April was a bad month for portfolios; however, in the past week, three unbelievably bad days accounted for most of the 9% decline in the SP500. The sharp selloff was precipitated by the comments made by Federal Reserve Chairman Jay Powell about raising interest rates during a period where inflation is extremely high. Investor concerns about the Federal Reserve’s goal to increase interest rates too high and create a deep recession is believed to be the primary factor in the decline in stock prices and the rise in bond yields. The Federal Reserve controls the “Fed Funds” rate which is a short-term yield. At the beginning of 2022, investors were expecting 2%, which is considered “neutral and the long-term average rate.” Some participants on the Federal Reserve have mentioned rate increases to peak between 3% to 3.5%. More recent rumors suggest 5%.
Given the sources of inflation, if the Federal Reserve were to continue to increase interest rates, this action only be partially effective. The problem is that the primary underlying causes of inflation are shortages of commodities and labor initially the result of the pandemic and worsened due to the Russian–Ukraine war. And, yes, greed is a big issue since consumers have cash and are willing to pay more. While raising interest rates will eventually address issues of greed, it will come at a huge cost to the economy. For example, rising interest rates make the commodity shortage worse as businesses need to invest in innovative technologies to improve productivity. Higher interest rates only make capital investments more expensive, although dampening overheated spending by consumers.
With respect to client portfolios, we continue to reduce equity exposure which began in the 4th quarter of 2021. Equity holdings were holding up much better than the SP500 until last week. Earnings reports for the 1st quarter 2022 have been generally “okay.” The biggest challenge is that the companies that reported a strong percentage growth from 2021 versus 2020 is difficult to justify as a comparison measure since many people were staying home and purchasing items during 2020.
In noteworthy reports, Tesla has produced the best financial results so far. Sales, earnings, and profit margins are all positive. Unfortunately, Elon Musk’s pending acquisition of Twitter was considered an unnecessary distraction to Tesla, which led to a sharp decline in the stock price. Other good earnings reports were from Microsoft, Apple, Thermo Fisher Scientific, and Enphase. There were only two bad reports from Align Technologies and Amazon. Costs of fuel and labor are hurting Amazon and Align has raised prices too much in the United States and China is halting business. The Amazon position had already been reduced to zero and the moderate position in Align was sold. Looking forward, if the equity market declines further, there will be few survivors. When investors sell the best performers, that is a good indicator that a market bottom is approaching.
In bond portfolios, the smartest investment so far this year has been the Fidelity Conservative Bond Fund, which is invested in high quality, short-term issues. It is even for the year and should soon start yielding significantly more as the Federal Reserve raises interest rates. While this is not a long-term strategy, once yields in the bond market stop rising, we will begin to purchase corporate and municipal bonds between one to twelve years in maturity.
Gold is providing clues as to what the world economy is doing, weakening. The price of gold has peaked and is now falling sharply. Historically, gold will decline while the economy is still strong, and decline as interest rates rise. Exposure to gold in client accounts is via Newmont Mining, one of the largest gold miners worldwide.
On Wednesday, the Federal Reserve will conclude its meeting and is expected to increase Fed Funds by 0.5% to 0.75%. The real story will be the commentary towards future increases. Given the recent sharp selloff among all financial assets, a short-term rally may be possible.
For the short-term, the general investment strategy remains defensive favoring high cash balances and underweighted equity exposure to most clients’ target allocations. We will continue to favor companies with strong financial resources to manage the forthcoming challenges. Keep in mind that the three of the top ten holdings, Johnson & Johnson, Apple, and Microsoft have credit ratings of AA+ or higher. We continue to hold material positions in equities and bond while holding a significant portion of client portfolios in cash and money like investments so that we have the option to invest in longer term opportunities overtime.