Tailwinds to Headwinds
The first four months of 2022 were a rollercoaster in the investment markets. We believe the first half of 2022 will be challenging for investors, but the year-end will deliver good investment opportunities. For those who have been clients of Riggs for a long time, you know during periods like this is when we put the defensive team on the field with positions in gold, dividend-paying stocks, and/or higher cash allocations. We would expand our allocation to fixed income in normal times, but these are not normal times. Our trading activity increases as we cut losses short to protect portfolios and adjust our holdings as new market leaders emerge. We will dive into the reasons for the market turmoil, but our base case for the year remains the same—a pullback in the first half of the year with a strong rally into year-end.
“Everything is out of sync in the world.” This was the quote we heard from the CEO of Restoration Hardware as he began to describe a challenging economic landscape—from the Omicron variant to the highest inflation in 40 years to supply chain bottlenecks and, finally, the most significant conflict in Europe since World War II. This was the first quarter of 2022, and the volatility of the markets reflected it. When you are in a market that is churning downward, our primary investment strategy is capital preservation, keeping losses short, and looking for the opportunities the volatility should eventually provide.
The investment market year to date returns are:
| ASSET CLASS | INDEX | YEAR TO DATE RETURN |
| FIXED INCOME | 20-Year Treasury | -18.46% |
| FIXED INCOME | 7-10 Year Treasury | -9.99% |
| FIXED INCOME | 3-7 Year Treasury | -6.60% |
| FIXED INCOME | Corporate Bonds | -14.34% |
| FIXED INCOME | High Yield Bonds | -9.38% |
| EQUITY | S&P 500 | -12.22% |
| EQUITY | Nasdaq | -20.17% |
| EQUITY | Dow Jones Industrial Average | -8.36% |
| COMMODITY | Gold | +2.94% |
| Data as of 04/27/22 |
As the table shows, we are in a market with very few places to find a safe haven. And fixed-income has taken the brunt of the pullback. Why is that?
THE FEDERAL RESERVE PIVOTS—LESS LIQUIDITY AHEAD
Two years ago, the Federal Reserve and Central Banks worldwide took extraordinary steps to support the global economy by pumping money into the system. They lowered short-term interest rates to near zero, stepped in to buy Treasury bonds and Mortgage-Backed securities, and signaled to investors and corporations that they would use whatever tools were necessary to support the global economy. This allowed our economy to weather the economic shutdown and build resilience in the U.S. consumer.
Accommodative Federal Reserve Policy:
- Interest Rates Reduced to Near Zero
- Federal Reserve Buys Treasuries and Mortgage-Backed Securities on a large scale
Result = Liquidity and Appreciating Assets
As the U.S. economy re-started and lockdowns eased, companies who provided significant growth in a slow-growth environment were richly rewarded. Valuations rose substantially and quickly. With the money the Central Banks were pumping into the economy, all assets rose—from home values to artwork to classic cars to investment markets. Demand was strong, supply was tight, and the result was inflation.
Too Much Liquidity = Inflation
A quantitative easing program of this size and with this level of global coordination had never been done before. The question in our minds was what happens when the Federal Reserve and global Central Banks have to reverse course and pull liquidity out of the economy? We are starting to get the answers to that question now.
The Federal Reserve has a dual mandate to realize full employment and keep inflation in check. By infusing money into the economy, they spurred economic growth and achieved near full employment (for those still in the labor market). They believed that inflation was transitory and would naturally ease. It was not, and it did not.
In the fall of last year, the Federal Reserve quickly adjusted its policy stance to slow down economic growth and inflation. The first step in this policy adjustment was to taper their Treasury and Mortgage-Backed Securities purchases. They had been purchasing Treasuries and Mortgage-Backed Securities to the tune of $120 Billion a month since March 2020. Their original plan was to begin tapering in January 2022, reducing their purchases by $10 Billion a month over 12 months. A slow approach to avoid spooking the market.
Last fall, they realized the economy was running too hot. They changed course quickly. They started with tapering in November 2021 and accelerated the reduction to end purchases in March 2022—just five months.
In addition to accelerating their tapering plan, they will also be accelerating by raising short-term interest rates. Their initial increase was 25 basis points in March, and they have signaled very clearly that they are likely to raise rates by 50 basis points in May and 50 basis points in June.
In May, the Federal Reserve will begin its quantitative tightening program. To understand quantitative tightening, we must first understand the quantitative easing program.
