The trifecta of inflation, higher interest rates, and the War against Ukraine has pushed the US equity market into a correction (a decline greater than 10% from the previous high). For long-term investors, we would typically be adding positions at this point. Market corrections are common and should not be feared if the economic fundamentals remain healthy.
Today's economic fundamentals are still ok
We look at three readily available sets of indicators to assess the state of the economy.
The trend of the Conference Board US Leading Economic Indicators Index. This a composite of the 10 sub indicators that foretell if the US economy is expanding or contracting. The latest reading points to further economic growth.
The shape of the Yield Curve. When long-term government bond yields drop below short-term ones a recession typically starts within few quarters. The so called "yield curve inversion" expresses investors' expectations that interest rates will fall due to an economic downturn. In order to maximize their rewards, investors buy longer dated bonds and shun short-dated ones. Since financial institutions typically borrow at short-term interest rates and lend at long-term ones, a yield curve inversion tends to compress their profits and pushes them to contract the amount of credit that they grant. The US yield curve has not inverted yet.
High yield bond credit spreads versus US treasuries are one of the most visible barometers of credit availability (highly correlated to the business cycle). Once they start climbing, companies have a harder time accessing capital and weaker companies may fail. Credit spreads remain low and did not materially expand.
If the US economy is ok, why aren't we taking advantage of the correction?
The Russia-Ukraine conflict has added "fuel to the fire." Geopolitical conflicts rarely have an enduring impact on markets. However, in this particular case, Russia is one of the largest suppliers of oil and gas globally, especially to Europe.
While modern economies are moving away from fossil fuels, they are still heavily reliant on them for the time being. "Oil shocks" of the magnitude seen in recent days (+100% in a year) frequently lead to a recession within 6-18 months. Economists debate if the oil price spike or the response of the central banks causes these commodity-led recessions.
Even if the current economic data still shows resilience, the probability of a premature end of the current economic recovery has increased substantially. This is why we stay shy of adding risk to our clients' portfolios. A strong "relief market rally" is likely when the geopolitical crisis subsides but unfortunately the harm to the global economy can't be undone quickly.
So what should an investor do?
How can investors position their portfolios for an environment of high inflation and possibly lower economic growth, especially when interest rates are already very low?
Build an adequate cash buffer even if short-term interest rates are near zero and inflation is high. This will help redeploy money when opportunities arise.
This is also a good time to build a buy wish list.
Limit the exposure to risky investments to an amount you're comfortable losing partially (-25%) and temporarily.
Purge the portfolio of undesirable positions, even if they are at a loss.
Focus on investments that have a record of predictable cash flows across sectors and geographies: dividend growing companies should be favored. So are REITs and infrastructure plays with recurring and increasing cash flows. These have historically been the best investments in inflationary periods.
Be wary of chasing commodities and commodity-related investments. They have a record of protecting well in the initial phases of inflationary episodes, but they are not good stores of value. They follow "boom and bust" cycles that are very difficult to predict and time.
Focus on long-term returns and do not get sidetracked by the daily noise of current events.
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