April 20, 2022 Letter to Clients

In reviewing our last economic and market commentary letter in February, little has changed since that time with many of the issues facing the markets still present; some of which we have more clarity and guidance on, monetary policy for example, and some, namely the Russia-Ukraine war, continue to present uncertainties. In this, our second letter of this year, we will provide an update to those issues and discuss our outlook.

The first quarter of this year quickly saw the markets transition away from a year of exceptional recovery with record low volatility directly into a year that has proven very challenging for the markets, most notably due to the implications of the unexpected and shocking Russian invasion of Ukraine, the Federal Reserve signaling their intentions of sooner-than-expected interest rate hikes, and persistent soaring inflation. We certainly had hoped that COVID would not be continuing to impact our lives at this point, and while we’ve made significant strides in moving closer to a return to our “normal” way of living, new variants continue to present limitations to that complete return, especially in China. These factors, amongst less newsworthy issues and events, present a challenging job for both policymakers and investors.

Key Factors Impacting the Markets and Economy:

The Russian invasion of Ukraine is having a profound global impact.
Inflation in the U.S. has accelerated and has proven not to be transitory.
The Federal Reserve is taking a less accommodative stance and fiscal stimulus will be far less.
China is struggling with Omicron and manufacturing plant shutdowns exacerbated already strained global supply constraints.
2022 is a midterm election year with history telling us to expect heightened market volatility.

The Fed Versus The Economy

As we’ve discussed in previous letters, the Federal Reserve’s (the Fed) mission is to keep the U.S. economy simmering at a steady temperature – not too hot and not too cold. Managing our country’s monetary policy, defined as controlling the supply of money in our economy, is the primary task the Fed is charged with and influencing interest rates is one of the most effective tools they have at their disposal to accomplish this.

Undoubtedly, you have seen in the news much conversation and debate regarding the Fed’s projections for interest rate hikes throughout 2022, given that inflation in the U.S. has proven not to be transitory as once thought by Fed Chairman, Jerome Powell. Just last month, the inflation rate accelerated to 8.5%, the highest since 1981. My family, as well as yours, have experienced this pinch to our wallets as we are paying substantially more for most everything we use in our daily living. Energy prices increased 32%, food prices grew by 8.8%, shelter costs grew by 5% and new vehicles prices by 12.5%, to name a few. To put this in perspective, the annual inflation rate this time last year was 4.2%. On an optimistic note, analysts are predicting that March 2022 saw the peak in inflation despite the supply chain bottlenecks continuing, the war in Ukraine persists and consumer demand remains at a high level. Now that we’ve discussed inflation, we return to the topic of the Fed and how their decisions regarding the Federal Funds Rate impacts our economy and how they will raise that rate to cool, but not stifle the U.S. economy, and lower inflation in the process.

The Federal Funds Rate (FFR) is the average interest rate that banks pay for overnight borrowing. The Fed adjusts this rate as it deems necessary and does so because this rate greatly influences what is known as the prime rate. This ultimately influences other interest rates, including the rates being paid on credit cards, mortgages, construction and auto loans. One may wonder why increasing the cost to borrowers is beneficial at a time when they are already taking a huge hit to their wallets for everyday spending. The end goal by the Fed in raising the FFR is to increase the cost of credit for both consumers and businesses, which prompts those who are unable or unwilling to pay more in interest to postpone projects, encouraging people to save more to earn higher interest. This reduction in money circulating in the economy ultimately aids in lowering inflation.

The Federal Reserve aims to keep the FFR within a 2.0% to 5.0% sweet spot to maintain a healthy economy, however, there are exceptions. To curb rampant inflation, this rate has increased well above that range with 1980 being an example of this when the rate was 20% at a time when inflation had hit staggering double-digits. In 2008, and then again in 2020, in response to the financial crisis and then the global pandemic, the Fed implemented the all-time lowest rate, zero. For the first time in more than three years, last month the Fed approved a 0.25% rate hike with their message being clear: they are intent on taking an aggressive approach to combat inflation, with multiple rate hikes to continue throughout 2022 and into 2023.

War On Ukraine: Far-Reaching Global Impact

The Ukrainian people are burdened with bearing the heaviest of the weight. Devastation from this war has greatly impacted their people and that is at the forefront of our minds, however, at a time when the global economy is still grappling with pandemic-wrought disruptions, Russia’s war on Ukraine is further exacerbating the inflationary pressures and economic fallout felt worldwide. This war threatens to thrust Europe into a recession, inflict energy and food shortages as well as create social unrest in countries that are most sensitive to energy, food and agriculture inflation.