The Federal Reserve buys bonds in quantitative easing to drive down longer-term rates. As it creates money for those purchases, it increases the supply of bank reserves in the financial system, and the hope is that lenders go on to pass that liquidity along as lending to companies and individuals, spurring economic growth. Quantitative tightening means reducing the supply of reserves.
As the Federal Reserve let the bonds it purchased reach maturity and run off its balance sheet, it effectively created the money it used to buy the bonds out of thin air. Then the Treasury Department “pays” the Federal Reserve at the bond’s maturity by subtracting the sum from the cash balance it keeps on deposit with the Federal Reserve—effectively making money disappear. The Treasury needs to replenish that cash pile by selling new securities to meet its spending obligations. When banks buy those Treasuries, they reduce their reserves, thus draining money from the system and undoing what was created in quantitative easing.
Federal Reserve Quantitative Tightening Policy
- Raise short-term interest rates
- Federal Reserve stops buying new Treasuries and Mortgage-Backed Securities
- Banks and the private market step in and use their reserves to buy Treasuries and Mortgage-Backed Securities
Result = Less Liquidity in the economy
The Federal Reserve’s asset holdings more than doubled during the pandemic to about $8.9 Trillion from $4.2 Trillion. That total kept rising until March of this year, when the Federal Reserve completed its taper of those purchases. Federal Reserve officials have discussed shrinking its balance sheet at a maximum monthly pace of $60 Billion in Treasuries and $35 Billion in Mortgage-Backed Securities. As the quantitative tightening process takes money out of the financial system, some borrowing costs are bound to rise.
So, just as quantitative easing drove interest rates down, quantitative tightening will pressure them to rise. We have seen a significant rise in rates already, which has driven down the price of existing bonds. That is why the bond market could not serve as a safe haven when the equity markets began to correct.
You can see that the process of quantitative tightening is complex. From a risk management perspective, the probability of a policy misstep by the Federal Reserve is pretty high.
TAILWINDS TO HEADWINDS
In addition to the policy pivot by the Federal Reserve, we are also seeing three megatrends that have been strong tailwinds for corporate profits since the mid-1980s reverse simultaneously.
Those favorable trends were lower long-term nominal interest rates, lower corporate tax rates, and globalization. These megatrends have allowed companies to over-optimize their production costs, taxes, and the level of capital they are operating with to maximize return on equity. Higher financing costs, higher tax rates, and supply chain disruptions will all impact economic growth. We may soon be entering a slower economic growth environment.
The wind has shifted, and those tailwinds are now becoming headwinds.
THE BRIGHT SPOTS
As you know, the market does not like uncertainty. The last several months have delivered a great deal of uncertainty to the markets. Much like the acceleration of the Federal Reserve policy shift, we have seen an acceleration of bad news from supply chain issues to inflation to the Russia/Ukraine war. There was a lot of bad news for the market to absorb in the first four months of the year. As we move through the quantitative tightening process in May and June and the mid-term election cycle, we believe much of the bad news will be baked in, and the markets will likely stabilize in response and rally in relief.
Growth companies have taken a significant hit over the last 6-9 months. Now we are seeing some incredible bargains. Companies that can grow in a slow-growth environment will likely be richly rewarded as the economy slows. Investors will have some excellent investment opportunities in this area.
While the monetary policy may be slowing, fiscal policy is accelerating. The U.S. Congress recently passed the most extensive infrastructure package in decades, which will benefit companies in natural resources, construction, engineering, and consulting. In addition, a $50 billion package of aid for the semiconductor industry is in a Joint House/Senate Conference Committee. Should Congress come to a compromise on this bill, this could be the start of significant investments in onshoring critical manufacturing and production back to the U.S.
Finally, after two years of staying at home, the U.S. and the world are poised to travel again. Data coming out of TSA and Hotels indicates close to pre-pandemic level bookings and travel. Pent-up demand in this area will provide substantial growth opportunities for the hospitality industry.
In summary, we are facing strong macro headwinds. These headwinds will continue to create market volatility for the next few months. As we move through the year, the market will gain greater clarity on the new investment landscape, and we believe a significant relief rally will follow.
IMPORTANT DISCLOSURES
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Riggs Asset Management Company, Inc. (“Riggs”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Riggs. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Riggs is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Riggs’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a Riggs client, please remember to contact Riggs, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Riggs shall continue to rely on the accuracy of information that you have provided.