by Brad M. Weafer, CFA | Chief Investment Officer
EXECUTIVE SUMMARY
- 40-year highs in inflation have roiled financial markets this year
- In an effort to protect portfolios, we are taking proactive measures such as diversifying in additional asset classes, managing unrealized gains and losses, and evaluating additional investment opportunities
Inflation remains the key concern for financial markets and has global stock and bond markets under renewed pressure in recent days. Data released on Friday by the U.S. Bureau of Labor Statistics showed prices in May increased at the fastest rate in over 40 years (see chart below). The Consumer Price Index (CPI) increased 1% relative to April and 8.6% compared to a year ago. The increase was broad-based, with housing, gas, and food categories showing the largest increases. Energy prices are dominating attention, but the less volatile components of inflation are also concerning. Core inflation, excluding food and energy, rose 6%. Both were higher than expected sending financial markets sharply lower. As of this writing (on Monday June 13) the S&P 500 is down 20% since the start of the year. The pain has been even more acute in smaller and growth-oriented companies. The Russell 2000 (the small company index) is down 23% and the technology and growth-focused NASDAQ Index has fallen 30%.
Year over Year CPI and CPI ex. Food and Energy
January 1972-May 2022
Source: U.S. Bureau of Labor Statistics
The new data is discouraging, but inflation has been top of mind all year with investors, and rightfully so. Rising inflation puts pressure on consumers which strains economic growth and makes it challenging for companies to recoup profits as their costs rise. Inflation is also terribly difficult to predict. This key indicator has a tremendous track record of humbling policymakers and market prognosticators alike. Just last week, former Federal Reserve Chair and current U.S. Treasury Secretary Janet Yellen admitted in an interview¹ having misjudged the specter of inflation. In the interview she was quoted as saying “There have been unanticipated and large shocks to the economy that have boosted energy and food prices, and supply bottlenecks that affected our economy badly that I didn’t, at the time, fully understand.” With price increases proving more persistent than policymakers perceived, they are now moving quickly to raise interest rates materially, pressuring the valuations of all financial assets including both sides of the traditional core of balanced portfolios, stocks and bonds.
Investors have two key avenues to help manage risk in this challenging time, asset allocation and security selection. At BFM we are using both levers and continue to evaluate additional investment opportunities given the changing landscape.
Asset allocation outlines how, and in what percentages, we should diversify your portfolio amongst all the available kinds of investments. For the better part of the last 20 years, with inflation tame, the traditional “60/40” portfolio was a prudent way to manage risk and return. The 60% (or a percentage tailored to individual risk tolerance) allocated to stocks provided growth in capital and drove returns for the portfolio. It was also a source of risk, suffering frequent declines and volatility. The 40% invested in cash and bonds provided stability and income. Returns for bonds were lower (but generally positive) but offset some of the losses inflicted by equity allocations when times were tough.
In inflationary environments like today, accompanied by rising interest rates, unfortunately bonds have not provided the same level of return or protection. Our research team has analyzed additional asset classes which perform better in the current economic environment, and earlier this year we initiated a position in a fund investing in private loans which carry higher yields and floating rate structures. These loans are subject to credit risk, but do not suffer losses as interest rates increase and perform better than fixed-rate bonds in this type of environment. Even cash (or short-term U.S. Treasury notes) is providing higher income than it has in years and provides a relative safe haven amidst falling prices elsewhere. The 2-year treasury note is now yielding 3.2%, having increased by more than 3% from just a year ago. Further, we continue to evaluate additional investment options such as commodities, hedge funds and managed futures strategies. While poor performers for much of the last decade, these strategies may offer an advantage should inflation persist.
Selecting the right stocks for portfolios is proving equally difficult. We have always found the best way to invest through challenging macroeconomic environments is with a portfolio of profitable, durable, and well-managed businesses. Companies with attributes like recurring revenue, stable demand for leading products, and pricing power amongst others have proven through multiple cycles to reward investors with above-average performance. Equally important is purchasing those shares at a reasonable price relative to the cash flow and value they will produce over the long term. These types of companies though are not immune to periods of volatility or short-term underperformance. Today’s market has been particularly harsh on companies where growth is expected to accrue to shareholders over the longer term (see relative performance of the NASDAQ noted above). Many of our companies have been associated with this ‘market rotation’ away from growth and seen share prices decline. Amidst that volatility, we are proactively recognizing taxable losses where appropriate and reinvesting in companies that have also seen share price declines and present compelling investment opportunities but now trade at more attractive prices.
Market weakness tests the resolve of even the most long-term oriented investors. Short-term portfolio declines elicit an emotional response that is challenging even for professional investors to overcome. Historically however, patience has been rewarded and thoughtful investing and remaining calm in the face of pressure has proven to be the right approach. Case in point was the panic selling at the height of the Covid-19 outbreak. It was an incredibly stressful time for investors. Though it took some time for stocks to find their footing, and it was unclear if and when they had without hindsight, eventually level-headed thinking prevailed after the initial shock and markets ultimately recovered.
In time we expect the markets to stabilize, though this elevated volatility may continue as the global economy contends with persistent inflation paired with supply chain issues and the war in Ukraine. Our research team will continue to adjust our strategies by selling positions where the investment thesis has changed and investing the proceeds in companies that better meet our investment criteria at more favorable valuations. We will also continue evaluating additional investment options to provide added diversification. Should you have questions specific to your portfolio, please don’t hesitate to contact your Wealth Manager at any time.
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA level examinations.