Lessons From a Volatile First Quarter

Jim Lowell:

Hello. This is Jim Lowell and I’m the chief investment officer at Adviser Investments. I’m here with another The Adviser You Can Talk To Podcast to review the first quarter of 2022 and look ahead to what may lie in store for the second quarter and the remainder of this year. And to do so, I’m joined by Dan Wiener, chairman of Adviser Investments.

Dan Wiener:

Jim, I didn’t know we were going to be doing a multihour podcast. You want to review the entire first quarter? I don’t know if we can do that. I don’t know if anybody would listen. I don’t know if anybody would care.

Jim Lowell:

Right. Point well taken. We will try to be short in our summaries. Dan, let’s jump right into the fray. Russia aggression, China lockdowns, real inflation and increased talk of a looming recession—all the while crossing our fingers that a new COVID variant doesn’t upend current assumptions of having shifted from a pandemic to endemic. Let’s begin with that bugbear of inflation. It continues to run rampant due to supply chain disruptions on the one hand and well-employed consumers whose demand for goods and services remains strong. We did finally see the Fed respond with not just their first quarter-point rate hike since 2018 but with a plan of attack that now rules in half-percent rate hikes and perhaps successive rounds until they think they’ve got a handle on inflation. Dan, first, what is inflation? Why is it that all we hear about inflation suggests that we should only fear it? Are there investments to consider and avoid if inflation remains elevated or goes higher? And, to everybody’s concern, where do we think we are heading? Are we heading into an inflationary period?

Dan Wiener:

First, let’s go to that supply chain thing. We were looking to buy a new refrigerator and we were told, “Oh yeah, you could have one, but it’ll be delivered in two years.” That’s nuts.

Jim Lowell:

Yeah. And my wife’s car has been literally at the dealer’s for two and a half months because it is missing one key component to its carburetor.

Dan Wiener:

Great. Carburetor? First of all, I’m not sure everybody should fear inflation. Inflation can be in the eye of the beholder. Higher prices are actually good for the seller, not so great for the buyer. But let’s define it two ways. It’s an increase in prices that we all pay for goods and services over time. Or you could say inflation is the decrease in value of our spending dollars. We’re experiencing inflation all the time or almost all the time. If the economy goes into a tailspin, we might see prices decline a bit, but that’s not the norm. The U.S., we last saw negative inflation—deflation—over several months in 2015. The global economy was really weak, demand dropped. But also we saw it in 2009, of course, during and right after the financial crisis.

Dan Wiener:

But like I said, that’s not the norm. The norm has been, over the last 10 years or so, about 1.7% inflation per annum. And that’s actually pretty low. When I got into this business in the late ’70s, early ’80s, inflation was running double digits. Although we used to talk about average inflation being about 3%. But back then you could earn double-digit returns on money market funds, which sounds great today. But of course, when inflation’s running double digits, not so good. Your money was losing value as fast as prices were going up. And then you had Paul Volcker, who was the cigar-chomping head of the Fed. He took care of it with a massive and fast hike to the fed funds rate. He sent the economy into a recession, but at the same time, he extinguished the inflation fires and we went back to lower inflation. And as a side note, I used to see Paul Volcker walking down the sidewalk in midtown Manhattan when he was a consultant to Citigroup. The guy was enormous.

Jim Lowell:

You’d have to step off the sidewalk just to let him pass.

Dan Wiener:

Yeah, he was enormous. And I can imagine that central bankers around the world were pretty frightened of him. When he spoke, people listened. Anyway, today, the fear of inflation—the fear is that we’re in these high single digits. Last week, the Fed’s favorite inflation benchmark, the PCE, came in around 6.4%. The headline inflation number that most consumers are aware of, the CPI, is running at 7.9%. Given that the CPI was 1.7% a year ago, this is a concern. But break-even inflation rates right now—as bad as people are talking about this 6.4% or 7.9% read is—in the bond market, the five-year break-even inflation rate’s 3.4% and the 10-year is 2.9%, which is back to that what I said was the old average of 3%.

