Q1 2022 Compass Review
The quarter started off predictably enough with December’s market weakness continuing to reflect fear of war, Fed tightening, deflation of the growth stock bubble and supply disruptions. Just when it looked like the bears were in control of the market, it turned with a vengeance and rallied back to regain nearly all its losses for the year.
The market rallied despite the war heating up, despite the highest energy prices in decades and despite one of the worst performing bond markets this century. Just another bear market rally some say. A predicable phenomenon of every bear market, but hardly a change of course. Plus, the yield curve tells us a recession is coming. Nonsense others say, the economy is roaring despite all the bad news and stocks follow the economy not the headlines.
We were welcoming the correction as a necessary adjustment in speculative excess that in the long run would threaten market stability. Whether this rally can hold or not is anybody’s guess, but we are pretty sure there are enough headwinds out there that we haven’t seen our last correction in this market cycle.
Prudent investors use choppy markets like this to lighten up on the riskier stocks in market rallies and pick up bargains on dips. Last quarter’s volatility was so severe that we didn’t have much of a chance to do that, but we look forward to more opportunities as international and domestic events play out.
Domestically, inflation will continue to take center stage which puts the Federal Reserve in the difficult position of raising rates enough to slow the economy but not kill the recovery. They never get it just right, but stock investors can sleep easier knowing that stocks in general outpace inflation and there are whole sectors of the market like energy and mining that do extremely well. After that, all eyes will be on the midterm elections later in the year to see if the country becomes even more polarized.
Internationally it is all about the war in Ukraine, who is winning and how long it will last. That is being reflected in energy prices and a clear division of world powers between west and east not seen since the cold war. Economically this has accelerated deglobalization as supply chains with hostile countries become less dependable. In the short run this increases costs and is inflationary, but the costs borne by the west are nothing compared to the costs being borne by Russia. Whether China learns from Russia’s mistake or continues down the path of becoming a belligerent state will shape the world economy more profoundly than any event this century.
So here we go. The world and the US will be divided between winners and losers like never before which is incredibly scary until you look at the US position versus the rest of the world. We are the only major developed economy that is near energy independence unlike Europe and China. Democracy is a messy system, but authoritarian regimes are proving much less reliable. While China goes from lockdown to lockdown, we have largely defeated Covid thanks to the world’s best pharmaceuticals industry and a measured public health policy.
Warren Buffet’s famous saying comes to mind. When the tide goes out, we find out who is wearing swim trunks and who isn’t. Clearly world events have caused a tidal shift and we are seeing the advantages of the US economy. Not surprisingly, that is being reflected in our stock market, and gives us comfort in the durability and strength of US companies.
Even so, we remain in a state of shock when we look around us at the amazing wealth accumulated over the last 2 years despite the difficulties many faced. No matter how far we search for a different answer, we keep coming back to the enormous number of dollars printed to fund extraordinary levels of monetary and fiscal policy. We can’t shake the notion that inflation will be difficult to stop unless the Fed aggressively begins to remove its still somewhat accommodative stance. Whether that means quicker interest rate hikes or a faster balance sheet reduction, we expect more volatility over the coming months.
Our bond portfolios also took a short term hit this quarter as interest rates tried to keep up with future Fed hikes. Thankfully, this is just a “paper loss” and if our companies and municipalities remain in good financial shape, we already know our expected rate of return on the bonds we purchased. As these bonds mature, we can reinvest the proceeds at much higher yields than where they were purchased over the past few years. By following this pattern, returns will eventually turn positive again, and bonds will continue to provide a good balance for our retired clients living on their portfolio.
As we discussed in our recent newsletter, the notion of the market returning to peak covid level valuations feels misguided. The rally to end the first quarter was an attempt to recreate those conditions as money piled back into speculative trades. They could be right, but if the Fed truly needs to remove the punch bowl, our clients will be much safer with our core, diversified portfolio of growing businesses at reasonable prices. In any case, we’ll look to take advantage of whatever opportunities the market presents as it tries to find the new normal.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.