In hindsight it seems obvious that the good times would end. In the last two years, it had become too easy for investors. The record amounts of cash sent out by governments and central banks to fend off the pandemic’s economic impact found its way into every investible asset class. After two straight years of double-digit returns in equities and all risk assets flying, the term “everything bubble” was coined.
But all bubbles must deflate at some point and that’s what we’re going through this year. The headlines are all screaming about how we had the worst start to an investing year since 1970 and that the largest amount of capital was destroyed in history, but all this needs to be put into perspective as we came into this year on a sugar high that needed to be reset.
We all knew that there was too much excess in the economy in the last few years. The rise of SPACs, spec tech, and NFTs proved that money was too easy to come by and to earn a return the economy was willing to go to areas of extreme risk. Like all manias, this came to a crashing halt once the tides turned, and the days of easy money ended.
Central bankers are finally admitting that they are “behind the curve,” meaning that they know they waited too long to adjust policy and combat inflation. Last month, the FOMC hiked the Fed Funds rate by 75bps, which is the largest increase since 1994, signalling that they are finally serious about addressing inflation.
In normal times, the Fed Funds rate and the U.S. CPI are at similar levels. It's striking when you look at it today as the U.S. CPI is over 8% while the Fed Funds rate is at 1.75%, with a target of 3.5% by year-end. That spread is the largest on record and needs to be addressed. This of course can be achieved in three ways: more hikes, inflation coming down on its own, or through a combination of the two. Central banks have been talking about “transitory inflation” for a while now as supply chains took time to adjust from the lockdowns, and we will get to test that theory soon. If that’s the case, we may be starting to see peak inflation, but it’s too soon to call it.
During the month of June, it seemed like there was a constant battle between the fears of inflation and the fears of a recession. In the earlier months of the year, inflation worries allowed real assets, such as energy, to perform very well and show impressive gains. However, as we switched to fears of a recession, commodity and asset prices took a hit. Energy stocks, which had been the only hiding spot for the year, ended the month off 16.6%; however, they are still positive on the year, meaning this may in fact be a tremendous buying opportunity.
We may also be entering a period of the economy where bad news is actually good. The stock market remains incredibly tied to central banks. The adage of “don’t fight the Fed” has never been more apt. While central banks are now willing to accept a recession in order to slow inflation, if they are successful and achieve that result, they may be able to adjust to a more neutral stance earlier than expected.
That will be the most important question to answer in the second half of the year.
The selloff that hit risk assets so far has really been all about a contraction in valuation multiples. The next fear is that earnings will have to be adjusted lower. It would be hard to imagine a scenario where the economy goes into a recession and S&P 500 earnings don’t contract. This will be important to watch for July.
However, as we talked about before, if there are too many signs of weakness from consumers, we may see a tone change from central banks. Bond yields have already picked up on this, as the US 10-year bond yield is well below its high of 3.5% from a few weeks ago.
So far in 2022, there has been nowhere to hide. Fixed income, which is normally a diversifier in balanced funds, is down and bond investors are losing money for the first time in years. Everyone knows the bear case for stocks, but what will be interesting to watch for the balance of the year is when things begin to turn. Financial markets are forward-looking in pricing terms—if you wait for the absolute peak in inflation, it will be too late. It may be time to become a contrarian.
It hasn’t been a good start to the year by any measure. We still need to have markets become more comfortable so that central banks have a handle on inflation, but once that occurs, there could be a nice recovery. Sentiment indicators are showing signs of capitulation from many investors, which is what you need to see for a bottom.
So, are we there yet? Maybe not today, but I would be much more comfortable putting cash to work at these levels than last December when everything felt priced for perfection.
— Greg Taylor is the Chief Investment Officer at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.