Global food prices are soaring, and we turn to history to show us what occurs when the world’s most vulnerable countries are burdened with food and agriculture experiencing fast and sharp price increases. Ukraine, with its extensive fertile lands of rich, dark soil and vast fields, is known as the “breadbasket of Europe” with more than 70% of the country being made up of prime agricultural land. The Ukrainian people have been some the world’s largest contributors to the World Food Programme, a United Nations agency providing food and nutrition aid to those countries and communities considered most food insecure. Both Ukraine and Russia play a major role in the global food supply with both countries being significant exporters of crops, including sunflower oil, barley, wheat and corn. While all countries who import these commodities will experience food inflation, the inevitable reduction of these essential crops will not be felt equally worldwide. Countries across the Middle East and Africa are extremely reliant on both Ukraine and Russia for wheat as they supply more than two-thirds of imports in Egypt, Libya and Lebanon. The reliance on both countries for corn has an even larger geopolitical reach across East Asia and Europe. Additionally, Russia is one of the largest global exporters of fertilizers, adding another factor in the rise of food costs. Seeing this unfold, we don’t have to look far back in history to remind ourselves that when basic resources such as food and energy are low or financially out of reach for certain populations, political unrest ensues. Combine the export issues that the war has created, along with pre-existing political conflicts, droughts as well as the economic chaos brought about by the global pandemic. The climate is ripe in poorer countries with a fragile political environment to experience social distress and political upheaval. Signs of this are already occurring in Peru, Pakistan, and Sri Lanka, with others being closely monitored.

In our last letter, we expressed concerns related to the disruption to the energy sector, particularly oil and natural gas. The invasion of Ukraine, in simple terms, has wreaked havoc on the global energy market. This isn’t the first time that world leaders have had to fret about their reliance on Russian energy as Russian military aggression in the past has led nations to rethink their own energy sources and security. It appears, however, that the lure of cheap Russian energy has proven difficult to resist as Germany, Italy, Belarus, Turkey, and the Netherlands remain at the top of the list of countries heavily dependent on gas imports. Despite promises in the past of cutting ties with Russia, Europe remains heavily dependent on that country for its energy. Turning off that dependency is no small feat, especially given the investment in pipeline infrastructure. This makes substituting gas for another energy source very difficult. Strict sanctions have been placed, with countries banning or announcing plans to phase out Russian oil, gas, and coal by year-end. World leaders are now faced with the question on how to sever, or at least diminish, their energy dependence on Russia in order to reduce their dependence and create energy security for their own nations.

Sadly, the devastating updates and images continue to come out of the Ukraine as it has been approximately two months since Russian President Vladimir Putin launched a full-scale invasion on that country on February 24, 2022. The Ukrainian people have demonstrated exceptional strength, courage, and resilience in the face of this tragic attack. Our thoughts and continued support to all those impacted will most certainly continue. It is our sincere hope that our next letter will provide promising news related to the status of this war, something the stock market would welcome as well.

Staying The Course and Staying Informed

It may feel, especially coming out of the pandemic, that there is much out of your control. We, as investors and consumers ourselves, fully recognize the angst this can cause. It is true that we cannot control what Russian President Putin does or if the Federal Reserve can effectively bring down inflation within a reasonable amount of time. We cannot control the price of gas or which way the stock market swings. However, there is much we can control, and we strongly recommend we all remain focused on that. Regarding our financial wellbeing, there are things we can actively do. We can limit the amount of news we consume and the source of that news, make even small changes as needed in our spending habits while inflation persists, and we can remind ourselves that we are invested intelligently in accordance with our personal timeline and risk tolerance. The outlook for markets and the economy is uncertain given what we have discussed, and we do anticipate continued market volatility and a slowdown of economic growth ahead. But while risks remain, as they always do, there are numerous positive factors supporting the economy and markets, and it is important to remember that remaining invested in a well-executed and diversified financial plan, developed to meet both short and long-term needs, can overcome bouts of intense volatility such as we experienced these past few months.

We are committed to helping you effectively navigate this challenging economic environment, just as we have done in the past, and welcome the opportunity to address any questions or concerns you may have or to simply chat about your financial situation. Wishing you and your family good health and an enjoyable start to the long-awaited Spring.

Best Wishes,

Steve LePage