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Centerline Market Update 2020 Q2

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2022 Q2

Holding up against stiff headwinds

Last year, the reopening of the economy, new vaccines, strong profit growth, and low interest rates fueled big gains in stocks. By December 31, 2021, the broad-based S&P 500 Index, which is comprised of 500 large publicly traded U.S. companies, had more than doubled from its late March 2020 pandemic bottom, according to data provided by the St. Louis Federal Reserve.

The bull market was just 449 trading-days old, and the S&P 500 Index had advanced 113%. In fact, when we compare the current bull market to the six best performing bull markets since the end of World War II (through the first 449 days), the current run easily exceeded its contenders.

The winds have shifted in 2022.

Inflation is a growing problem, supply chains are constrained, oil and gasoline prices are up sharply, investors are grappling with the fallout of Russia’s invasion of Ukraine, and the Federal Reserve has pivoted away from its easy money policy. With all that said, the major averages have been quite resilient in the face of stiff headwinds. The economic expansion, low unemployment, and rising corporate profits deserve much of the credit for providing a cushion to the downside. Stocks don’t move higher in a straight line. Volatility and corrections are to be expected as we’ve discussed before in our commentary. Still, heightened uncertainty is rarely a cause for celebration, even if losses have been relatively modest.

We don’t try to forecast when markets might correct. Instead, we make recommendations and individually craft portfolios based on several factors, including the idea that we will run into unexpected detours along the way. Pullbacks are a normal part of investing, and they are sparked by unexpected events. We will usually experience several corrections over the course of an economic expansion. But history says they are temporary.

While uncertainty generated by geopolitical events has rarely caused long-term damage to the major market indexes, they do create short-term volatility. The initial news of an event usually generates heightened uncertainty, which forces short-term traders to pull back. But if the crisis does not affect U.S. economic activity, investors typically incorporate the new normal into their outlook.

Let’s look at Ukraine. It’s fair to say this isn’t your typical geopolitical event. But so far, it seems to be following the historical pattern. Let’s acknowledge the obvious. What is happening in Ukraine is atrocious, and how the war may unfold is a big unknown. Recently, there have been no significant developments that might negatively affect investor sentiment, and investors seem to be taking the apparent stalemate in stride. It’s not that we are immune to the horrific acts of aggression by Russia. We’re not. But investors look at geopolitical affairs through a very narrow prism. That is, how will an event or events impact the economy?

Few see a cessation of hostilities in the near term. However, investors may slowly be growing accustomed to the daily reports coming out of Ukraine. It’s as if we are becoming comfortably uncomfortable with the war. Put another way, investors seem to slowly be incorporating a new normal into their collective outlook, as there hasn’t been a significant shock to demand for goods and services at home.

What about oil prices? What about the surge in gasoline prices? For starters, it’s painful every time we fill up, and it will likely translate into higher inflation. The broader economic impact is less certain. For every penny increase in the price of gasoline, U.S. consumer spending drops by $1.18 billion a year, according to an estimate from Federated Global Investment Management (Bloomberg). For example, a $0.75 jump in gasoline, if maintained over a year, would hit spending by roughly $90 billion. But U.S. Gross Domestic Product is over $24 trillion, which would translate to less than 0.4% of GDP. It’s not insignificant, but by itself, it’s not enough to throw the economy into a recession.

According to JPMorgan, annualized Core CPI stayed the same at 6.4% from February 2022 through March 2022, but annualized headline CPI rose from 7.9% to 8.5%. Core CPI removes food and energy from the inflation calculation because both of those can be affected by geopolitical issues and drought or disease. Russia’s invasion of Ukraine shows how much the global economy depends on that region for energy, agriculture, metals, and fertilizer. Add a very contagious bird flu wreaking havoc on poultry in the U.S. and it is not a surprise to see headline inflation rising.

Then there is the Federal Reserve. Its commentary has grown increasingly aggressive as it hopes to rein in inflation. At the March meeting, the Federal Reserve raised the fed funds rate by one-quarter of a percent to 0.25%–0.50%. Its own Summary of Economic Projections suggests we may see a fed funds rate of 1.75%–2.00% by year-end. And, as Fed Chief Powell has said, don’t discount the possibility of at least a half-percentage point rate hike (or hikes) at upcoming meetings.

Why is this important? For savers who want safe, interest-bearing investments it’s good news. For equity investors, it’s more problematic. When bond yields and interest rates are low, they offer little competition to stocks. But rising rates and yields could encourage some investors to look at alternatives outside of equities. From an economic perspective, some are asking if the Fed can bring inflation back down without causing a recession.

In past cycles, rate hikes were preemptive and proactively implemented to stave off any future jump in inflation. The Fed succeeded in engineering what’s called a soft landing in the mid-1980s and mid-1990s. We acknowledge the economic uncertainty on the Fed’s ability to attain the soft landing has led to an increased risk of a recession happening in the next 24 months, however, that is currently not our base case.  We will continue to carefully monitor the Fed policy, economic indicators, and the geopolitical environment.

We trust you’ve found this review to be educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give us a call.

 

This research report has been prepared by the Centerline Wealth Advisors Investment Committee 2022©

 

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