The first quarter of 2022 brought about a sea change of events that hasn’t occurred in decades. The Federal Reserve has maintained a targeted inflation level of 2% per year for the last twenty years and the USA has enjoyed stable price changes for the last forty years. In 2021, that began to change, but it was difficult to tell whether higher inflation readings were a result of dislocations from the pandemic, and thus of a temporary nature, or not. Now, we can see inflation measures breaking out. In the most recent readings, the Consumer Price Index has risen 7.9%, producer prices are up 10% and wages are up just over 5 ó% in the last twelve months. These are forty-year highs. The Fed, with short-term interest rates having been set to zero, and additional emergency accommodation measures provided up until very recently, now finds itself way behind in the dealing with this problem. As a result, this quarter likely marks the end of the easy money era of bond buying and exceptionally low interest rates which have been utilized since the Great Financial Recession. The Fed has an enormous challenge on its hands as it attempts to slow the economy to deal with inflation that has in part risen due to supply constraints rather than from an overheating economy or monetary policy.
Global trade has grown in the years after WWII and was catalyzed since then by two events: the fall of the Soviet Union in the late 1980’s, and China’s acceptance into the World Trade Organization twenty years ago. In the case of the former, the collapse of the Iron Curtain opened the world to what had been a closed economy. In the case of China, its acceptance to the WTO allowed a secluded, mainly agrarian economy to manufacture for the world. Global exports increased from 5% of global GDP at the end of WWII to 14% in the late 80’s, and now are just over 29%. If you double this figure, you get the value of both imports and exports, which is world trade, and that finished 2019 at 58.2% of global GDP. At such a large share of the planet’s economy, you can readily see how important trade and the interconnectedness of supply chains has become. Globalization allows production to be performed where costs are lowest, and when things run smoothly, it is a deflationary force. This is ending for now.
The pandemic, China’s zero-Covid policy, and the terrible Russian invasion of Ukraine have severely stressed supply chains. For many companies, offshoring was many years in the making and has now come back to create substantial problems. Rather than finding the country with the cheapest source of goods, we will likely see a change to more local production that places a premium on the safest means of securing inputs. This is inflationary, of course, but helps to assure producers of the availability of supply.
There are many industries where the basics of supply and demand are very much out of balance. Semiconductors are a great example. Thirty years ago, the US and Europe produced more than three-quarters of the world’s semiconductors. Now, they produce less than one-quarter. US new vehicle sales in 2021 were expected to come in at just under 15 million, which is a 9% reduction in sales from the five years before the pandemic. The difference has nothing to do with demand which has stayed high, but rather from the lack of semiconductor availability which has curtailed production. The car companies just can’t produce enough to keep up, causing depleted inventories and used-car prices to skyrocket by thirty-seven percent last year. The shortage in chips was expected to cost the global automotive industry $110 billion in lost revenue in 2021. Car manufacturers are likely to rein in their supply chains to be much closer to home, but at higher costs to ensure adequate supplies. Many other industries are of course facing a similar mismatch of inadequate supplies to meet the demand for their products. On top of the economy trying to heal from the pandemic time frame, Russia’s war against Ukraine has now exacerbated many other imbalances. Two others deserve a mention: energy and agriculture.
Energy security has now joined the energy transition as a priority. Russia is the third largest oil producer in the world and is the second largest export country. It supplies 1/3 of Europe’s oil, 45% of its natural gas and almost half of its coal. With sanctions, and technological know-how leaving Russia, the world is going to have to replace critical supplies in short order. This is a particular challenge since petroleum products are so integral to our daily lives.
Ukraine is a significant producer and exporter of agricultural products, and together with Russian output, disruptions will likely cause food inflation and even potentially social unrest in countries that lack their own production. Ukraine is the world’s 4th largest exporter of corn. Ukraine and Russia together export 30% of the world’s wheat and have a 75% export share of sunflower seeds/oil. Fertilizer markets were already challenged before the conflict and are more so now as Russia is a significant exporter of all three nutrients that compose fertilizer: nitrogen, phosphate and potassium.
The good news for Americans is that we have abundant resources and are largely self-sufficient in these areas. Supply and demand will eventually be brought back into balance in the areas that have struggled. It wouldn’t surprise us to see inflation somewhat elevated in the next few years compared to the very low levels we’ve seen in the last twenty years. However, as the economy and supply chains heal from these dislocations, the rate of increase in inflation will begin to soften, and we expect that to start later this year. As investors, we are quite happy to have focused our energies on the many abundant opportunities in the USA.
With the prospect of higher inflation for now, higher interest rates to come, and with uncertainties presented by war in Europe, the major asset classes fell in value this quarter. Positions that most benefited from speculation and years of easy money have been hurt the most. Examples include IPO’s, SPAC’s, NFT’s, Cryptocurrencies, stocks with unprofitable / futuristic business models and even many areas of the bond markets. The types of companies we own on your behalf did fall in value, but fortunately were spared the worst of the downturn as our process leads us to companies of much higher quality that are profitable, that have solid management teams, and whose business prospects can have tailwinds for years. In the last 5 months we exited a few of our positions that lack pricing power or are susceptible to higher interest rates and inflation. We also added a few new companies that meet our investment criteria and can be successful in a higher a higher inflationary environment.
In this start to 2022, US equities fell for the first time in the last seven quarters, with the S&P 500 Index losing 4.6%, the Nasdaq off 9%, and the Russell 2000 Index down 7.5%. This is the 26th negative first quarter in the 72 years since 1950. In those 26 years, the market averaged a 3% gain in the remaining nine months of the year with a gain occurrence of 50%. Historically, a weak first quarter has led to a coin flip as to whether the balance of the year showed a gain, and gains on average have been muted. With a move higher in interest rates, bond performance suffered and the Barclay’s Aggregate Bond Index’s return of -6.2% was its worst showing in 40 years.
Early in the quarter, Covid presented another issue for the economy to deal with, as the Omicron variant didn’t lead to as many casualties as previous waves, but did further challenge supply chains with worker shortages. The good news on this front is that the latest wave wasn’t nearly as lethal, and perhaps we’ve seen the last of disruptions from this virus.
The market has had a lot to contend with to start the year and now some of the previous uncertainties are very much out in the open. It’s difficult to get too bearish on the economy when the American consumer is in such great shape. Unemployment is at a 53 year low, and excess savings coming out of the pandemic is $2.7 trillion.
Many of our investors have enjoyed very strong returns for the last three years, and this quarter will show that all of us have taken a breather. Our private account strategies’ estimated performance in the first quarter:
As you know, the portfolios we build for you are customized, so your experience will typically be different than the composite averages. Bond portfolios also lost value on the year as interest rates rose. The good news on the bond side is that we will be able to reinvest will higher yields when your bond maturities are put to work.
We appreciate the confidence you have placed in us and wish you the best.
Sincerely,
Mark E. McMeans, CFA
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