effectively 50% higher inflation than we’ve experienced in the two decades prior to the pandemic. This is likely to further drive a shift in consumer behavior, and by extension, that of companies and investors. If this recent bout of inflation were purely the result of disruptions due to a pandemic and a war, we might discount such a scenario. However, when combined with underinvestment across primary industries in the past decade and demographic headwinds in parts of the developed and emerging world, we cannot help but wonder if there is a regime change towards a global economy that must contend with inflation in a way that it has not for some time now.
As financial history has demonstrated, inflation, especially runaway inflation, can wreak havoc on an economy. Luckily, this is far from a secret, and one component of the dual mandate of the U.S. central bank is price stability. Though the Federal Reserve spent a great deal of the previous year dismissing this recent bout of inflation as “transitory”, they entered the year with a decidedly more hawkish stance. In addition to cutting back asset purchases, the Fed has taken the decision to raise rates three times so far this year, with each increase larger than the last. As further rate hikes are almost a foregone conclusion, it appears that the U.S. central bank is taking a strong stance when it comes to bringing inflation under control. While this may be encouraging for an increasingly stretched consumer, it also represents yet another major “regime change” for markets. In the decade and a half since the Global Financial Crisis, accommodative policy by central banks provided a meaningful tailwind to asset valuations around the world. Yet as central banks shift their primary focus from stimulating growth to combating inflation and policy becomes more restrictive, valuations may have to recalibrate in kind. This could well explain, at least to some degree, the downdraft in markets we have seen as of late. Even if central bankers prove successful in bringing prices under control, we feel this recent inflationary episode may leave them more reticent to make use of some of the policy tools so commonly used post-GFC, be it zero/negative interest rate policy or large-scale asset purchases. Should this be the case, not only would valuations likely need to move lower, but market volatility may rise as investors begin to discount the backstop, real or imagined, from central bank intervention. At least to some extent, we believe markets are beginning to price in a world where central banks are less likely to come to the immediate rescue of falling asset prices.
While we believe that these three “regime changes” may be the cause of some of the volatility we’ve encountered in markets this year, we also recognize this to be mere conjecture. We would be remiss not to highlight the fact that this has likely been one of the more muddled economic backdrops we have encountered in some time. On the one hand, though central banks appear to be taking strong action to fight inflation, supply issues may continue to exacerbate pricing pressure. Simultaneously, despite some bright spots (like employment numbers), much of the data we have seen as of late suggests the economic backdrop may be deteriorating, and many market pundits believe that we may be on the verge of, or already in, a recession.
We take no strong view one way or the other regarding the trajectory of the global economy from here. Instead, we have made use of this environment to seek out opportunities where markets may be mispricing the prospect of a recession, or its impact on certain asset classes. For example, despite the Bloomberg Commodity Index hitting a 5-year high at the beginning of June, clear concerns over a contracting economy dragged it down nearly 15% by the end of the month. We believe such a dramatic shift in sentiment likely created an opportunity to add exposure to this space, especially as we believe recession fears may be overshadowing a more structural shift in demand for key industrial inputs and energy in the years ahead. While we noted some contributing factors earlier (underinvestment, demographics), we also see many underestimating the resource intensity of the transition to clean and renewable energy, another long-term tailwind for the commodities space. Given that this is likely to occur in fits and starts, we are of the view that investors may be well-served to take advantage of periods where markets take a shorter-term view of the situation. (As an aside, we intend to publish a piece exploring this issue in greater detail later in the month, which we will share with you when available.) Similarly, we feel equity investors may be underestimating the prospects for a number of businesses purely due to near-term potential economic woes, with no regard for their leverage to structural trends in technology or consumer behavior. We have begun to identify, analyze and in some cases, invest in such businesses along with adding to our existing holdings levered to these trends; and for the first time in a while, we are constructive on the possibility of a widening opportunity set in the coming months and years. Similarly, on the fixed income side, we see the prospect of rising rates and more adequate compensation for various forms of risk as creating a backdrop in which we will be able to find new ways to put funds to work. Although we remain defensively positioned in fixed income for now, we are again beginning to see the early signs of a shift.
However, as we move into the second half of the year, we once again must emphasize that we take no strong view on the trajectory of global growth from here. That said, there will be several issues we intend to keep a close eye on, very much “signposts” of the regime changes we believe may be underway. We see tightening monetary policy and its impact on the real economy likely to weigh on consumer and corporate sentiment, not just in the U.S. but in other major markets as well. In China, ongoing zero-COVID policies may continue to disrupt supply chains the world over and have the potential to counteract the moves by central banks to reduce inflation. Finally, in Europe, we see the potential for major challenges when it comes to energy security. While this certainly would have an impact upon the consumer on the Continent, we feel there may be further-reaching consequences for industry in the region, which may create further supply strains globally. Should any of this come to pass, we are of the view it would only compound the volatility we have seen as of late.
While none of this is likely to be terribly reassuring, we must again reemphasize that we are not in the business of making macroeconomic prognostications. Rather, we work to invest on behalf of our clients in a measured and prudent manner, with clear consideration for the market environment at any given time. Things are indeed uncertain at the moment, but as discussed, we feel this creates opportunities in and of itself. It is our intention to allocate capital in situations where we see more bleak outcomes already more than priced in. Given our recent defensive positioning and the relative returns of that positioning decision when compared to equity market indices year to date, we also feel we are well prepared to adapt to whatever environment may lie ahead.
As always, we greatly appreciate your support and trust. Should you have any questions about our views on markets, or how we are thinking about the opportunity set ahead, we strongly encourage you to reach out. Once again, we must remind you that communication, though always valuable, is of particular importance in periods of market volatility. Given the wide range of possible outcomes for markets from here, it is important that you alert us to any major changes in your financial situation and investment objectives or wish to impose any reasonable restrictions with regard to how we manage your portfolio. To be clear, we do not make these statements to create concern, but rather to emphasize that you have a dedicated partner in the form of our entire team here at Drum Hill.
We hope that you have a relaxing, pleasant summer and wish you all the best as we move into the back half of this year.