LEVATUS Investments | Strategy Implications of Extreme Market Volatility

The past several weeks has been brutal for asset markets. Sharing our view on what this extreme volatility means for medium term strategy, positioning and financial flexibility.

May 6, 2022

What is driving the market?

The primary fundamental drivers of this year’s stock and bond market weakness are:

·         Inflation

·         Reaction of the U.S. Federal Reserve to inflation and the movement of interest rates

·         The breakneck speed with which these very significant economic conditions are changing. When such economically significant conditions change this rapidly, the possibility that the velocity of the change in and of itself will cause something to ‘break’ goes up. Some refer to this as a ‘Black Swan’ event.

A perception that the Federal Reserve is behind the curve in fighting inflation reached a crescendo this week as wage and price inflation continued to march higher.  The more aggressive the U.S. Federal Reserve needs to become in fighting inflation, the higher the probability that these policy moves push the economy into recession. Mortgage rates are a good example of how policy is transmitted into the economy. Since the beginning of 2022, the interest rate on fixed rate mortgages has risen by over 70%. This increase in the cost of a mortgage will cause the housing market to slow. This is, in fact, the US Federal Reserve’s intended outcome. By cooling the economy, they hope to cool demand, which would reduce upward pressure on prices.

When does it end?

The short answer is when the U.S. Federal Reserve acknowledges that there has been sufficient progress in fighting inflation.

There are some signs that inflation may have already begun to peak. We expect the next twelve months to remain volatile, as the ebbs and flows of this topping process occur. Two events that would accelerate a slow down in the rate of inflation are:

·         The war in Ukraine ends. From a purely economic perspective, the war has accelerated food and energy inflation.

·         China’s COVID shutdowns end. China’s shutdowns have accelerated inflation via shortages caused by supply chain disruption.

Will we have a recession?

Fed policy is explicitly directed at cooling demand. While they would like to avoid a recession in the process this is not their primary objective. Their primary objective is to slow demand to tamp down inflation. Under these conditions, the chances that the Fed pushes the economy into a recession are not small.

While market multiples have adjusted down since the beginning of the year, earnings estimates for 2022 have not yet been adjusted. If the Fed is successful in slowing demand we expect that earnings will come down and that this will extend the period of volatility in markets, especially over the next two quarters.  Of the last thirteen monetary policy tightening cycles engaged in by the U.S. Federal Reserve, ten have ended in recession.

What does this mean for strategy?

As we have discussed with clients over the past several quarters, our outlook for 2022 is cautious. We expected rates and inflation to rise throughout the first half of the year and that the unwind of the historically unprecedented liquidity measures implemented by the US Federal Reserve and other Central Banks would cause significant market volatility. The war in Ukraine and the China shutdown were additional shocks to the system that exacerbated existing weaknesses. The strategy mix coming into 2022 included:

·         Ensuring client mortgage rates were locked in at low fixed rates

·         Taking profits in balanced accounts and rebalancing equity weights down

·         Shoring up Funding accounts to ensure financial flexibility

·         Delaying deployment of new capital, with build up to Funding allocation in the interim

·         Shifting employer sponsored retirement contributions to spread out contributions, versus front loaded early year contributions

·         Very short-term laddered bond portfolios in Funding accounts, positioned to take advantage of rising rates as bonds matured

·         Some dry powder in growth accounts; focus on free cash flow, balance sheet, margins and return on invested capital

After several years of robust exposure to growth markets, clients entered 2022 with significantly more conservative structure. At the same time, the long-term secular and structural quality growth orientation of the companies that are held in the portfolio has been maintained. While trends and rapid cyclical rotations can cause growth to fall out of favor for a time, over the long-term it is the companies that run high quality businesses in areas that help the economy to become more efficient by producing goods that people and businesses need that will thrive. It is these companies that both help to solve for inflationary pressures and ultimately re-accelerate growth through efficiency, innovation and productivity. Chasing cyclical trends is a mistake.

Are there any new strategies you are considering given market conditions?

In addition to the existing structural elements of portfolio strategy we are also considering a small amount of covered call writing on select growth portfolio stock positions, to take advantage of elevated levels of volatility. Covered call writing allows one to earn an extra income on stock positions by selling an option to buy the stock you hold at a certain price. If the stock price does not move or if it goes down over the set amount of time in the option contract then you simply pocket the income. If the stock price goes up the holder of the call may want to buy the stock from you at the agreed upon price.

Covered call writing is a strategy that is particularly well suited for the current environment, as high volatility increases the amount of money earned for selling covered calls.

What do you think the market is missing?

Healing takes time. The economy is in the process of healing from multiple consecutive shocks and the unwind of the unprecedented policy response that were put into place to address the worst of them.

Over the past decades, the markets need for immediate gratification has been satiated by the US Federal Reserve coming to the rescue at almost every turn. As we said in our annual Seven Percent Report, it is our view that in order to turn the corner to the next leg of growth the private sector will need to take the reins. The transition process will take times.

The good news is the seeds of the recovery are being planted. Many high-quality companies are priced much more attractively today than they were six months ago. The trends in innovation that are set to shape the next industrial revolution are still in place. And importantly, investors inclined to invest more conservatively are finally able to earn a nominal yield on their money as interest rates have risen.

While there are still many unknowns, and markets are likely to remain volatile during 2022, we expect high quality companies to shine as we emerge from the multiple shocks that have created so much near-term uncertainty.