Commentary

January 2, 2023

We recognize duality in various aspects of our economy and markets, as we say “hello” to 2023 and “goodbye” to 2022. But will the key concerns of inflation, Fed action, and a possible recession go away with the mere turn of the calendar page? For at least the past two decades we have enjoyed low inflation, and at times even lamented that it was too low. That reversed dramatically in 2022 with a spike in inflation caused by several trends reversing simultaneously in the year. We expect inflation to eventually stabilize but at a higher level, more in line with long term averages than we have enjoyed in the past. 

Open vs Closed Markets: In its eerily prescient article “The Long Boom” Wired Magazine published in 1997, Peter Schwartz and Peter Leyden made a strong case for 25 years of global prosperity and integration based on “fundamental technological change and a new ethos of openness”. There is no question they were right on technology, which accelerated change for the better. Technology enabled companies to manufacture more efficiently domestically. Open markets enabled companies to seek and access low-cost labor and materials wherever they could find them abroad. Globalization was a win for emerging economies and a win for us as our consumer-focused economy benefitted from cheaper goods and services. Goodbye inflation. 

Communication between individuals accelerated significantly after the iPhone was introduced 10 years later in 2007. Being linked by this and similar devices unfettered by boundaries of country and culture certainly promoted openness, for a while. For a moment we had the Arab Spring. But then we experienced 9/11, regime change in China, the Covid pandemic and this year, the Russian invasion of Ukraine. 

Clyde Prestowitz (“Industrial Policy Comes Full Circle” WSJ of December 15, 2022) posits that Covid shutdowns of the last few years have exposed the perils of being too intertwined with countries separated from us by geography and radically different political, legal, and philosophical systems. He cites the example of Germany paying dearly for becoming too reliant on Russian natural gas. The US too, learned from the pervasive computer chip shortage that recently crippled many industries. The new production facilities planned for the U.S is our response. But these chips are unlikely to cost less than imported chips which also benefit from being purchased with the stronger US dollar. Mr. Prestowitz also points out that shipping generates 14% of global greenhouse gas emissions, a cost that is not currently incorporated into the price of the product shipped. If it was, we would be more likely to buy local. 

Tariffs have been around in some form for all of our history. Tea anyone? But their magnitude and impact began to accelerate in earnest by tariffs placed on China pre-Covid. These are still in place and expanded with embargoes on Russian oil and other commodities after the invasion of Ukraine. There is a direct relationship between tariffs and the cost of imported goods across the globe. Hello inflation.   

Demand vs Supply: During the Great Recession of 2008, the Fed embarked on an extensive and successful program to lower interest rates to stimulate demand for goods and services. During the Covid crisis years, the Fed followed the same game plan, injecting a huge amount of liquidity into the economy. These policies were also supplemented by direct payments to households and loans to businesses to keep them afloat. Those actions helped the country get through the crisis and prevented certain industries like the airlines from going bankrupt when few were travelling. This time however, the problem was supply, not demand. During the Covid years, homebound households and businesses flush with cash had little to spend it on due to supply bottlenecks. There were too many dollars chasing fewer goods and services. Hello inflation.

Mild vs Severe Recession: Yields on Treasury notes with maturities greater than 10 years are now lower than those with maturities under 2 years. This situation, an “inverted yield curve” has traditionally been known to foreshadow a recession. The Fed has insisted that it will continue to raise rates to 5-5.5% from the current 4.25-4.5% if the labor market, the last pin to fall, stays stubbornly resilient. There are indications of softness, with drops in job gains and a slight rise in unemployment projected for December. Those results will be out later in the first week of the year. This time bad news on the labor front will presage good news for markets, as it may stay the Fed’s hand. 

Stocks vs Bonds: Markets dashed hopes of a Santa rally in stocks with the S&P 500 down over 19% for 2022. Bonds as measured by the Bloomberg US Aggregate Index also dropped 13% for the year decimating the traditional 60/40 balanced portfolio. In market history, there have been just two other calendar years when both stocks and bonds had negative returns. The consensus outlook for 2023 remains murky for both, with investors expecting a poor first half while the Fed is still in a rate raising mode. Investors expect a rebound in the second half, expecting to eke out a positive year overall. 

Active vs Passive: Due to the challenges ahead, 2023 is very likely to be a stock pickers’ market. Investors will have to throw out the old play book to adjust to the brave new world of higher inflation and higher rates. As we have seen in 2022, investors will reward the companies that are nimble enough to adjust their cost structure to maintain earnings growth. Also rewarded will be companies with strong enough brands to raise prices without affecting sales. Good cash flow and solid balance sheets will be more important than ever, playing into the high-quality stocks and bonds we prefer. Goodbye “meme” stocks, hello active management. 