Dan Wiener:

The bond market is pretty much saying that inflation’s going to be higher than it’s been over the last decade, but it’s not out of control. You asked me to talk about investments. Stocks are great investments during inflationary times. If inflation’s sticky, then producers of goods and services can raise prices to combat their higher input costs or their labor costs. And at some point, they may not be able to keep raising those prices, but there’ll be very few times when prices will get cut. Even when inflation goes away, those higher prices are going to stick. Stocks. You can make money in bonds, particularly if you’re a regular buyer. Just as the best times to purchase stocks are when they’re falling, so it is with bonds that lose value in inflationary periods. And commodities tend to do well and have done well this time around in inflationary times, but they can very quickly become overvalued. And then, wham! Inflation appears under control or tamed, and watch out below—commodity prices begin to lose value.

Dan Wiener:

I look at one commodity index quite often. It’s up 49% over the past 12 months. That’s great, but it’s also very dangerous. And by the way, stocks have outperformed commodities even during periods of high inflation. I’m a believer in stocks, but I’ve done enough talking. I’ve gone way over my time limit here. Talk to me, or talk to our listeners a little bit about how inflation or the fear thereof—and I think fear is also an issue; I said I’m not afraid, but there is a lot of fear out there. How do you get from inflation to recession? What’s that path?

Jim Lowell:

Right. The technical recession is defined as two quarters of negative GDP. It is loosely defined as too few dollars chasing too many goods, which eventually is seen to drive prices consistently lower. The fear right now is that we are going to enter into some kind of recession, at least if you read any headline or listen to the evening news. That seems to be running parallel to a fear of inflation. In order for a recession to occur, we’d really have to see the U.S. consumer, the employment numbers, crack from where they are, and they are at robust levels. One would call them strong to potentially strengthening.

Dan Wiener:

3.6% unemployment. Wow.

Jim Lowell:

It is the bedrock, the driver of our economy. The U.S. consumer, who relies upon jobs to enable them to fuel their spending habits, is in very good shape, but it doesn’t mean that we don’t think we will see something like a recession. Maybe not the technical recession of two negative quarters of GDP, but what we would characterize as an existential recession—something that feels like a recession even inside of 2022. And that could have a self-fulfilling prophecy of basically encouraging consumers to rein in their spending horns. But all the hue and cry that we’re necessarily going to go into some sort of long-lasting recession seems to us to be based more on theory than on fact. We would not only have to see the U.S. consumer crack; we would have to see the Chinese consumer crack.

Jim Lowell:

It doesn’t mean that we don’t think some areas of the globe are very prone to recession. We’re not one of them. Europe, I think, clearly is. And of course, for both inflation and recessionary issues, the Russian aggression in Ukraine is just adding some fuel to both fires and to the collective fear. But I don’t think we need to fear recession. As Dan noted, I don’t think we need to fear inflation. We need to look for opportunities to manage the risks and the opportunity sets that either engender. And in order to do so, what we think is prudent is to definitely focus on quality across the capitalization spectrum. In terms of mega-cap, large-cap, U.S. growth and value names, we think there’s plenty of opportunity there. There’s probably even opportunity coming in the form of multinationals that are domiciled overseas that have the lion’s share of their revenue profit, their sales and services, going to U.S. consumers, going to Chinese consumers. This is not a marketplace that’s completely void of opportunity, even though it is chock full of headline fears.

Jim Lowell:

Dan, on that note, I know that Russian aggression is just the latest example of an exogenous event that impacts economies and markets. And while the human toll of Russia’s outlandish aggression is tragic, the market carnage was very short-lived or at least appears to be so. Granted, the bond market had its worst quarter in maybe as much as 50 years, maybe going back to the ’70s, but the stock market, after looking like it was on very shaky ground, regained and recouped the lion’s share of its intraquarter losses. Given that we’re on this cusp of ongoing Russian aggression, ongoing inflationary pressures, ongoing issues relating to the global marketplace, should one avoid international markets lock, stock and barrel?

Dan Wiener:

No. Or maybe I should say, “Mais non, mais non.” Foreign markets have definitely been a drag on performance for diversified portfolios for many years, for the past several. But they won’t always be. There are a lot of outstanding global companies that trade only in foreign markets. It would be a shame not to own them or at least have exposure to them. It’s very easy. Think of a Heineken, Volkswagen, Taiwan Semiconductor, Sony, Toyota—all of these are foreign companies that you get exposure to by investing in overseas funds or investing in overseas markets. At one time or another, foreign companies have been global and market leaders, so you don’t want to just cut off your nose to spite your face and say, “I’m just not going to invest overseas.”

