By Stuart Katz, Chief Investment Officer
March 15, 2022 – First, we want to recognize that any discussion of investments pales in comparison to the beyond tragic devastation and loss of Ukrainian life. Since the Russian invasion of Ukraine on February 24th, the investment backdrop has changed considerably, with an escalation in geopolitical tensions putting upward pressure on inflation, downward pressure on growth and generally raising equity risk premia (an excess return earned by an investor when they invest in the stock market over a risk-free rate) as uncertainty spikes. When one adds geopolitical conflict of this magnitude into a market backdrop where the S&P 500 Index was already in correction territory (down at least 10% from its previous high) and the NASDAQ was in bear market territory (down at least 20% from its previous high), it is perfectly normal for investors’ concerns to become elevated.
Wall Street analysts are beginning to cut forecasts for U.S. and European GDP growth for this year and next, while also raising projections for inflation on the back of higher energy and food costs. While the Investment Office’s base projections currently do not anticipate a U.S. recession in 2022, investors are raising the probability of a recession to reflect the increasing concerns regarding a wider range of possible outcomes and not necessarily the fragility of the underlying U.S. economy. However, the European outlook is impacted by the strength of their commitment to endure the pain of eliminating Russian natural gas supply and their willingness to offset that drag with extraordinary fiscal support.
Even if the global economy manages to avoid falling into an outright recession, the stagflationary conditions that are building in the developed markets, namely slowing growth and rising inflation, have important implications for investors. Broader macroeconomic conditions point to a more challenging backdrop for corporate profits as slowing top line momentum coincides with growing margin pressures from higher input costs. At the same time, heightened geopolitical uncertainty and rising interest rate environment are putting downward pressures on equity valuations and widening credit spreads, thereby lowering the price to earnings ratio at the same time as profit expectations retrench especially in European equity markets.
After an approximate 20% decline from their January highs, it’s reasonable to say that European stocks are pricing in bad news, with equity valuations now below long run averages and near record lows vs. U.S. stocks. In early 2022, the Investment Office allocations were overweight U.S. equities relative to benchmark non-U.S. holdings and we believe European markets will likely remain problematic in the short term as investor sentiment oscillates between hope and fear. Our experience suggests that equity markets, more generally, rarely trough on valuation metrics alone, instead requiring a backdrop of broad capitulation, coupled with a more positive pivot in the news headlines and tangible catalysts (e.g. European Fiscal Stimulus Plan similar in scale with the prior U.S. American Rescue Plan) – conditions that have not yet come together.
In many respects, stagflation is a challenging investment environment as slowing growth weighs on equities at the same time as higher and more persistent inflation weakens the case for fixed income. Recently, credit spreads have been moving wider, but absent Emerging Market Debt, the spreads remain well below the post-Great Financial Crisis average levels. The current investment playbook has several key features including short duration fixed income, floating credit and quality equity holdings. We define quality as companies with strong positions in large markets with durable competitive advantages. Additionally, certain value sectors such as healthcare, energy, and consumer staples offer companies that are essential to people’s everyday lives and pricing power to offset higher input costs. Historically, we have also observed that high dividend stocks typically outperform during periods of high inflation. Portfolio construction could also benefit from incorporating alternative strategies, targeting real return assets such as multi-family and single-family rentals.
Finally, there are several macro considerations the Investment Office continues to monitor including wage price inflation, the level and duration of higher commodity prices that would potentially tip Europe and the U.S. into a recession and the Fed’s reaction function to more persistent and widespread inflation. As we watch events unfold in Ukraine, the Investment Office is managing its portfolios to address persistent inflation, high volatility and slowing growth. Despite the increasing range of uncertain outcomes, we encourage investors to avoid the behavioral short-term temptations that may impair long-term performance.
Sources: Bloomberg
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