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Quarterly Letter to Clients

3/31/2022

Written by:  Thomas Flaig, CFA

Investment veterans often say that the market climbs a wall of worry.  It certainly was an uphill climb for the markets this past quarter as investors not only had to contend with soaring inflation, but also a major international conflict involving Russia.  While commodity related securities soared, just about every other sector of the market proved fair game for nervous sellers.  At its low, the S&P 500 was down double digits and the Nasdaq was down nearly 20% from its recent high just three months prior.  Bonds provided little shelter as interest rates rose and bond prices declined.  Markets however began to rebound off their lows in mid-March and managed to cut these losses by more than half by quarter end.  For the three-month period the S&P 500 declined 5% and the Nasdaq Composite was down 9%.

The Federal Reserve finally got around to doing what it probably should have done nearly a year ago – raising interest rates.  A quarter point increase in March represented the first rate increase since 2018.  However, the Fed has put itself in an untenable position by waiting too long to raise rates and is now desperately trying to extinguish the flames of inflation.  The current rate of inflation is somewhere in the vicinity of 8%, roughly six percentage points above what is considered acceptable.  Investment strategists are expecting interest rates will climb two full percentage points higher by the end of 2022.  One silver lining is that job openings are still plentiful and wages are rising.  The U.S. economy should be able to absorb several rate hikes without risking a recession.

One hard earned lesson over the past several years is that manufacturers need to have more of their production capacity located in the U.S.  Over-reliance on cheap labor countries, such as China, is no longer a viable option as political differences have widened and overextended supply chains have become too unreliable.  The good news is that many companies are finally beginning to see the light and are starting to direct sizable amounts of capital toward new manufacturing facilities that will be located either in the U.S. or more friendly countries within Europe.  Intel recently announced that it will build a new $20 billion semiconductor chip manufacturing facility in Ohio and will also add multibillion dollar plants in both Arizona and New Mexico.  Samsung has also announced plans for a new $17 billion chip manufacturing facility in Texas.  While semiconductor facilities can take several years to complete, it is definitely a step in the right direction.  Hopefully manufacturers from other industries will follow suit and bring more of their production capacity back to the U.S.

From a global investment perspective, U.S. stocks appear better positioned to withstand the current economic headwinds compared with most other parts of the world.  Europe is not only geographically closer to Russia, but also has more direct economic ties, which will be difficult and costly to untangle.  China has proven to be an unreliable business partner, and the Chinese government has used a heavy hand to manipulate their local businesses.  With interest rates around the globe expected to continue to increase, bonds are unlikely to provide a safety net for investors.  It is noteworthy that long-term U.S. Treasury bonds declined 11% this past quarter, which was more than twice the decline of the S&P 500.

Corporate earnings are still expected to rise this year, but will likely grow at a significantly slower pace than last year.  Inflation will continue to be a negative headwind.  However, many companies are finding ways to cope with the problem.   While companies found it fairly difficult to raise prices over the past several years, they are now finding it easier to justify these actions.  It is worth noting that stocks have historically performed fairly well when interest rates are on the rise.  Investors also need to remember that Fed rate hikes usually happen near the middle of an economic cycle, which means there still could be several years left of potential gains for stocks and the economy.