Three Key Thoughts:

1. Real Chaos

2. No Break in Inflation

3. Globalization and Peace No More

Real Chaos

Amid 2021’s rising stock market, we witnessed pockets of craziness as IPOs, SPACs and meme stocks soared to outrageous prices, driven largely by retail demand, often induced by social media. Having witnessed these bouts of euphoria previously, we were pretty sure that this chaotic party would end badly. Sure enough, as interest rates began to rise in January, the party ended pretty suddenly. The selling also pulled down the valuations of many very good growth companies whose stock prices had also risen to excess.

Then the real chaos ensued as Russia invaded Ukraine. We believed, incorrectly, that Putin might not invade because he had already maneuvered Europe into the position he desired, with high energy prices and a hearing on his security concerns. What we didn’t appreciate was that this invasion was part of a long simmering desire by Putin to eradicate Ukraine and continue reassembling the former Soviet Union.

After having been embarrassed by his army’s early failures to capture Kiev and overthrow the government, Putin is now expected to escalate the fight much further in the eastern part of Ukraine. Putin has already demonstrated that he has no compunction about killing innocent civilians or destroying the country’s infrastructure. In addition, he clearly has little regard for his own people who will be the ones to suffer under the sanctions imposed by the West. More importantly, Putin has no interest in peace so we expect this conflict to drag on for some time.

While it does, Ukraine and Russia are largely removed from the world economy, with only the sale of Russian oil and gas supporting that country. Oil and gas prices are likely to stay high as will another major export of both Russia and Ukraine: wheat.

No Break in Inflation

With this as backdrop, it is no wonder that consumer price inflation has risen to more than 8% at this writing. Here in the US, we already have a very tight labor market that is leading to higher wages, which will push up prices across the board. The energy price increases are now working their way through the US economy and, after abandoning the energy independence we spent forty years acquiring, the current administration does not appear to have a credible plan to bring down energy prices.

We were just beginning to come off the worst of the pandemic-induced shortages of goods when the Omicron variant struck China. Sticking to its COVID Zero policy, the Chinese government has instituted massive lockdowns, keeping the citizenry in their homes and factories idled. It will be interesting to see how long they continue this policy, as the rest of the world recognized that the Omicron variant spreads too quickly to be controlled by lockdowns but that its virulence is dramatically less than prior strains.

Finally, we continue to see exceptionally strong demand for real estate in the US. Some of this is generational and some is a desire for more space, a reasonable reaction to a two-year battle with COVID isolation. And likely some is a reaction to the fact that real estate has historically been a good inflation hedge. Regardless of the reasons, rising real estate prices will also continue to put upward pressure on inflation.

This reality hit bond yields hard in the first quarter as the rate on ten-year Treasury bonds nearly doubled from 1.5% at year end to about 2.8% at this writing. The Federal Reserve hung onto its “transitory” inflation wish for too long and now finds itself in the difficult situation of having to raise interest rates very rapidly to try to cool inflation. The Fed also realizes, however, that doing so flies in the face of an economy that is already weakening after the stimulus-induced growth of 2021. It is no surprise that talk of recession is now commonplace and mostly in the context of “when,” not “if.”

Globalization and Peace No Longer

Two fundamental assumptions were key to our investment of a portion of our clients’ assets in international stocks: (1) the world was largely at peace and (2) globalization of production and consumption gave rise to many new opportunities, particularly in serving growing middle classes in developing countries. These assumptions may no longer be true. The Russian attack on Ukraine and the distinct possibility that this is only the beginning of a larger set of conflicts means we can no longer expect peace. And the Europeans are learning a difficult lesson in the downside of counting on an unpredictable dictatorship to supply its energy needs.

China’s turn inward and toward greater self-sufficiency, which started prior to the pandemic, is being reinforced by its COVID response. Even as China wants to become more self-sufficient, the rest of the world wants to become less dependent on China. COVID taught us the downside of global supply chains. While they are great for cost efficiency when all works well, they can quickly become unreliable in the wake of unforeseen events.

These trends add more fuel to the inflation fire. Without the free movement of goods, services and capital throughout the world, production costs will likely keep rising and corporate profit margins may suffer.

Investment Implications

We remain optimistic that the reopening of the US and developed economies will continue, despite the recent setbacks from the Omicron variant of COVID. However, the reduction of government stimulus and Fed tightening will prove a challenge to continued growth in the economy, even as inflation stays strong. “Stagflation” is a term we expect to hear more of. We have modestly reduced allocations to international stocks and will likely use rallies to trim further. More volatility is likely for the remainder of the year and we plan to use that volatility to make investments we believe will do well over the long term.