Sound asset allocation is the critical foundation for every successful investment portfolio. We at CWM have always preached the need to be diversified, to own quality, and to have patience when markets are volatile and fear is outpacing greed. Some days that is easier said than done, but we strongly believe that discipline and good process will drive investment performance over the long term.
While the table below notes the substantial outperformance of stocks over bonds and cash holdings over the past five years, that outperformance did not happen without volatility. During this timeframe, the equity markets suffered two major pullbacks of more than -25%. Equity markets were able to rebound due to factors that drive economic cycles: corporate earnings growth and availability of credit. Even in today’s volatile markets we expect earnings to experience above average growth for 2022 and credit conditions to remain robust.
Since the start of the pandemic in March 2020, the growth in money supply has increased more than 40%. Trillions of dollars of monetary and fiscal stimulus may have saved the global economy from the initial wave of the pandemic, but the economic lasting effect of such stimulus is that today we live in a world of both excess saving and excess money supply. The U.S. banking system has $4.4 trillion more in deposits today than when the pandemic started. The balance sheet of the Federal Reserve has increased $5 trillion in size since the start of the pandemic due to record monetary stimulus and the Fed’s quantitative easing activity. The capital markets are awash in liquidity and that liquidity is causing inflation to surface in both asset prices and the price of goods. The stock market has seen a pickup in inflows as low yields and excess savings are attracting capital in search of return. Residential housing prices are up substantially over the past two years. The combination of limited housing supply and low rates pushed up the average national home price by double digits. Commodity inflation is rampant, and we all are feeling it in our grocery bill, at the gas pump, or in the price of goods or services. Too many dollars are chasing either the same or fewer units. The result is higher prices. Some of these higher prices appear to have already peaked in certain segments but inflation has been persistently higher over the past year. It’s difficult to ignore. Temporary inflation feels more than transitory right now. Inflationary pressures are likely to continue well into 2022. To date, companies have been able to pass along price increases and maintain operating margins. History says the equity market peaks when earnings peak. We constantly are monitoring operating margins and the level of earnings. The direction of earnings drives the direction of the equity market, not every day or week but over time. Follow earnings and you’ll follow the direction of the market.
This inflation is causing the Fed to act. A policy transition from “quantitative easing” to “quantitative tightening” will occur over the coming quarters as the Fed limits their open market purchases of Treasuries and mortgages. This will result in a reduction in the pace of the Fed’s balance sheet growth and a tightening of overall financial conditions. This coming March the Fed will likely raise their benchmark Fed funds rate by 25bps for the first time since the onset of the pandemic. The bond market is now predicting 3-4 rate hikes in 2022. The yield curve has recently been flattening with the front end increasing in anticipation of future rate hikes. History says it takes 2-3 years for a Fed rate hiking cycle to result in an inverted yield curve. An inverted yield curve will signal the end of the current cycle. Monitoring the relationship between short and long rates will be important as this cycle advances. When short rates exceed long rates, no credit can be created let alone good credit. The shape of yield curve is a great predictive tool of when we will likely see the next recession. Our best guess is that such remains years away, but we will stay disciplined to our data driven process and will continue to follow such carefully. History does rhyme and the next recession will likely be preceded by an inverted yield curve.
We’re overdue for some volatility and it’s been snowing volatility so far this January. The combination of surging COVID case counts, a Fed headed towards interest rate hikes, and geopolitical challenges in the Ukraine have produced more than enough volatility this month. Pullbacks even in bull markets do occur and we’re amid one right now. Volatility brings about opportunity and we will continue to search for new opportunities across asset classes. The price you pay for an asset often dictates the return of that asset. As an activity, selling is easy but buying is very hard. During volatile times we’ll continue to communicate a lot and hopefully land some new ideas in the portfolios that will generate good risk adjusted future returns.
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This note is provided for informational purposes only. Congress believes this information to be accurate and reliable but does not warrant it as to completeness or accuracy. This note may include candid statements, opinions and/or forecasts, including those regarding investment strategies and economic and market conditions; however, there is no guarantee that such statements, opinions and/or forecasts will prove to be correct. All such expressions of opinions or forecasts are subject to change without notice. Any projections, targets or estimates are forward looking statements and are based on Congress’ research, analysis, and assumption. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. This note is not a complete analysis of all material facts respecting any issuer, industry or security or of your investment objectives, parameters, needs or financial situation, and therefore is not a sufficient basis alone on which to base an investment decision. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this note. No portion of this note is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Investing entails the risk of loss of principal.