We saw that April was a cruel month for investors in both stocks and bonds. After a brief reprieve in March, the stock market resumed its downward path, resulting in what we see as one of the worst months since the beginning of the pandemic. Bonds followed suit as they recorded a fourth straight month of negative returns. All of this left most segments of the stock market solidly in correction territory and bond yields substantially higher than at year-end 2021. The emphasis on quality provided a defensive element to the portfolio and worked to limit the downside effects of the markets.In our letter at the end of the first quarter we highlighted the unusual amount of uncertainty that currently exists in the economy and markets. Developments in April, we feel, failed to provide more certainty, although the timeline for one of the greatest areas of uncertainty–inflation–may have been shortened. The Federal Reserve (Fed) has now embarked more forcefully on its path of tightening monetary policy in an effort to address the inflation problem. Its federal funds rate has increased another 50 basis points, and a schedule for reducing its balance sheet has been released. The fact that the Fed is on the move suggests that some resolution to the inflation problem is drawing closer.
We know that headline inflation is increasing at an 8% rate measured year-over-year. Our position is that such levels of inflation are unacceptable in the United States. As a result, the Fed is under tremendous pressure to do something about it. What they seek to accomplish is a “soft landing” in the economy, that is, to reduce the rate of inflation to near the target of 2% without seriously damaging the economy. The hope is to be able to bring inflation down but, at the same time, maintain high employment. In order to achieve this desirable state in the economy, it will likely be necessary for demand to be reduced and supply increased. It would be fortuitous if, by raising interest rates, the Fed can crimp demand just enough to take the edge off inflation while the supply side improves naturally as disruptions in the supply chain moderate. Such a favorable outcome means that a lot of things have to go right. Thus, a degree of skepticism is held by investors as they discount the risk of failure by the Fed. We see that this skepticism is showing up in the increased volatility in the financial markets.
Although in hindsight they should have moved faster, the Fed is now signaling that they are willing to act. The risk is that they will go too hard and cause an economic downturn, or they will go too slow and inflation will remain high for a longer period, eventually requiring more drastic increases in interest rates. An important element is the longer-term inflation expectations that are held by investors and consumers. Although expectations for the next year or so are high, the longer-term expectations have remained much lower. Admittedly, these expectations are moving up, which adds pressure on the Fed to pick up the pace in an effort to keep these longer-term expectations anchored at reasonably low levels. If these expectations begin to move higher, it means the Fed will have to do more in terms of a tighter policy to keep them contained.
Our view that 8% inflation is unacceptable implies that we expect the problem to be solved. The uncertainty lies in how long it will take to solve the problem and what the economic repercussions will be in the interim. The range of potential outcomes is wide–the worst being a recession and the best being the above-described soft landing. It is far too early to make a definitive judgment about the resolution of this uncertainty, although there is some evidence that inflation may be in the process of peaking. Peaking and being reduced to acceptable levels are two different things, but at the very least, a process of inflation peaking would be encouraging.
In terms of the portfolio and the stocks owned, we have largely been pleased with the fundamental progress of the companies. Despite the economic uncertainty, the underlying earnings are meeting or exceeding expectations. This relates to the quality bias of the stock selection and, amidst a higher level of stock market choppiness, the portfolio has been defensive and less volatile.
We view all of these potential developments in the context of what we have described as the transition back to a more normal economic environment. The transition is lasting longer than expected, due primarily to the inflation problem. Nevertheless, we believe it is likely that the U.S. economy will again find itself in a more stable condition, less uncertain, and more favorable for investors. Until we again enjoy such conditions, we expect to continue investing for the longer term in the highest-quality securities we can find, the kind that provides more certainty as to future results. We believe this is the best way to invest through an uncertain environment.
Crawford Investment Counsel is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Crawford Investment Counsel, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request.
This material is not financial advice or an offer to sell any product.
Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.
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