Given the renewed market downturn, fed by high uncertainty around inflation and the war in Ukraine, we want to share our most-current views and portfolio positioning with clients and followers of our research. We will start with a brief recap of what brought us here as context for this discussion.
The past two years have seen a difficult-to-imagine series of major macro events and responses that are still in the process of playing out. Going into 2020 we had low interest rates and a strong economy. The emergence of the global COVID pandemic resulted in lockdowns and restrictions that in turn led to layoffs and supply chain disruptions. The global policy response was to provide economic stimulus including keeping rates ultra-low and increasing government spending to support affected businesses and workers.
After a sharp initial downturn in growth, the global economy recovered impressively, but the stage was set for a new challenge in the form of sharply rising inflation. The short version is that supply chain disruptions led to shortages in a wide swath of products where demand was high, and when demand outstrips supply the result is higher prices. At the same time, a shortage of workers led to rising wages as businesses competed to attract and keep workers. That combination – rising wages and rising inflation – can become a self-reinforcing spiral that is damaging to the economy. The Fed (and Central Banks around the globe) recognize this risk and have committed to preventing it by increasing interest rates to whatever extent is required.
Enter the next macro wildcard, which was Russia’s invasion of Ukraine. The war in Ukraine has had wide-ranging but diverse impacts on the global economy and individual regions. Besides Ukraine itself, the most direct and damaging economic impact is on Russia. Given that Russia’s economy is less than 2% of global GDP and that the Litman Gregory portfolio strategies had close to zero exposure to Russian stocks or bonds, the Russian invasion has had an immaterial performance impact on the Litman Gregory portfolio strategies.
However, Russia is a major producer and exporter of oil and natural gas—to Europe in particular, accounting for roughly 50% of Europe’s natural gas imports and 25% of its oil imports—and certain agricultural commodities and base metals. As such, the war and the sanctions imposed on Russia by the West are having, and for the foreseeable future will continue to have, a material impact on global economic growth and inflation.
In a nutshell, the war is a “stagflationary” supply-shock: it fuels higher inflation via sharply rising commodity prices (especially oil) while also depressing growth via negative impacts on real disposable income and consumer spending. It is also triggering various government and central bank policy responses, which create additional risks and uncertainties for the economy and markets, given already-high inflation and decelerating growth coming into the year.
The path, timing, impact and ultimate outcome of the war remain highly uncertain. Russian and Ukrainian commodity exports could be further disrupted forcing prices even higher, or we may see a quicker resolution than the current consensus (to give just two examples out of many possibilities). As we’ve often said about shocking events such as this: the truth is no one knows, and if they think they know, they’re fooling themselves. As Nobel Prize winner Daniel Kahneman put it: “The correct lesson to learn from surprises is that the world is surprising.” In short, we want to build portfolios that are resilient in the face of surprises rather than ones whose success depends on predicting them.
The disheartening events in Ukraine came as the COVID-19 pandemic news was getting better. There has been a recent uptick in new cases globally—in China (leading to full lockdowns in the affected areas under China’s “zero-COVID” approach), other Asian countries and Europe—and the U.S. may see a similar uptick. But over time, with continued rising immunity rates, vaccines, medical advancements, and social and business adaptation, the economic damage and disruption should continue to recede. That is our base case.
If so, this should both support economic growth via consumer and business spending and mitigate some of the inflationary pressures the U.S. and global economy experienced last year caused by widespread supply-chain bottlenecks, supply/demand mismatches for consumer durable goods (e.g., autos) and the sub-par recovery in the U.S. labor force participation rate, which has contributed to higher U.S. wage inflation and increased the risk of a self-reinforcing wage-price spiral taking hold.
That said, Jerome Powell and the Federal Reserve are in a tough spot. They know they need to tighten monetary policy to prevent a wage-price spiral from taking hold. If they fail, it will require even more drastic policy tightening down the road increasing the likelihood of recession. Yet, much of the current inflation is driven by exogenous supply-side disruptions due to COVID and the Ukraine war that the Fed can’t control. Raising rates is intended to crimp aggregate demand and should eventually have a downward impact on inflation. But it also raises the risk of driving the economy into .
We have long positioned our portfolios in anticipation of eventual rising rates, mainly because with rates so low there is limited downside protection from bonds (there’s little room to go lower which is what drives bond prices higher) and longer-term bond return forecasts are poor, for the same reason. In other words, we’re happy with our fixed income positioning away from core bonds through our diversification into flexible fixed income and alternative investment strategies.
Another important consideration is the impact of rising rates on stocks. A handful of U.S. large-cap growth stocks (e.g., the tech-heavy FANMAG* group) account for an historically large proportion of the overall U.S. stock market. These companies can be thought of as “long-duration” investments – in that they require a longer time period for company performance to eventually justify their high current valuations relative to the broader market. Low interest rates are a strong factor in supporting these high valuations and as rates have risen the toll on those stocks has been significant.
Here too diversification is key as simple large-cap stock index exposure is likely to remain vulnerable in a world of rising rates. Our equity positioning is broadly diversified, both through our use of active managers, in many of our portfolios, who can avoid areas of the market they find unattractive and through dedicated exposure to smaller-cap and value-oriented domestic companies as well as developed international and emerging market stocks. In addition, our portfolios have benefited from the uncorrelated performance of alternative strategies, including distinct areas that have had positive performance so far this year.
We dislike market declines and periods of high uncertainty as much as anyone, but both are an inevitable part of investing. While uncomfortable, these stretches remind us of the fundamental principles that define our approach: invest for the long term because the short term cannot consistently be predicted, stay disciplined, diversify, and remember that disruption creates investment opportunities for those with the research skill and conviction to take advantage of them. As always, this is what we will to do in managing our client portfolios.
We appreciate the trust that our clients place in us to guide their investments through both volatile and steady times. We encourage you to reach out to your Litman Gregory Advisor to review your portfolio, individual situation, and any questions.
~ Litman Gregory Investment Team
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