At Optivest, our advice is built upon in-depth research and analysis that evaluates the ever changing global economic landscape. For insight into our strategies, you can explore our quarterly updates and economic thoughts below.
This is not about a recession, at least not yet. Corporate profits continue to grow robustly along while pent-up demand for travel, consumption, investment, borrowing, and the housing market remains solid. Unemployment is at 3.6% while jobs available versus those seeking work is at a multi-decade low. This is about valuation and the reassessment of risk, with the forward price/earnings ratio for US stocks falling from more than 21 times in January to less than 18 today. As markets contemplate a Fed Funds rate discounted to increase to more than 2.5% by year-end, volatility and the positive correlation between stocks and bonds is a particularly challenging combination. Bonds will not, for some time, provide a hedge to stock volatility so real estate that adjusts/raises rents in inflationary times and alternatives that have low or negative correlation are a high priority to all investors. Diversification is more important than ever and real assets and alternatives are places to move and earn cash flows.
We are now in week three of the Russian invasion into Ukraine and the market is still trying to digest the different news stories that are making headlines and fueling volatility. While our thoughts are with the Ukrainian people who have been impacted by a conflict, not of their choosing, we are also focused on how this will affect the global economy, the energy markets, and the Fed’s response.
Since the COVID Recession, the S&P 500 has returned 113.02% (cumulative) from its low point on March 23, 2020 through the end of 2021. During that same period, Optivest clients enjoyed phenomenal returns on their diversified portfolios. In fact, our portfolios, depending on the model risk tolerance, overall experienced the highest returns our portfolios have seen in decades. Thanks to conditions such as ultra-low interest rates and easy money, political deadlock on tax law changes, and gradually improving supply chains, we have benefited from a tremendous rally that brought the stock markets back to all-time highs in an incredibly short period.
As we approach the end of February, 2022 has seen heightened volatility that has been reminiscent of past corrections and bear markets. US economic data has increasingly indicated more persistent inflation and a tight labor market, both of which have driven the Federal Reserve to take a more hawkish stance. Forecasts for rate hikes have subsequently moved higher and have spooked the markets, especially expensive growth stocks. To make volatility even worse, we have seen numerous headlines over the past few weeks about a possible invasion of Russian forces into Ukraine. We believe the geopolitical tensions have created more noise in the background and we should focus on the issue at-hand, which is a Fed that will have to raise rates multiple times this year. The rate and level of rate increases remains a subject of much debate. Below we outline how the market reacts in a rising-interest rate environment.
In 2021, we made tactical moves in our investment portfolios to underweight US bond exposure, be overweight in real estate and build cash reserves for deployment in 2022 when we see volatility increasing due to headwinds. The US Barclays Agg (a moderate-duration bond index) is -4.31% from its high last year and only faces more losses in face of rising rates. The multi-decade bond rally is indeed over and in reality, it was only briefly interrupted by the pandemic. Our real estate exposure continues to out-perform other asset classes as the interest on leverage is still historically low (and often was refinanced to low fixed-rate over past years) and the asset values appreciate with inflation bringing total returns to the highest levels seen in years. Pensions and institutions continue to invest heavily into real estate in the new bond bear market. In this environment, keen asset selection can make value add purchase and development deals very profitable.
Markets seem primed to equate higher rates as being negative for equities. We’ve seen this before and don’t agree. What really matters is that the Fed is signaling slow and cautious rate hikes, supportive of minimal market impact. This historically muted response to inflation should keep real rates low, in our view, supporting equities and real estate. Stay invested and stay diversified for positive returns occur more frequently over longer periods than negative returns and policy is supportive of high-quality investing. Fundamentals matter.
With COVID cases rapidly falling and inflation heating up, many investors are focused on Federal Reserve policy. Monetary policy will need to walk a fine line between tackling inflation and financial risks and supporting the economic recovery. The Fed, Central Banks, and governments will need to act with clarity and consistency to avoid making policy errors that will roil financial markets and set back the global recovery. Congressional brinkmanship around the debt ceiling, government funding, the bipartisan infrastructure agreement and President Biden’s social infrastructure plan all risk increasing market volatility to even roiling the financial markets. China’s problems revolve around disorderly debt restructurings in their property sector to escalating cross-border trade and technology tension which their recent common prosperity initiative makes more critical to be resolved.
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