Mid-Quarter Update

Markets Respond to Economic Transition

In February we shared our thoughts on market volatility and our expectations and strategy looking ahead. In the last 90 days:

·        Global markets for both stocks and bonds continued adjusting to growth and inflation expectations for the future

·        The potential for conflict between Russia and Ukraine unfolded in a full-scale invasion (and defense of sovereignty) with no clear optics on a potential near-term resolution

·        Public health and societal responses to the evolving COVID pandemic/endemic (yes, we will be dealing with some form of the virus for the foreseeable future) continued to ebb and flow from one region to another

Investors around the globe in virtually every asset class continue to experience declining prices. Volatility remains high as the economic outlook appears to be more challenged over the next couple of years. The core issue stems from current expectations for inflation and interest rates.

The prevailing cause of today’s inflation is twofold:

1.      Governments and central bank policy around the world engaged in unprecedented monetary easing to avert the potential of a global depression from the Pandemic

2.      Goods and service shortages due to supply chain disruptions from the Pandemic exacerbated by the Russian invasion of Ukraine

The first issue is being aggressively addressed. Monetary policy is reverting quickly. In March and May, The Federal Open Market Committee raised its target Federal Funds Rate to 0.75%. By July, markets anticipate that the rate will more than double to 1.75% and increase another 1% by February 2023. This policy shift will drain significant liquidity, helping to slow demand which historically has reduced inflation.

The second issue is more complicated. Structural changes to markets and supply chains over the last 30 years have resulted in greater availability of superior products at a lower cost. Unfortunately, global production has been disrupted. Robust demand and limited supply are the recipe for higher prices. This market condition will subside, but it will take time.

So why are asset prices falling? For risk assets such as stocks, the share price at any given moment represents a value that can be expressed in terms of a multiple of revenue or earnings going forward. In general, as interest rates rise, multiples usually decline, resulting in lower prices. This holds true for bonds as well. The advantage stocks have is their earnings and revenue are not static figures; they can continue growing even if market multiples decline.

In the 20-year chart below, we plot the Target Federal Funds Rate. You’ll notice that it took years for policy makers to start raising rates after the Great Financial Crisis of 2008-2009. By 2019, the economy by most measures was finally back after a decade of steady expansion. However, rates were reduced three times in the back half of the year to help maintain stable growth. Crisis funding was provided in the spring of 2020 to address the Pandemic. As policy makers engage in the process to remove the emergency funding nearly as quickly as it was provided, it is our belief that leaders will stop increasing rates well before reaching current market expectations. With stable rates and lower costs of capital, prices will once again stabilize, which should support higher stock prices.

Source Data: Bloomberg LP

 Although we expect equity markets to remain choppy for the next 6-9 months, valuations and expectations have corrected so quickly that the risk/reward for well-capitalized and operated businesses is far more compelling. We remain confident that the positions we hold will provide superior results in the quarters and years ahead as these businesses deliver significant value to their respective customer bases and shareholders. Over time, equities have proven to be the best defense against the ravages of inflation. Earnings growth can outpace inflation, providing support for valuations even while multiples compress.

With the US 10-Year Treasury Note now yielding nearly 3% (an increase of 1% in the last 3 months), value has quickly returned to the fixed-income market. The real yield is still negative, but if inflation declines as we expect over the next  12-18 months, bond buyers may be able to earn a positive real return from the yield alone. This has not occurred for nearly 15 years.

Our low exposure to traditional fixed-income and relatively high exposure to alternative investment classes (e.g. private equity, real estate) has provided insulation from daily swings in the public markets. With most companies reporting first quarter results in recent weeks, we are reassured that EPIQ’s portfolio exposure is well-positioned.

As always, thank you for your confidence and trust. Please contact us to continue the conversation.   

EPIQ Partners