Bottom Line: We take comfort from the fact that two back-to-back down years are extremely rare in stock market history. It is also easier to find attractive entry points in a market down 20% than the other way around. Due to the “known unknowns”, we are maintaining clients at the low end of their target ranges for both stocks and bonds. While we wait for stability, however, there is an alternative: U.S. Treasuries with short maturities that are still yielding north of 4%. Instead of choosing between hello or goodbye, “Aloha” seems about right.

*Song title by The Beatles

October 2, 2022

The markets’ swings this year would make a grandfather clock proud. We thought the S&P 500 stock index had hit bottom on June 16, bumping along each month but holding this bottom until Thursday, September 29. The day before, the market had risen about 2% on the hope that our Fed would follow the Bank of England’s lead and stop raising rates. Reality stepped in the next day when certain Fed members made it clear that there was little chance of the U.S. following England’s lead. The market promptly reversed Wednesday’s gains and dropped to below June’s lows by September 30.

The Good: It is tempting to say the damning words “this time it’s different” because this correction is anticipating a mild recession in the face of low unemployment and still robust personal and corporate balance sheets. Prices at the pump have dropped to more reasonable levels, the previously red hot housing market is showing signs of softening, and the affluent have continued to travel, eat out, and pay for entertainment. 

The Bad: The Fed has made it clear it is bound and determined to keep raising rates to clamp down on inflation, regardless of the pain the economy suffers. Unfortunately, inflation statistics, which admittedly are lagging indicators, still show inflation at higher than the Fed’s annual target of 2 %. The proverbial supply-chain issues that companies had to deal with have eased, but are still hampered by rolling lockdowns in China as it aggressively combats Covid. 

Or the Ugly: The market action is anticipating a hard landing, expecting another 0.75% raise in November, and a couple smaller raises continuing into 2023. The fear is that these moves could overshoot, causing a severe recession with negative implications on profitability, productivity and people. 

Geo-politics are not getting better either. The overarching war in Ukraine now promises to continue indefinitely. Putin has ramped up his rhetoric by vague threats of using nuclear weapons. Russia’s sham referendum to approve the annexing of occupied areas of Ukraine ups the ante, dashing hopes of a diplomatic resolution. Meanwhile, Europe faces a serious energy crisis as Russia curtails supplies of oil and gas to the region, with winter around the corner. Looming large on the horizon is the face of global hunger as shipments of grain from Ukraine are erratic and dependent on the winds of war.

As is normally the case, global turmoil has strengthened the US dollar, raising it to all-time highs against major currencies. The strong dollar helps curb inflation by keeping import costs low, while pricier exports lower foreign demand, curbing domestic production. This environment is good for U.S. consumers who will enjoy the advantages of cheaper imports. Multinationals, however, will feel the sting of negative foreign exchange adjustments tempering their third quarter earnings and outlook. 

Bonds: What has been disconcerting to many investors this year is that bond returns have been almost as volatile and negative as stocks. While bond prices fall as interest rates rise, their move downward is exacerbated by the Fed stopping the bond buying program it began during the Covid crisis. It is also letting the bonds roll off at maturity without replacing them, and has hinted on the likelihood of selling bonds in the future, if additional tightening is needed. Without the backstop of the Fed as a major purchaser, there is now a greater supply of bonds, trading down to the yields their credit levels deserve. The resulting dismal performance of both stocks and bonds simultaneously has devasted the returns of the standard 60/40 stock/bond portfolio held by the average investor. 

Cash is King (Again): There is one silver lining to the perennial storm clouds. As short interest rates rise due to Fed action, the yield on US treasuries which mature in a year are bumping up against 4%. This is a level not visited for more than a decade. Although yields on money market funds are rising, bank deposits remain stubbornly low. 

Bottom Line: So, what is an investor to do in this terrible, horrible, no-good, very bad bear market? “Nothing” is the surprising consensus. To quote Sir John Templeton, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”. If you were not prescient enough to sell at the top, on January 3, 2022 when the S&P 500 hit its peak this year, now is not the time to take any action, apart from making sure you have sufficient cash set aside for daily needs. Not taking action is hard, the very antithesis of the American psyche (“Don’t just stand there, do something!”) . 

