October 25, 2022 Letter to Clients
We hope this letter finds you and your family all in good health, having enjoyed a restful summer and now enjoying this beautiful fall season.
Investing appears easy when the markets rally or are generally calm, but as we know markets don’t move in a single direction, as evidenced in the first three quarters of this year and it is during these tumultuous periods when remaining steadfast as an investor can truly be difficult. We fully recognize and appreciate this being investors ourselves, being subject to the same fluctuations the market brings our clients. How we each face these inevitable downturns determines the outcome and success of our investment portfolios. As your financial advisor, I remain committed to drawing on my experience and knowledgeable resources to offer sound guidance and to employ a tactical selection of investments to continue my goal of adding value to your portfolios over time and, to the best of my ability, hedge against risk. In this letter, we discuss the state of the economy, both global and domestic, the outlook on both, midterm elections and outlook for year end.
World Economy
The world economy is in a precarious situation. The list appears to be getting longer as the year progresses and will most certainly carry into 2023. Three issues stand out as being the most pressing. First is the ongoing energy crisis, triggered by Russia’s invasion of Ukraine, leaving high natural gas and electricity prices going into winter. Second, high core inflation persists, driven by tight labor markets and high wage inflation. And third, China’s zero Covid health policy, coupled with property deflation, which is threatening their economy. These issues affect economic regions differently; the energy crisis is primarily a European problem. Core inflation appears to be the most challenging to deal with in the US with the Federal Reserve (the Fed) in catch-up mode, and China’s trials are primarily a domestic issue, leaving the already vulnerable supply chains subject to severe downturns. Each notable issue listed, amongst others, contributes to the threat to the overall world economy.
After a rapid recovery in 2021, the global economy is poised to experience a significant slowdown in growth in 2023 and the probability of a global recession is shaping up to be a probable scenario. In addition to no catastrophic events occurring, a lot of things would also have to go right and turn around for this to be avoided. Some examples include a resolution to the Russia-Ukraine war, either a mild winter in Europe and/or government intervention to soften the shock of high gas prices, as well as avoiding a sharp rise in Covid cases in any of the major economic regions. The likelihood of all these things occurring, while possible, is slim and in all reality, Europe is likely in a recession already and I firmly believe the US has already entered one as well.
US Economy
The Federal Reserve’s interest rate policy is a providing a source of uncertainty for investors. While the stock market and the economy are not one and the same, the market is most certainly sensitive to economic data, drawing on experience to make educated guesses about future actions of the Fed. Aggressive interest rate hikes have weighed on stocks and bonds this year more than anything else, however, market volatility on its own is not going to deter the Fed from their rate-hiking course, which we see being carried out into next year.
A strong US economy, resilient corporate profit margins and a tight labor market are a few reasons the Fed may opt to remain steadfast with the hikes in their mission to tame inflation. While we are all feeling the pinch to our personal economies at home, the US economy is still running hotter than the Fed would like. Corporate profit margins remain resilient (keeping in mind the Energy sector accounts for a considerable jump in these numbers). The jobs market is flourishing, having added a very robust 263,000 jobs last month, dropping the unemployment rate to 3.5%, with workers remaining confident they can leave their current positions and easily find a new one. Such data makes it unlikely the Fed will back off the rate-hike campaign anytime soon as Fed Chair Jerome Powell has acknowledged that the fight against inflation will likely involve “pain for some households and businesses,” alluding to the eventual economic risks ahead, albeit temporary.
US interest rates do not affect only the US economy – higher rates lead to a stronger US dollar and weaken other countries’ currencies against it. If signs of global financial instability emerge it is possible the Fed may choose to impose smaller than expected rate increases in the months ahead. However, whether large or small, the rate hikes are most certainly going to continue.
Keeping Recession Concerns in Perspective
While the outlook mentioned above paints a grim picture, there are positives. The term recession doesn’t exactly conjure up positive, warm and fuzzy feelings, but if there is to be good news it is that the current one is likely to be shallow and less damaging than ones we’ve experienced in the past.
It is believed the current recession falls into the category of a cyclical one rather than an event-driven one, such as the one brought on due to the pandemic. While painful, cyclical recessions are necessary to reset the economy on a new path of growth. If we use history as a guide, an inflation-triggered recession, such as this, may be less severe than one caused by credit excesses. Except for the brief pandemic-induced 2020 recession, previous recessions have been credit-driven. Tink of the Great Financial Crisis of 2007-2009 and the dotcom bust in the early 2000’s for example. These recessions were brought on by debt-related excesses, which had been overly used as the platform for housing and internet infrastructure. Their subsequent collapse devastated the economy.
