Geopolitics: February will be marked in history as the month Russia invaded its neighbor Ukraine. Historically wars have surprisingly little impact on financial markets but in this case, the past may not be prologue. Russia holds 11% of the world’s known oil reserves, and already there has been sizeable price volatility in energy and other commodity markets.
In addition, the destruction of the Russian ruble holds unforeseen consequences for markets as asset owners and speculators significantly mark down their Russian holdings (the ruble has fallen nearly 30% relative to the U.S. dollar since the invasion began). This is largely in response to a coordinated effort by the West to bring the full force of the financial system to bear against an aggressor country. Cutting off access to the global payments system will have a dramatic and negative effect on Russia’s economy, and along with the West effectively closing off Russia’s ability to freely convert its currency to dollars, will likely mean whole scale bankruptcies in the country.
Stock Market: The stock market as measured by the S&P 500 Index suffered its first 10% correction since the global pandemic in 2020, falling more than 14% from its peak of 4,818.62 on January 3, 2022. The NASDAQ indices fared even worse. While multiple reasons can be given as to why (change in monetary policy, the conflagration in Ukraine, a growth slowdown in the economy), it was clear as early as the middle of 2021 all was not well with the market. In fact, many of the uber-speculative meme stocks and SPAC offerings peaked over a year ago. This weakness was disguised over the course of 2021 by the strong rally in mega-cap technology companies that lifted the major indexes in a final ascent in December. Both Managed Income and Dynamic Growth picked up on this underlying weakness, exiting long positions in November and December, thereby avoiding the bulk of the significant losses that investors have suffered in 2022.
Fixed Income: Fixed income markets remained unsettled, with yield spreads between Treasuries and lower grade bonds continuing to widen given heightened uncertainty around the geopolitical backdrop and the domestic economy. The ongoing reduction in the Fed’s purchases of Treasury and mortgage-backed securities (also known as MBS) and its announcement that March would bring to conclusion its quantitative easing program also gave investors reason to pause. This was reflected in the stickiness in Treasury yields. Normally, in conditions of elevated uncertainty, there is a strong bid for government securities in a flight to safety move. During the month, however, there was little evidence of this up to the point that hostilities broke out in Ukraine.
Monetary Policy and the Federal Reserve: The fallout from the Ukrainian conflict adds to the difficult decision facing the Fed this month. Year over year prices continue to leap ahead even as the overall U.S. economy slows quite dramatically. The Federal Reserve of Atlanta’s GDPNow model (an estimate of real annual GDP growth) estimates the growth rate of real GDP for the first quarter of 2022 at 0.0% (literally no real growth), a somewhat remarkable slowdown from Q4 2021 when the model forecast real growth of 6.5% as recently as January 26, 2022.
Such a slowdown would normally suggest a go-slow approach in Fed policy. Unfortunately, inflation measures have failed to fall commensurate with the slowdown, leaving the Fed in a bit of a quandary. Compounding the situation are the events in Eastern Europe – the conflict is placing upward pressures on oil and other commodities at the very least – and worries the FOMC is now facing a toxic combination of rising prices and slowing output. Market expectations currently are for a 25-basis point increase in the Fed Funds rate with the number of future hikes in a state of flux as investors attempt to divine how the events in Europe will play out.
Managed Income Strategy – There is an old Wall Street adage that says, “Keep your eyes on fixed income, they’re the smartest guys in the room.” While perhaps a bit hyperbolic, the saying offers an important insight. Fixed income managers are paid to ensure the monies with which they are entrusted are returned in whole to clients with interest. The focus can be described as: will I get my money back and when? Given this singular mandate, keen market observers know to keep an eye on credit markets as when debt instruments begin to move in a volatile fashion, it’s a sign something’s likely afoot.
One measure that tracks the underlying health of these markets is the spread between Treasury securities and lower rated fixed-income securities as seen in the chart below. Comparing the behavior of spreads to equity prices over the course of Q4 2021, we can see that even as stocks were rebounding to new highs in December spreads were counterintuitively widening.
This was suggesting all was not well. Sure enough, the broader indices began rolling over in November, marking the beginning of the current market correction.
Managed Income’s proprietary model is sensitive to such changes in the fixed income environment. It adapted accordingly in late 2021 and remains in Risk-Off mode. This capability to adapt is essential to the Strategy’s ability to weather the ups and downs in volatile markets, thereby preserving capital while generating an attractive fixed-income return, which it has done successfully since its inception 30 years ago.
Dynamic Growth Strategy - In the last commentary, we highlighted the expansion of trading ranges and increased volatility (and thus risk) in the market. This elevated risk, combined with a current down-trending market, has driven the Dynamic Growth Model to maintain a Risk-Off posture. The macro landscape is unusually uncertain as “big picture” concerns such as inflation, monetary policy and interest rates are all in flux.
Fortunately, our investment approach has been stress-tested under a variety of adverse conditions and has successfully navigated such challenging conditions. We fully expect it to do so in the coming months and years. Our primary goal is to generate steady, above-average positive returns with low volatility and downside protection. At certain times, as is the case today, that can mean exiting market exposure altogether until a more favorable environment presents itself. We will continue to monitor markets for potential re-entry points, as we do believe that heightened volatility can create meaningful opportunities, but for the time being are inclined to avoid exposure as risk outweighs any opportunity for price advancement, and our model-driven process re-affirms this position.
Kensington Asset Management Team