Enemy at the Gates

Enemy at the Gates

One of the best analogies for the financial markets is a voting machine. A machine bound by the competing expectations of investors. Optimists versus pessimists. Realists versus idealists. Many would agree that the future of America is bright, especially now as we emerge from the pandemic to reclaim our lives and our economy. Try as we might, the U.S. is not immune from the shadow of uncertainty materializing in the global system.

The Russia-Ukraine War and China’s zero-COVID lockdowns are directly producing regressive effects for the world’s second and third largest economies: the European Union and China, respectively. These economies alone represent one-third of global GDP. We face significant questions about the shape of things to come.

Stock Scare, Bonds Get Reprieve

In May, the S&P 500 tumbled through the lows set in February and March. However, an impressive pullback at month-end kept prices flat. Incredibly, the market ended its circuitous journey in marginally positive territory, +0.2%. Stocks encountered a lackluster earnings season while valuations continued to fall closer to historical averages.

Bonds found a foothold in the first week of May and steadily countered their YTD rout with a month-end gain of 0.8% (Barclays Aggregate Bond Index), a welcome “rally” for the traditionally safe asset class. More pain may be in store down the road as the Federal Reserve continues raising interest rates in its quest to achieve 2% annual inflation. As of May, the annual inflation rate rose 8.6%, the highest rate in over 40 years. Forcing interest rates higher amid supply chain disruptions and energy price shocks may prove to be a case of using a sledgehammer to crack a nut. Time will tell.

Are We in a Bear Market?

In late May, the S&P 500 crossed the -20% bear market threshold—if only for a moment. Off a high set on January 4, the market sank to -21% on May 20. It then spent the last six days of May rallying 8%.  This kind of price action fuels irrational decisions. In turbulent markets, it is essential to maintain a proven, rules-based investment process.

Fossil fuels remain the lifeblood of a modern economy. While everyone fixates on transportation costs, petrochemical costs are just as central to our daily lifestyles. These fossil fuel derivatives are literally in everything—from dog collars and water pipes to solar panels and aspirin (see a longer list here). Consumers and producers alike will continue to face major headwinds as energy prices soar.

The benchmark for world oil prices, one barrel of Brent crude oil, has again extended beyond $110. The year started at $80. Some of FSA’s strategies profit from investments in commodities and commodity-related stocks. But with first quarter economic growth at -1.5%, this sector will not be bulletproof. Potential deceleration in economic activity as well as the possibility of government intervention (e.g., price controls) could reverse the trend.

On a positive note, the U.S. economy is forecast to grow in the second quarter. Favorable components include the resilience of American consumers as well as solid growth in business fixed investment. One of the tools used to measure economic health is the Financial Stress Index. Seen below are two separate calculations produced by the St. Louis Fed and Chicago Fed. While nowhere near 2008 or 2020 levels, the two indices have diverged. One worrying indicator is the rise in credit spreads. You have probably noticed mortgage rates jumped through the roof. The average 30-year fixed mortgage rate is currently well over 5%.

Flight to Safety

The FSA Safety Nets® started getting triggered back in January. At this time, FSA has now beached many portfolios with cash at 80% or more in our most conservative strategies. More aggressive strategies are holding up to 70% in cash or money markets.

Holding cash during bouts of high inflation is not easy on your savings. The good news is that money market rates have trended higher since January, increasing from near zero to greater than 0.5%. We are shifting some of our so-called sweep cash into these higher yielding money markets to pick up at least some modest yield.

It is a complicated investing environment, and change is certain. This is exactly the time where it pays to be flexible and adaptable.

I hope everyone gets a chance to enjoy the warm days of summer.

Jordan Daugherty, CFA
Investment Analyst


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