Dan Wiener:

Many of our listeners might not have been investing in the early aughts, but for seven years, from early 2002 through 2007, foreign markets were way ahead of our domestic markets. Way ahead. Asian and South American markets were on fire. They were returning multiples of the U.S. market. The dollar was declining, which helped U.S. investors’ returns as well. And back then, the question was: “Why should I invest in the U.S. at all when foreign stocks are so strong and the dollar is so weak? Clearly the place to be is overseas.” The pendulum moves back and forth, and you just have to both be patient and take a long-term perspective. But I think the foreign market that a lot of people have—us as well—focused on, and we focused on it a lot during these podcasts, has been China.

Dan Wiener:

Last year, the government there imposed all these harsh rules against tech and online education companies, among others. And that spooked the entire marketplace; stocks really took a hit. This year, they mishandled COVID, they were returning to lockdowns, and it seems like at the same time they acknowledged maybe they went a little too far and they need to more directly support the economy, the markets, and some of the companies that are really the market leaders there. That’s breathed a little bit of life back into them. You spend a lot of time thinking about China, reading about China. Talk for a minute about both our direct China market exposure and whether investors should have any exposure to China, in fact.

Jim Lowell:

Absolutely. Our direct exposure is probably less than 1.5% or so in our more growth-oriented portfolios, a minimus exposure. The rationale behind our exposure to China is, of course, that it’s the world’s second largest economy, the world’s second largest superpower next to our own, and it has 1.4 billion consumers give or take a population, a census count, compared to our own consumer-driven market and economy, which has maybe about 280 million consumers, 300 million consumers. We do think that for truly long-term investors, China’s marketplace makes sense. Not just as a way to benefit from Chinese companies that are exporting goods and services but also as a way to capitalize on Chinese consumers who are increasingly buying “brand China.” But we go in with eyes wide open. China is not a free marketplace.

Jim Lowell:

Dan was talking about how they effectively went through a series of self-inflicted wounds on some of their leadership technology and online learning companies last year. To the point where it hit their markets, their economy, and their consumer confidence hard enough for them to reverse course this year and come out and say that they’re going to do whatever it takes to support the market, support the economy. It’s not a free marketplace. It may evolve into a free marketplace; it may devolve further into a marketplace driven by the politburo and politics. We watch that. We understand there are human rights issues that are sincerely troubling in China’s marketplace. We definitely weigh that over and against the long-term investment benefits and the benefits of having a Chinese consumer increasingly interested in investing in their own marketplace, empowering themselves to perhaps become more enlightened down the road.

Jim Lowell:

One of the things that we know is that as we go forward, the EU—while certainly there are some companies inside of it, as Dan noted, that we want to be able to take advantage of—overall, Europe’s economy seems to be translating increasingly into more of a tourist economy as opposed to a service or manufacturing economy. And we are moving from a global economy—and I’m saying moving, it might take decades, some think we may already be there—from a global economy to effectively a duopoly where U.S., China, and the relations between the two and how they treat their own markets is going to have a material impact on the ways in which we invest in those markets.

Dan Wiener:

Well, the Chinese—if you think of the Great Wall of China, as you said, they’ve got billions of consumers there. They can build their economy on the backs of these billions of consumers, but of course they can’t completely wall themselves off.

Jim Lowell:

Correct. And nor would they want to. First of all, they’re pretty good at taking a lot of our intellectual property and turning it around into their own manufacturing and service productivity. Just on that level, they need to be as open as they can. But increasingly, I think, as the Chinese consumer strengthens, the Chinese politburo will recognize that strength is not a weakness to be feared. And I guess speaking of fear, Dan, I know that we did.

Dan Wiener:

Uh-oh, here it comes.

Jim Lowell:

Yeah. We just talked about investors avoiding China at all costs. Why we don’t think that’s a good idea. But an even bigger market that investors may be thinking about avoiding is the bond market. Bonds delivered a very disappointing Q1 if you are a bond investor used to seeing reasonable returns. Zigging when the stock market zigged rather than zagging. It didn’t give us the defense that we were looking for. And we know that rising rates hit bonds hard. Should investors avoid bonds altogether?