At Fern Capital, we are at the low end of client equity allocations, but keeping an eye on some high quality stocks that are reaching tempting valuation levels. With rates rising, companies with low debt and earnings that generate steady cash flow are able to hold their own better in challenging times. Further, those with generous cash reserves are able to take advantage of opportunities that arise more frequently in troubled times, or buy back their own stock at bargain prices. We believe this environment is particularly good for the kind of securities we prefer to hold. Putting money to work is better with values that are down 20% for example, rather than up 20%. That rationale goes far in explaining a quote from legendary investor Shelby Cullom Davis “You make most of your money in a bear market, – you just don’t realize it at the time”. Perhaps like Alexander, cited in the book’s title, this year will get better, eventually.

*Inspired by “Alexander and the Terrible, Horrible, No good, Very Bad Day” written by Judith Viorst 

July 4, 2022

Both stock and bond markets buckled simultaneously this year. The last time this happened was over 50 years ago. So, investors are justifiably anxious to know when this dismal period will end. Let’s go on this road trip together… 

The Pandemic: The seeds of the distress we are currently experiencing were sown during the pandemic. To offset the loss of income caused by the shutdown of all non-essential businesses, a massive amount of liquidity was pumped into the economy in the U.S. and abroad. Some of it took the form of direct cash assistance to individuals and loans to companies to help them survive the effects of the Covid related disruptions. In addition, the Federal Reserve kept the Fed funds rate low and embarked on a bond repurchase program to support the fixed income market. After a severe drop in March of 2020, the stock market rebounded quickly, resulting in the S&P 500 returning over 16% in 2020 and 26% in 2021. 

“Meme” stocks, Cryptos and SPACs: With time on their hands and cash burning a hole in their pockets, it is not surprising that some found non-traditional ways to put it to use. Some banded together to intentionally support the stocks of failing companies. Others bought crypto “currencies” which burgeoned during the pandemic years, resulting in wind-fall profits for those who were early in the game. Then there were SPACs. It was a new way for nascent companies to trade on public exchanges without incurring the time, expense and vetting necessary to go public using the IPO format. Not surprisingly, we saw the birth of some public companies that were no more than a gleam in the founder’s eye, many with no sales, and very few with actual profits. Meanwhile, traditional investors were enjoying a boost in stock valuations resulting in the S&P Price to Earnings (PE) ratio peaking at 39 in December 2020. By comparison, the current PE of 19 shows a market correcting to more normal levels of valuation. 

Supply-Chain Woes, the Russian War and China: The next stop on our journey is the pressure on supplies caused by the rolling shutdowns across the globe. We have become painfully aware of our reliance on products shipped from halfway across the world and exacerbated by “just-in-time” inventory practices that left domestic manufacturers high and dry, waiting for the parts essential for their production. Inflationary pressures already building up with backlogs at ports and the shortage of computer chips are magnified by the Russian invasion of Ukraine and  the resulting tariffs on Russian oil and gas. The final straw is the strict shutdowns in China, which is attempting to stop the spread of Covid variants there. 

Inflation & the Fed: At this point of the trip we’ve taken, it is hardly surprising that the price of goods and services is going up. We have seen this in spades with the recent eye-popping inflation numbers. The most recent CPI for May was an annualized rate of 8.6%, the highest seen since December 1981. The Federal Reserve got the message, a little too late as critics assert. At its June meeting, it raised short term interest rates by .75%, the biggest rate increase since 1994, and stopped its purchase of bonds. Although this move was not a surprise, the stock and bond markets responded by dropping anyway. Now, the consensus is that there is more pain to come to get inflation down to reasonable levels. 

Recession Watch: The hottest parlor game among economists, is guessing whether the Fed can tamp down inflation without pushing the economy into a recession. Chances are we may be technically in a recession already, defined by two consecutive quarters of negative economic growth. We had a drop in Gross Domestic Product in the first quarter of 2022 and are likely to hear in August that we had a drop in GDP in the second quarter too. So far, the consensus is that if we have a recession this year, it will be mild. 

Bottom Line: Although we have had a few pit-stops along the way, we are not there yet. There are signs that the economy is slowing in response to the rate hikes, but the Fed is expected to raise rates again in July as inflation has not dropped enough yet. In times like these we take comfort from market history. Per the Wall Street Journal analysis this past weekend, in the two years (1962 and 1970) when first half returns were worse than 2022, stocks rose sharply in the second half. In 1970 it even eked out a positive return for the year. These periods test our ability to focus on the long term. But we need to stay invested in quality securities to benefit from a rebound when it happens, or the paper losses we see will indeed turn out to be real. 

At Fern Capital, we are at the lower end of equity targets, preferring stocks with yields that pay us to wait. As we maintain a shorter laddered bond portfolio, we can replace the bonds that mature with ones at higher yields. Meanwhile, we echo the article also in this weekend’s Wall Street Journal that posits “Checking balances frequently when markets decline can lead to some bad decisions – and possibly more losses over time”. Keep the faith.