The difference this time is excess liquidity, not excess debt, being the catalyst. Extreme fiscal and monetary stimulus during the pandemic pumped money not only into households and businesses, but the investment markets as well. In turn, this, along with supply chain issues, contributed to inflation. This is welcome news for investors as damage to corporate earnings is historically more modest during inflation-driven recessions. In addition to relying on history, there are several current economic factors that point to the recession being less damaging. These strong fundamentals include: a continuing robust labor market, an optimistic outlook on the auto industry as supply chain issues clear and the backlog of orders keep manufacturing high, household and corporate balance sheets still being in decent shape, the outlook on corporate spending on energy infrastructure and automation appearing strong, and lastly, corporate revenue appearing durable with more companies having adapted their business models to benefit from recurring revenue streams. All-in-all, there are certainly unforeseen factors that could alter the recession outlook but the current economic fundamentals point to this one being less severe.
Midterm Elections
Midterm elections are around the corner, and the outcome will determine which party has control of the House of Representatives and the Senate. These elections are important as they can have significant potential impact on policy and laws. Historically, market returns tend to be range-bound and volatility remains elevated compared to non-election years. The subdued returns and higher volatility can most likely be explained by the well-known fact that the markets don’t like uncertainty from potential policy changes to come. This correlation between stock market performance and midterm elections is well documented, and in 17 of the 19 midterms since 1946, the market performed better in the six months, following an election than it did in the six months leading up to it. This can be explained by the market’s expectation of increased government spending by a new Congress. However, this year’s market performance has already diverged significantly from the average midterm election year, leaving investors wondering if they can anticipate the similarly strong post-election performance. The additional infusion of funds from government spending, which normally follows an election, seems unlikely given the historic level of spending and stimulus in response to the pandemic. Having already contributed to the 40-year high in inflation, any new spending would in fact exacerbate this issue. This, along with all the other forces at play that are already impacting the markets, means we shouldn’t put too much weight on this midterm-year performance.
The Bottom Line
Recommending patience is difficult, especially when 2022 has been a stark contrast to the exceptionally strong, and arguably overinflated, valuations and returns in recent years, particularly following the February and March 2020 pandemic-induced drastic market downturn. Patience will be required though as bear markets (defined as a prolonged drop in investment prices) take time to heal. Although they may take another leg down before beginning their recovery, we can’t call an equity market bottom as timing the markets is near impossible. We are beginning to take a more optimistic outlook on equities as the market will bottom before the real economy does. Cash positions in investor portfolios are showing to be well above the long-term average and that cash will be deployed into the market as it shifts into rally mode.
In the interim, investing and leaning into the market drops provides some of the greatest value to portfolio growth over time. Staying invested and buying into the market down cycles (continuing to consistently contribute to your workplace retirement plan for example) is what allows investors to reap the benefits of the next up cycle. We do understand that is much easier said than done, especially for retirees, however investment success relies on avoiding hasty decisions and maintaining confidence that your portfolios are continuing to be managed in a manner consistent with your long-term objectives. And for those who are questioning right now if they are still considered a long-term investor, the short answer for the majority our clients is yes. While there are exceptions to this, many of our investment portfolios are designed to be a source of income during retirement. A person retiring at age 65 needs to plan based on living another 20 plus years on average. Therefore, the need to be properly invested is imperative.
Given the present market and economic conditions, here at LePage Financial, we will continue to employ tax-efficient rebalancing of portfolios, take advantage of tax-loss harvesting opportunities, remain committed to seeking out opportunities as appropriate for each portfolio, invest in high-quality, well-managed companies who continue to maintain strong balance sheets, companies with a demonstrated history of resilience during recessions and those who benefit from one, and to continue to draw on our own and the expertise of the bond managers we work with to identify fixed-income opportunities in this rising rate environment.
Our primary goal remains committed to investing in an intelligent manner, consistent with each of our client’s needs for both the short-and the long-term.
As always, we encourage you to contact our office should you wish to have a conversation regarding your portfolio or finances. If we do not speak beforehand, we wish you and your loved ones a wonderful Thanksgiving holiday.
Best wishes,
Steve LePage