Newsletter – Quarter 2, 2022

Investors will likely look back at the 2010s as an ideal period for owning assets.  Valuations were low for many asset classes as we exited the Great Recession of 2008-2009, the economy was recovering – albeit  at a low growth rate, and inflation levels were low and very consistent.  To add to this ideal environment, the Federal Reserve (“Fed”) provided a tailwind to asset prices by keeping interest rates at or near zero while implementing quantitative easing (“QE”), a practice in which the Fed purchases treasuries and mortgage-backed securities.  Every time the Fed attempted to normalize monetary policy by raising rates and reducing QE, markets reacted negatively.  Fearing a deflationary spiral from the decline of asset prices in a highly indebted economy, these adverse market reactions were met swiftly with the Fed reverting back to easy monetary policy.  

Episodes like this occurred frequently enough that many market participants were wondering if the Fed had expanded its dual mandate – maximize employment while keeping price stability – to include a third mandate: support asset prices.  The era of easy money seems to have peaked during the COVID pandemic when the Fed slashed interest rates to zero and expanded QE to include the purchase of corporate bonds.  Furthermore, 2020 and 2021 saw trillions of dollars handed directly to individuals and businesses, even if they were not feeling the effects of the lockdowns. 

It appears 2022 will be the year where geopolitical and economic forces work together in unison to disrupt the era of easy money and force the Fed’s hand into a period of monetary tightening.  High demand from consumers flush with cash bumping up against disrupted supply chains, years of underinvestment in commodity production, and geopolitical turmoil, have caused inflation to reach levels not seen in four decades.  With worries about inflation becoming a persistent problem, the Fed has set itself on a mission to restore price stability by raising interest rates and tightening monetary policy with the hope of suppressing demand.  Yet, reducing demand without inducing a recession, often referred to as a “soft landing,” is no easy task, and the market knows it.  The monetary policy of the last 10+ years has created the perfect set-up for the market volatility we are experiencing today.  Valuations across many asset classes had expanded to historically high levels.  In addition, low interest rates have allowed both private and public institutions to take on high levels of debt while keeping interest cost low. 

Unfortunately, nearly every asset class has been impacted by the Fed’s tightening.  Stock and bond markets are down double-digit percentages for the first half of 2022.  Real estate hasn’t been significantly impacted, but it is slower to react and is facing some near-term headwinds.  We do believe the Fed will be successful in reducing demand in the economy.  Yet, we are not sure the Fed will achieve a soft landing.  If history is any guide, the odds are against it, as the Fed has achieved a soft landing only three times in the last 12 big tightening cycles.  We also wonder if the Fed will be successful in reducing inflation to its 2% target over the next few years.  Much of today’s inflation is due to constrained supply.  Supply chain issues will eventually ease, but underinvestment in commodity production will take much longer to correct.  It is very possible these structural issues lead to elevated levels of inflation versus the prior decade.  However, there are counteracting disinflationary trends such as aging demographics and technology that could help offset inflationary pressures.

While the first half of 2022 has been rough for investors, there is some good news.  Historically, significant market declines present great buying opportunities for long-term investors.  No one knows exactly when the market will bottom, but bear markets often set the stage for attractive future returns.  As Warren Buffett is famous for saying: “Be fearful when others are greedy, and greedy when others are fearful.”  There are many high-quality businesses with long runways for growth that are selling at cheap valuations.  Additionally, if you have some positions with losses in a taxable account, it may be a good idea to consider tax loss harvesting.  Capturing losses to shield current or future realized gains could be beneficial to increasing your after-tax returns.  Lastly, it is always important to use volatile moments like today to review your risk tolerance and investment goals.  If you have any questions regarding these subjects, please feel free to contact our team.