Peter Goodall
The market has had a tough start to the year but there is cause for hope. As of this writing, the S&P 500 is down -17.54% and the NASDAQ has fallen -25.77%. Safe to say, this is a bear market with Russia attempting to extend its sphere of influence by risking an escalation in the Ukraine war, and central banks needing to aggressively raise interest rates to curb inflation contributing to this year’s weakness. The emotional urge to disengage and ride out the storm is understandable but it misses an opportunity, and perhaps the broader picture.
Fear is overblown
Markets hate uncertainty. The less confident we are in the future price of a security, the cheaper it should be. Asset managers typically use the volatility index to assess how worried people are about the near future. The ‘fear index’ has been hovering around 30. That’s pretty rare, as 10 to 15 is the most common trading range. We only see these levels of ‘fear’ about 10% of the time.
Expansion of the war appears to be contained
While Russia may be concerned by NATO expansion, they have limited means of response. Ukraine’s ability to defend its borders has well exceeded expectations. Russian aggression has unified much of Europe and redrawn political alliances. Finland and Sweden appear likely to apply for NATO membership. Even if NATO members were to veto their inclusion, we are seeing defensive alliances forming in response to the perceived Russian threat.
Russia is overextended militarily
Russia has committed much of its active ground troops to the war in Ukraine and finds itself now bogged down in a conventional war. While we see sabre-rattling against neighbouring Finland and Sweden, when push comes to shove, Russia has a smaller army than NATO. Conscripts would not be as effective in an armed conflict against Sweden/Finland and the UK, and their hardware is tied up in Ukraine. There have been threats in Russian media of using nukes (part of Russia’s military doctrine of escalating to de-escalate). However, Russia is aware that NATO contains several nuclear powers and there would be risk of retaliation. Threats to make the Baltic nuclear puzzled neighbours, who noted that Russia already has nuclear weapons stationed in Kaliningrad.
Inflation is beginning to come down
Core US inflation figures fell in April, marking the first slowing of inflation since August 2021. This comes on the back of the Federal Reserve running off their balance sheet (quantitative tightening) and increasing the reserve rate by 0.5%, the largest rate hike in 22 years. This is an attempt by central banks to slow down the economy. Less engagement in capital markets and higher interest rates should slow down the overall economy as it becomes more expensive to borrow money for homes and businesses. While the cost to consumers comes in the form of higher borrowing costs and fewer jobs, the benefit is lower inflation.
Supply chains are recovering
The pandemic-related shutdowns had large ripple effects on global logistics. Shipping costs spiked by 617.36% from their pre-pandemic levels. This has been a real cost to producers. At the peak of these increases, shipping a 40-foot container cost an additional $8,914.65 on average. Those costs have flowed through to consumers in the form of inflation. Hidden in all the news of inflation is the fact that those costs have been coming down over time. They actually peaked in September 2021, falling 26.1% from the peak since then, and we have been seeing this flow through in the inflation numbers.
The labour market is running hot
Unemployment is back at 3.6%. That is 0.1% off from the lowest unemployment in 50 years. Slowing down the broader economy during a time of strength can help mitigate the risks that we are overheating. Getting a 5% pay increase every year does not mean a lot when prices are increasing 7%. By raising interest rates, central banks are trying to break inflation before it spirals out of control.
Speculative activity is on the decline
Bitcoin has fallen 59% from its high and less mainstream cryptocurrencies, like Dogecoin have fallen 89%. The meme stock mania shows periodic spurts but is trending back to earth. Meme stock poster child, GameStop, has fallen 80% from its 2021 peak. It is devastating for the retail investors that bought into the hype but it is also the sign of a healthy market: asset values are tied to the fundamental prospects of the company.
Conclusion
We don’t have a crystal ball but we can say that markets are trading at 10% to 20% discounts from where they were only a few months ago. There are plenty of profitable companies caught up in the market sell-off. If you are working, it is a great time to be saving for retirement. If you are already fully invested, you can look at changing allocations around to take on more risk, assuming you have the willingness and ability to take on more risk if things do not work out.
Peter Goodall, CFA, FRM, is Associate Portfolio Manager at LOM.
Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
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