Dan Wiener:

Well, I’m not going to say no. We’re covering a lot of bases here. Inflation, stocks, foreign markets, bonds. Wow, the landscape. Bonds are, I think, the unloved asset class right now. Death of the 60/40 portfolio is the classic headline these days. But yields are rising. Isn’t that a good thing? Less than two years ago, the yield on the 10-year Treasury was half a percent. You gave the government your money, they held it for 10 years, and in exchange they gave you half of 1%. Ludicrous. You put $100,000 in a 10-year bond, they gave you 500 bucks a year back for the privilege of using your money for 10 years. No thanks. That was not interesting to me. Today, that same bond pays around 2.4%, which still isn’t a ton of money, but it’s five times better.

Dan Wiener:

And I know that one of our listeners is going to be sitting here going, “Hey, wait a minute. What about inflation? You guys are just talking about inflation, of course the yield is higher.” And that’s true, but that’s why I still think investors should focus on stocks for the long run. But that being said, bonds with yields of 2.4% are still going to protect your portfolio a lot better than bonds at half a percent. And if inflation begins to recede, as I think it should, then the yield you bought today sticks, so you’ve still got your 2.4%. Bond fund owners—those who buy funds as opposed to individual bonds—they can continue to buy low, and they do continue to buy low if they’re reinvesting their monthly distributions. Bond funds have what we term a self-healing characteristic in reinvestment.

Dan Wiener:

When interest rates slow, their income is going to catch up. All that income you’ve been building up is going to catch up and begin to repay the lost principal in that bond fund. No, I don’t think you want to avoid bonds altogether, but I think you have to have reasonable expectations for what they will do for your portfolio.

Dan Wiener:

Just to move on here, I saw a story this morning again about the whole value versus growth argument. It’s amazing to me—people still talk in these broad categories like they’re monolithic. We invest with at least one quote unquote “growth manager” who more than outperforms growth indices and tends to do well against broad market benchmarks as well. Do you think the growth/value conversation has just gotten too simplistic and lacking in any content?

Jim Lowell:

I think it has, and I think that when we say growth versus value, it’s effectively—it has all the authenticity of a pro wrestling match. What we’re looking for, of course, are companies that are selling at a discount but that have growth potential. Whether they’re in sort of classic growth or classic value camps, we know, as you pointed out, that many of the managers we invest in invest in both growth and value names. They are being led by where they think the greatest opportunities are, not by an Investopedia definition of what is or is not growth or what is or is not value. The traditional way of thinking is that growth stocks have a cycle, value stocks have a cycle. I think the cycles are moving so quickly, and we saw it in the first quarter of this year alone, that you really do want to own both sides of the ledger and take a nice, balanced, blended approach and do so not just domestically but globally.

Dan Wiener:

Listen, I see our producer giving us the cut. We’re getting down to the end of this. I would be remiss if I didn’t invite everyone who’s listening to tune in to our quarterly webinar, Stocks, Bonds and the Fog of War. We’re going to be hosting it on Wednesday, April 20, in the afternoon. You can find more information on how to register, how to log in, all the rest of that at adviserinvestments.com/webinar, that’s adviserinvestments.com/webinar. We spell adviser the right way, with an “e.” Anyway, I’m going to throw it to you, Jim, to take us out and give our producer the rest of her day off.

Jim Lowell:

Very good. All right, overall, at Adviser Investments, we continue to think that vaccination success remains an important determinant for economic and market growth in 2022 but that fundamentals, earnings, interest rates and economic data will matter more and more. Our dedicated research and investment teams’ analytical assessments of economic and earnings data, based on what we know, not what others say we should fear, will continue to determine our disciplined investment decision-making process and plans. Overall, we remain in favor of the Fed and fiscal policymakers doing whatever it takes to safeguard our economy, including raising rates faster and further if conditions warrant doing so. And we remain confident in the long-term results of our disciplined investment approach but know that in any given year, there’s a high probability that it will be challenged by the velocity and momentum of event-driven markets. Know that even as we always have our eyes on long-term gains, we never let our near-term risk guard down. In fact, for over 25 years, we think it’s been our focus on managing risks well that has enabled us to pursue reasonable returns in both calm and turbulent times.

Jim Lowell:

And with that, I will conclude this first-quarter podcast. On that note, this has been Jim Lowell.

Dan Wiener:

And Dan Wiener.

Jim Lowell:

From Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback really is always welcome. If you have any questions or topics that you’d like us to explore, please email us at info@adviserinvestments.com, and thank you for listening.