Q2 2022 Investment Outlook
Clients of the Firm,
The first quarter of 2022 marked the first significant stock market correction in 18 months driven by the war in Ukraine and the commensurate inflationary pressures on the economy and corresponding Fed action to combat it. In February 2022, Russia invaded the Ukraine throwing recent post-cold war security norms to the wind. The battle has been bloody and filled with alleged atrocities that have not been seen in Europe for many years. From a human perspective, our thoughts are with those suffering.
NATO met the Ukraine invasion with crippling sanctions on the Russian economy, banking system, oil and natural gas distribution and infrastructure which will reverberate for years to come. Consequently, S&P 500 stocks corrected by over -13% during the quarter. However, the S&P 500 rallied to end the quarter down only -4.6% through March 31, 2022. The narrative in domestic markets prior to the invasion was a discussion of valuation levels and higher interest rates. We visited those topics at the beginning of the year in our communiqué with clients. Forward P/E levels were elevated going into the quarter and even though earnings were largely at or above consensus for most of our investments, multiples began to normalize. Indeed, markets had not priced in the tail risk scenario of the Ukraine war or the pockets of hyperinflation and market disruption that would result due to sanctions.
We believe there will be some drag on earnings and GDP as a result of the inflationary pressures from the conflict in addition to the economic disruption from the war and China COVID related shutdowns. The impact of both will be somewhat constrained demand and continued supply chain disruption. While the impact of these conditions is uncertain, consensus forecasts now call for a reduction in GDP growth of about 1%. As a result, revised expectations now call for +3% GDP growth for 2022.
Per our previous guidance, some inflationary impacts are likely to be sustained. The stickiest of these pressures are likely to be wages and energy. Wage increases are being driven by record low unemployment and the lack of workforce participation as baby boomers are retiring and prevailing wage increases are reducing the need for workers to hold multiple jobs. Energy prices continue to be high due to supply constraints from Russian oil going offline and other OPEC output constraints. For example, oil has consistently been above $100 for WTI and Brent Crude for several weeks.
Notably, interest rates have risen significantly on the short end of the yield curve creating an opportunity to invest in U.S. Treasury securities at yields north of 2% for a two-year duration. We have patiently anticipated this scenario as it now allows us the opportunity to rotate out of cash reserve assets (very short-term Treasuries) into income producing Treasuries at 2-year duration. Parts of the yield curve are currently inverted, meaning that interest rates for shorter duration exceed those for longer duration. This phenomenon is largely due to the Fed broadcasting its intentions to aggressively increase short-term rates to fight inflation. While we don’t yet think the longer end of the curve has priced in a prolonged higher interest rate environment, the Treasury curve under 2 years maturity is getting closer to terminal pricing on yield. In our view, prices now represent an opportunity to deploy previous cash and bond allocations in a more prudent way.
Stocks and bonds have both suffered a volatile beginning to 2022. Price declines in both asset classes have created some measure of opportunity. We expect the bond correction will continue over the course of the Fed tightening cycle and the impact of inflation will weigh heavily on both Fed strategy and the ultimate outcome of equity earnings. Some level of multiple compression has occurred in the equity markets, but not to levels indicating an earnings recession.
John Maynard Keynes, the noted economist, wrote of Lenin’s efforts to destroy capitalism, “Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch (devalue) the currency…Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which not one man in a million can diagnose.”
Ironically, sanctions against Russia and the devaluing of the ruble have further proven Lenin’s thesis and have instead worked to undermine Russia’s economy in a profound way. The strategy of both limiting the ability of a sovereign to transact in their fiat currency and pressuring the primary revenue source backing it creates a campaign of maximum economic pressure and may prove to be highly effective as time and unity allow. Additional measures may also be considered that create further pressure to end the Ukraine conflict. The situation remains highly dynamic and we will remain vigilant regarding its impact on financial assets.
As the second quarter of 2022 begins, we will look to the earnings season as a measure of near-term results as well as a harbinger of the impact of both the war and inflation on investment earnings. We expect some multiple compression to continue or at least be sustained in the face of these uncertainties. Consensus earnings forecasts remain at levels that are consistent with our investment strategies, but higher short-term interest rates and increased uncertainty provide opportunities and risks that merit careful attention.
We thank you for the opportunity to manage your funds and for your confidence in our firm.
Sincerely,
Peter C. Wernau
President, CEO
Wernau Asset Management
http://www.wernauassetmanagement.com/
Office: 617.871.0029
Fax: 617.507.8155
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