April 2, 2022

After two years of pestilence, we are now facing war and perhaps famine in certain parts of the world. The often cited “Wall of Worry” appears to be building up to the sky these days. So, what is an investor to do?

 “Turn Out the Lights”: This is happening quite literally in Ukraine. Initially, the consensus opinion was that Ukraine would fold quickly under Russian aggression and the world would adjust and carry on. That has not yet happened. So, we watch the horror unfold daily with a mix of shock at the devastation, pride in the Ukrainian spirit and grief at the human toll. We knew about Europe’s reliance on Russian gas. What has come as a surprise is Ukraine’s impact on global supplies of wheat, corn, seed oil and iron ore to name the top four. The longer the war lasts in Europe’s “breadbasket”, the more likely it is for shortages to hit Ukraine’s main customers, Europe, China, and North Africa. Demand from abroad will inevitably raise costs in the U.S., further fueling inflation here. While Ukraine appears to be beating back the Russians, there is a prevailing fear that Russia, in a desperate attempt to “win”, will resort to chemical or biological weapons (or worse). Crossing the line this way raises the odds that NATO will get directly involved. Investors are justifiably anxious, as evidenced by the daily gyrations of the markets responding to the most recent news on the war. 

“All Good Things Must End”: Federal Reserve Chair Powell raised rates on March 16, officially ending its easing policy and signaled its willingness to continue to raise rates aggressively until inflation is brought to its knees. The bond market answered in kind with the Bloomberg Aggregate Bond Index dropping 7.7%, worse than the S&P500 stock index which dropped 4.9% year to date through March 31. 

Is a Recession in the Cards?: An “inverted yield curve” that results from short term U.S. treasury rates getting higher than long term rates, is often considered a foreshadowing of a recession. In the past few days, the yield curve has flirted with inversion, causing much handwringing among market watchers. The caveat here is that while every recession is preceded by an inverted yield curve, an inverted yield curve does not always precede a recession. So “‘while the candles flicker and dim”, they are not out yet. 

 “Just Let it Go”? With bonds no longer cushioning the drop in stocks, it is tempting to sell and stay in cash until the coast is clear. Historically, this strategy has never worked, particularly for long-term investors. Cash cannot safeguard against the ravages of inflation, particularly when it is as high as it is now, above 7%. Investors seldom get back into the market in time to benefit entirely from the it’s rebound. In 2020, the S&P 500 dropped 34% in March from its all-time high in February. The rebound was sharp and steep, returning the S&P to its previous high in a mere six months, despite a pandemic-related shut down of most economic activity. While the situation was very different then, it is typical that investors who try to time the market often sell low in despair and end up buying only when the market has already rebounded and appears to be “safe” enough to get back in.

 Green Shoots: March unemployment of 3.6% is almost back to the pre-Covid rate of 3.5%. This was on top of higher labor participation rates and job growth over 400,000 for 11 straight months, the longest run since 1939. Foreign investors are paying attention, increasing their investment in the U.S., a haven from the turmoil in Europe, and new Covid restrictions in China. U.S. companies with strong management and “fortress” balance sheets, have demonstrated their ability to adjust to new challenges. Still flush with cash from the liquidity pumped into the economy over the last two years, these companies are rewarding loyal investors by increasing their dividends. Some are also taking advantage of current market weakness to buy back their own stock, boding well for their future earnings per share.  

We expect further market volatility as companies report first quarter earnings, if recent reports are any indicator. If companies are cautious on their outlook, we expect they will be punished regardless of reported results. However, we remain positive on the second half of the year, as the U.S. is in post-Covid recovery mode now, and consumers are raring to travel, shop, and be entertained. While high gas and food prices will put a dent in their Covid era savings, the statement “Never underestimate the propensity of the U.S. Consumer to spend” is still valid. With money market funds yielding under 1% and bonds experiencing loss of value as rates rise, T.I.N.A. (There Is No Alternative) holds true for long-term investors of U.S. stocks. 

Bottom Line: Jason Zweig put it best in his column in the Wall Street Journal of March 12-13, 2022: “...investors need not only courage to act, but the courage not to act – the courage to resist”. At Fern Capital, we see it as our responsibility to keep our clients invested, even when everything and everyone is screaming “sell!”. History has proven that this is the prudent thing to do over the long haul.

 * Lines taken variously from lyrics by Willie Nelson, Billy May, and Finneas Baird O’Connell