We are now in the middle of the third week of the war in Ukraine, following Russia’s invasion on February 24th. Both the ultimate outcome, and the path to get to that outcome, are still very much in doubt. In investment terms, the war is a prime example of an exogenous shock – events that occur that have no direct connection to investment markets yet have profound implications for investors.
The economic implications of the war have exacerbated already strained economic conditions around the globe.
The latest inflation numbers released by the Bureau of Labor Statistics showed February inflation running at 7.9%, which is the highest inflation reading since January of 1982 when it was 8.4%. Gasoline, groceries, transportation, and apparel were key components that pushed inflation up in February. Average gasoline prices are now well over $4 per gallon in the U.S. for the first time since 2008. While some may have expected inflationary pressures to ease later in the year prior to Russia’s invasion of Ukraine, the war may ratchet up these pressures by adding problems to supply chains and increasing the cost of energy as sanctions against Russian oil and gas production take full effect. The ongoing conflict may also increase the cost of food due to the loss of Ukrainian wheat production and higher fertilizer costs, as Russia and Belarus are the 2nd and 3rd largest producers of potash, an important component in fertilizer production.
Despite the war, the Federal Reserve is expected to raise rates by 25 basis points later this week in response to elevated and persistent levels of inflation. Given the high levels of inflation, the Fed will likely be hard-pressed not to continue with a program of gradually increasing rates throughout the year even if economic growth begins to slow due to energy supply shortages, supply chain problems, and rising interest rates.
The combination of high inflation and low economic growth is known as stagflation and has not been experienced in the U.S. since the late 1970s into the early 1980s, however, there are some key differences between today’s economic environment and the environment during our last bout of stagflation. In the 1970s and early 1980s, in addition to low levels of economic growth and high levels of inflation, the U.S. economy was hampered by high levels of unemployment. The unemployment rate in the U.S. averaged 7.5% between 1974 and 1983, peaking at 10.8% in November and December of 1982. Today we have the opposite problem in the labor market – a shortage of workers. The most recent unemployment number in February came in at 3.8%. Another positive factor today is that there seems to be very little stress in the U.S. banking system. Regulations put in place following the 2008 financial crisis have limited risk-taking by banks and have forced banks to shore up their balance sheets. And finally, potential corporate distress seems to be contained, at least for now, to sectors that were most affected by COVID and may not have fully recovered yet. These positive factors seem to imply that the economy is positioned to recover should stresses begin to ease.
In today’s environment, one certainty is that there are more surprises in store for us and that the road forward will be neither straight nor smooth. And that means that we should continue to stick to the fundamentals. A few possible examples are listed below:
- Be flexible and balanced in your investment approach.
- Avoid short-term thinking and investment strategies with binary outcomes.
- Seek quality.
- Avoid recency bias – models tied too much to the recent past may be flawed as the world is changing.
Practically, what measures should we consider?
- Diversify your portfolio. This could be as simple as making sure you are exposed to both value and growth stocks. Thus far this year value stocks (Russell 1000 Value) are down -5.56%, but growth stocks (Russell 1000 Growth) are down -17.89%.
- More broadly, diversification includes such things as floating rate bonds, gold, and absolute return strategies.
- Take advantage of tax-loss selling strategies and opportunities to rebalance when they make sense.
- Understand the risk you are taking today. In a world of falling interest rates, re-investment risk is real, and investors may find themselves putting new cash to work at lower yields. In a rising rate world re-investment “risk” isn’t risk, but it can be an opportunity to put cash to work at higher yields. In this new world of rising rates managing duration risk and cash flows creates opportunities for future higher returns.
- Generally, all investment decisions should be done within the context of a long-term, personalized investment plan. There is no one-size-fits-all solution. Your investment decisions should be made within the context of your financial goals and objectives.
At RGT we know that times like these can be unnerving, but we come to work every day to provide our clients with the highest level of service, performance, and integrity. We value our relationships with clients and are humbled by the trust you have placed in us. You should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from RGT. If you have any questions or concerns, please contact your RGT advisor.