Russia-Ukraine Conflict and it’s Impact on Markets
Volatility has picked up across both stocks and bonds as investors continued to come to grips with the Federal Reserve’s (Fed) hawkish policy shift, still elevated inflation, and Omicron’s dampening impact on economic activity. The S&P 500 fell for the third straight week through January 21st and is now down – 8.3% from its January 3rd high. This represents the largest pullback since September 2020. To put this in context, the biggest drawdown in 2021 was just over 5%, while a typical year sees a pullback of -14% on average. We were due for volatility. We are also coming off a strong year for U.S. equities. Here is some helpful perspective. Since 1980, when the S&P 500 is up more than 25% in a calendar year, the index experiences an early year decline the following year (usually in the first quarter). On average, the S&P 500 experiences a drawdown of 5.2% near the beginning of the year following a calendar year in which the index was up greater than 25% (with drawdowns that have ranged between -1.6% and – 30.8%). However, the average return following those years where the S&P 500 posted a return of greater than 25% is a positive 13%. Bonds have been acting better recently, but the U.S. Aggregate Bond Index is down (as of January 21st) just over 4% from its peak – so a slow start for bonds also.
Where do we go from here?
The fundamental case for owning stocks remains intact. Economic growth in the U.S. (according to the Conference Board Economic Forecast) is expected to slow down from 5.6% in 2021 to 3.5% in 2022 on waning fiscal stimulus and inflationary headwinds. Even with that downshift, the U.S. economy should easily outpace the 1.9% annual average growth rate it had achieved from 2000 to 2020, barring any unforeseen events. The U.S. Leading Economic Indicators (LEI) are still very much in positive territory at +8.5% year-over-year as of December, suggesting we are not near a recession. The Fed will raise rates this year in an effort to dampen inflation, but with an overleveraged U.S. economy, we find it hard to believe that the Fed will raise rates too much and risk causing a recession. Furthermore, a slowing economy to start the year will likely diminish some of the Fed hawkishness. We would also note that Fed rate increases are not necessarily bad for stocks. The chart below, courtesy of Credit Suisse, shows the average S&P 500 return before and after initial rate hikes since 1994.
Even if the Fed were to raise rates 3 or 4 times, interest rates will remain near historic lows. So the equity markets will continue to be supported by a scarcity of compelling asset allocation alternatives. From a relative value standpoint, low interest rates continue to make stocks look attractive on a relative basis to other asset classes (especially bonds).
In addition, high yield spreads (the additional cost of debt for low quality bond issuers) are still very low in an historical context, suggesting there is still ample liquidity. U.S. high yield spreads are just over 3%, suggesting very little distress. But this bears watching as rising borrowing costs could create cracks in credit conditions. However, at current levels there does not appear to be anything that investors need to be concerned about.
Finally, U.S. corporate earnings are still quite strong. While companies have continued to highlight a favorable demand backdrop and some pricing power, lingering supply chain and inflationary pressures continue to generate concerns. Operating margins are at all-time highs, and are likely to stay elevated, especially for those companies that have strong strategic moats.
In summary, our approach remains consistent regardless of market cycles, and we continue to believe that long-term investors will be strongly rewarded for maintaining a high quality bias in their stock selection over time, both from a return generation and risk mitigation standpoint, despite occasional rotations. For example, we have for the most part avoided bank, oil & gas, and deep cyclical stocks –all of which did well last year– many of which have burdened balance sheets, low barriers to entry and lumpy free cash flow generation. In our opinion, stocks with strong strategic moats, above average revenue growth, strong balance sheets, and are able to generate high levels of free cash flow will continue to outperform despite the recent volatility. While some of these companies have come down in value the past few weeks, the worst thing an investor can do is panic. While the initial instinct is to sell these stocks as they go down, it is almost impossible to pick the exact time to sell at the top (and pay taxes on capital gains) and then pick the right time of the bottom to get back in (you have to be right twice!). It is better to own really high-quality companies over time and be patient – challenging as that can be at times.
We thank you for your confidence and trust. Please rest assured that our entire team will remain dedicated to helping you successfully navigate these financial markets.