📝 Market Commentary for 2022-Q2
This quarter, we look at the underperformance of financial assets, historic inflation levels, a shortage of blue-collar workers in the U.S., and the appeal of commodities.
We conduct in-depth investment research and provide commentary on the most significant market events of the previous quarter and provide an outlook for the current investing environment.
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Financial Assets Underperform Commodities in Q2 2022.
Source: StockCharts
Q2 2022 was characterized by a continuation of underperformance of financial assets against cash and commodities until June, when performance reversed. The dollar remained strong as global tensions, such as the Ukraine war, continued throughout the quarter.
U.S. Inflation Accelerates.
Source: YCharts
Inflation remained persistent in the second quarter, with June’s CPI accelerating to 9% on an annual basis. However, inflation expectations, as measured by the Treasury Inflation Protected Securities (TIPS) spread dropped sharply in Q2 2022 on recession concerns.
Although I believe that the acceleration of inflation may slow going forward, my strongest contrarian viewpoint is that inflation will remain sticky and persist in the intermediate term as the U.S. reorganizes its supply chains away from Asia to something closer geographically. I believe that inflation is unlikely to have “peaked,” given the low level of real rates currently, and inflation will most likely persist, barring additional aggressive moves from the Federal Reserve. As the Fed continues to experiment with the “optimal” amount of quantitative tightening, we could experience inflation volatility as monetary policy tends to be a very blunt instrument.
The U.S. Faces a Labor Shortage.
The U.S. faces a short supply of blue-collar, “working class” workers. In contrast, redundant white-collar employees may be laid off as the economy cools. The demand for working-class employees will likely continue to rise as we move more manufacturing away from Asia (supply chain issues once again). At the same time, the U.S. labor force participation is likely to continue declining as more Baby Boomers retire. Thus, wage pressures should be positive, ultimately affecting many profit margins for U.S. equities in the short term.
Current Economic Data Suggests Stagflation.
My base economic case is one of stagflation, where economic growth slows while inflation remains high. As July 28, 2022, Q2 2022 GDP was released in conjunction with high monthly inflation prints, so the hypothesis has merit. With a dismal economic backdrop and the continued intention of Fed tightening, I believe that all financial assets are at risk of depreciation in the short term. The U.S. Dollar strength also remains at risk as geopolitical situations develop. The housing market is poised for a correction; however, financial institutions are much less levered and in better condition than in 2008. Credit markets don’t seem to be a concern right now, however, it could be possible that some bad crypto assets may have gotten into the global banking system or money supply; only time will reveal the depth of any contagion.
I think there is a general recency bias for most people on Wall Street and there still exists a level of complacency with retail investors. We live in a similar economic environment as the 1970’s with the asset valuations for equities and real estate similar to where they were in 2000 and 2008. What is different this time is major geopolitical disruptions that can create an adverse black swan event with dire ramifications for all asset classes. It is of note that typically, when countries have prolonged economic problems, historically war is an answer. We haven’t had a “hot” state-on-state war since the end of World War II in 1945, and the last significant geopolitical tension was the Cold War, which ended in 1990. Geopolitical situations can break an economic cycle, and the stakes are higher than ever.
Real Assets Remain Attractive, as Global Energy Demand Remains High.
As a whole, I am more constructive on real assets, particularly energy and agricultural commodities, and am less constructive on financial assets, particularly bonds. Commodities have their value in a portfolio as a hedge and diversifier at this time of geopolitical uncertainty. I still favor equities over fixed income in the long run. Stocks in healthcare, infrastructure, clean(er) energy, and agricultural materials sectors are also fundamentally appealing.
While overseas markets look more attractive than domestic markets from a valuation perspective, the uncertain geopolitical environment brings hesitation for confident investing unless a more sizable risk premium is offered. Investment in the Americas appears to be better plays than those in Asia or Europe, although that depends heavily on geopolitical developments, which are difficult to predict. The EAFE country of most interest is Japan, whose easy money policies continue and are likely to support Japanese equities.
Written by Joseph Lu, CFA®
Joseph is the founder and managing director of Conscious Capital Advisors and a CFA® Charterholder.
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