Stay the course!
Introduction
When I last wrote to you in January, I touched on some of the uncertainties and challenges that we might be facing this year. A few months later, several of what were possible issues are now realities. Geopolitical, monetary and economic factors, as predicted, have been causing choppy markets.
2021 was a phenomenal year for equities: the S&P 500 rose 29% and tech stocks in particular generated outsized returns. However, 2022 is off to a bit of a rough start. Markets are causing some queasiness due to the outbreak of war in Ukraine and the energy crisis that has resulted, skyrocketing commodity prices, and the Federal Reserve’s attempts to combat the highest inflation in 40 years.
As investors rotate from growth to value, you may wonder how the macro climate will affect your personal investments. Should you be concerned? How will equities perform in 2022 and 2023? Should current events be a reason to consider rebalancing your portfolio?
In this market update, I will explore 3 key factors that will likely drive markets over the next year and explain how we are dealing with the current turbulence.
1. The Ongoing War in Ukraine
The war in Ukraine has caused a human tragedy of epic proportions. While the long-term geopolitical and economic consequences are difficult to predict, there is little doubt they will be profound and far reaching. How have wars historically affected stock market performance? As expected, history shows that geopolitical events of such importance create significant short term stock market volatility. Investors fear uncertainty, in this case the prospects of World War III and potential nuclear conflict, and instinctively try to find safety in universally recognized safe haven assets such as gold, bonds, commodities, and large-cap value stocks. Historical data reveals that financial markets tend to perform well during times of war. In fact, the Dow Jones Industrial Average’s biggest gain took place in 1915, one year after the outbreak of World War I! Incredibly, markets tend to rebound and perform strongly just months after the outbreak of conflict.
Will this time be different?
Contrary to popular belief, the stock market tends to perform well even during episodes of revolts, terrorist attacks and war.
The loss of life and destruction of infrastructure in Ukraine is horrifying and not to be dismissed but from a global economic perspective, this is a regional conflict involving two countries that represent a very small – almost insignificant – percentage of the world’s total market capitalization. Indeed, Russia and Ukraine’s share of world markets is less than 1%. Wars serve as a reminder that defense is an important part of GDP. In recent years, military budgets were criticized as being bloated and overdue for cuts, but this conflict may reshape politicians’ relationship to the infamous “military industrial complex”. U.S. citizens expect budget increases to ensure their domestic security and protect human rights and freedom across the globe. Increases in military budgets will spur economic growth. In turn, this will likely drive global stock markets higher. Since global equities constitute a key aspect of well diversified portfolios, we remain committed to finding investment opportunities outside of the United States.
2. The Federal Reserve’s Dilemma
Currently, the world is faced with the highest inflation in 40 years. Granted, the inflationary trend started in 2021, but the war in Ukraine has exacerbated the situation. Russia is a major exporter of natural gas and other commodities, so the supply chain disruption is driving prices to record levels. Unfortunately, rising energy prices will hurt businesses and consumers worldwide, especially in the world’s poorest countries. The United Nations reports the world’s most vulnerable nations face the risk of energy and food shortages, which could drive up the price of commodities even more. The Federal Reserve is under immense pressure to raise interest rates in an effort to rein in inflation. In 2021, Fed officials hoped inflation would be transitory as the world inched closer to pre-pandemic normalcy. It is now clear that inflationary pressures have intensified and could get worse if nothing is done. Recently, the US Bureau of Statistics reported that consumer prices rose 8.5 percent in the year through March, the highest inflation rate since 1981.
The war in Ukraine has sent commodity prices soaring.
The Fed increased the target interest rate by .25% following its March meeting. While this raise – the first since 2018 – had little impact on the inflation rate, it sent a strong signal that they intend to combat the problem. Early in the year, Fed officials hinted they would raise the target rate seven times in 2022. The Fed is walking on a balance beam here as they try to dampen inflation without sending the economy into recession. The FOMC meets every 6 weeks and typically changes rates in .25% increments. The release of the higher-than-expected CPI could likely result in the target rate being raised by .50% at the next meeting in early May.
So, will it be inflation or recession?
Capital Group analysts, which we follow closely, believe the Fed will favor taming inflation, which tends to bode well for equities. In any case, investors should remain braced for a turbulent year, as the market weighs the rate increases against its priced-in expectations. However, despite the tightening monetary policy, markets have historically performed well during initial Fed tightening cycles. We will continue to analyze fundamentals to identify opportunities across major asset classes.
3. The Midterm Elections: Much Ado About Nothing?
Polls suggest the 2022 midterm elections could see a change in the Congressional majority. Obviously, the political uncertainty generates plenty of short-term market volatility since the midterms signal a possible change in political leadership at the national level.
What does history suggest will happen?
Midterm elections have very little impact on long-term investment returns. Historically, stock markets perform very well under either a Democratic or Republican Congress. In fact, the average one-year returns after the midterm election is 15.1%.
History reveals that stock markets perform well after midterms.
Our advice is consistent with the data: chances are the current political turmoil will not have negative impacts on your investments’ long-term performance. If anything, we may experience a market bounce back and pleasant returns.
The Takeaway
The world is facing a myriad of challenges. Despite the fear, uncertainty and doubt, investors should remain focused on their long-term investment plan and avoid making knee-jerk decisions. The past 100 years have been characterized by similar turbulence – which, at times, have been even more severe – and the markets have roared on.
At present, analysts remain optimistic. They predict more volatility and higher asset prices in 2022, since markets are expected to rebound strongly once the Ukraine crisis is resolved, and the midterm elections are over. We should all remember that markets are extremely resilient over the long-term.
Our best advice is: don’t panic and stay the course and please reach out to us when you have questions or concerns.
All the best,
— Priscilla "Cilla" McKinley
President - Brent Forrest & Associates LLC
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