Q1 2022 Commentary
Our tactical investment strategies have entered each of the last three calendar years with extremely defensive cash allocations.
The logic behind these allocations has been twofold: first, each of these years has been preceded by significant market strength, and our rotational approaches are designed to sell into excessive strength in order to lock in gains; second, each year has begun with stocks priced at historically high multiples – levels that have always preceded large drawdowns and poor long-term returns.
The high valuations were built upon a widespread presumption that low interest rates, recent market momentum and the lack of economic headwinds allowed for abandoning traditional valuation metrics and risk management. Markets entered two of the last three years seemingly assuming that nothing would go wrong.
This hope turned out to be very wrong in 2020, with the emergence of COVID-19. It turned out to be wrong again this year, with Russia’s invasion of Ukraine and the economic fallout from the accompanying global backlash.
The pandemic and the war can be seen as completely isolated events, but the global economic repercussions are inextricably linked.
The 2020 COVID crash was the result of a widespread shutdown of economic activity (both mandated and voluntary). Governments and central banks tried to fill the gap by throwing trillions of combined monetary and fiscal stimulus at the problem. In the U.S., fiscal stimulus alone summed to more than 25% of GDP. This far eclipsed the amount of money thrown at the financial crisis in a much shorter period. With this massive experiment, it was unclear just how much of the combined stimulus would translate to productivity and how much would fuel inflation.
The aggressive policy choices had profound productivity effects, allowing for the most rapid V-shaped recovery in history and helping to bridge the pre- and post-pandemic world. The benefits continue to evidence themselves across multiple metrics. The prime age employment/population ratio is back to 2019 levels. Real GDP continues to reach new highs. Corporate earnings have reaped the greatest benefits, surpassing pre-pandemic profits by over 40%.
Despite the positive metrics, the massive amounts of liquidity have been met by supply side constraints, where bottlenecks and shortages have led to the highest inflation levels in forty years.
Even before Russia amassed troops on the Ukrainian border, 2022 started on very different footing than the years before it. Inflation pressures had killed any plans for continued fiscal stimulus, while forcing the Fed to begin tightening monetary policy. Stocks began the year fighting headwinds not seen in some time.
Then the war began. Market optimists fairly pointed to past armed conflicts abroad, including Russia’s taking of Crimea, to argue that the threat to stocks was minimal. Western leaders, however, pushed an aggressive sanctions approach with global implications, sending commodity prices soaring and further stretching consumers’ disposable income.
The war in Ukraine is the type of exogenous event that would typically give the Fed pause or at least prompt some dovish language. For the last few decades, we have been in a relatively low-inflation environment that has given the Fed the freedom of accommodating every dip in the economy (though they have failed at optimally deploying that accommodation). Today, thanks to the actions taken during the pandemic, they no longer have that luxury. The FOMC scaled back from a 50 basis point rate hike in March, but they are now slated to embark on the most aggressive tightening cycle since the late 1980s. The Fed is focused on fighting inflation, and they are no longer prioritizing the appeasement of financial markets.
While inflation constrains consumer spending and corporate profit margins, rising rates will continue to put pressure on equity multiples, which are still at historically unsustainable levels. Even if the Fed does not prompt a recession, their actions are likely to continue to remove speculation from risk markets. The most speculative areas of the market have already been crushed, with many of last year’s high-flyers more than 75% off of their highs. We are now seeing damage in interest rate-sensitive areas, with major homebuilders more than 30% off of their highs.
The rest of the market still has plenty of downside risk.
Though there were clear drivers for the correction in Q1 and there are clear reasons for caution ahead, there are also reasons to remain optimistic. Inflation may be at 40- year highs, but jobless claims, one of the best recession indicators, have been coming in at 40 year lows. The underlying economic strength could be enough to offset continued multiple contraction, as it has over the last year, and as it did during the last comparable tightening cycle in the late 1980s.
There is also some encouragement to be found in the sentiment data and price action. Near the February lows, we saw sentiment surveys reflecting more pessimism than at the COVID lows of 2020. These levels have historically coincided with high probability buying opportunities. The subsequent market move, which included an 8% bounce in just two weeks, looks very similar to some historic market bottoms.
Strong economic data, technically oversold stocks and extremely pessimistic sentiment were enough to convince us to put more cash to work across all strategies in the first quarter.
Given our longer-term concerns surrounding inflation, interest rates and valuations, all Time Overlay strategies began reducing exposure before the end of the quarter. Markets have been relatively resilient so far, but we are dealing with issues not seen in decades, and it may take some time (and volatility) for stocks to adjust properly.
Robert B. Drach
Drach Advisors LLC