Covington Investment Advisors, Inc. Blog

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

With the dramatic compression in valuation multiples this year we can now start to plot the current positioning of the market versus historical averages to gauge whether or not equities are attractive. On the graph above I have the forward 12 month P/E ratio of the S&P500 which currently stands at 17.6x and represents a level of 4,029. Overlapped on the chart I have 5, 10, and 15 year average multiples along with corresponding S&P 500 prices...

Last fall we advised you that we were expecting an adjustment period for the capital markets [see blog here]. An adjustment to slowing economic growth, decelerating corporate earnings, higher inflation, and new Federal Reserve policy measures. Market valuation models are adjusting to these new circumstances. Ultra-low interest rates, massive fiscal and monetary initiatives elevated valuations beyond actual long-term earnings potential. Under the Fed’s efforts to contain inflation, valuations will now align to actual long term economic growth expectations which remain attractive. The economy is still expanding at historical trend line GDP growth of 3% and corporate earnings are more representative of expectations at 8%.

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The situation with Russia/Ukraine remains fluid but we wanted to follow up our note on the ‘Turmoil on the Eastern Front’ from the beginning of the invasion. In that note we showed the historical playbook for geopolitical events, and looking back the market has behaved remarkably in line with those precedents up to this point. But we don't think the situation is completely behind us and want to reiterate that historically what happens after the initial recovery mostly depends on what conditions were like going into the crisis. In today's case that was inflation and changing central bank policy. We continue to think that will be the dominant theme as we go into the second half of 2022.

For more on the geopolitical situation please see Schwab’s latest market perspective below:..

Geopolitical tensions continue to boil with the Russian invasion of Ukraine shocking an already inflationary global commodities market. Rumors of progression in ceasefire negotiations have boosted markets today but regardless, the economic fallout from the sweeping sanctions will likely last for some time. In our last note we outlined from a high level what the market behavior was during past episodes of similar geopolitical turmoil. We also reiterated why having operating cash set aside and being able to ride out volatility is essential to long term investing. But just as important is understanding what you own and making sure the assets are fundamentally strong...

After 18 months of very little volatility a cascading series of events including the escalation between Russia and Ukraine have reverberated throughout markets causing our first 10% percent drawdown in large cap stocks since March 2020. I'm not going to try to predict the path of military actions in Europe but I can try to put into perspective what the economic impact might be from what's taking place in the region.

Geopolitical events by their nature are difficult to predict and tend to be short lived, although there are certainly exceptions.Outside of the commodities sector, Russia is a marginal player in the world economy accounting for only 1.3% of global GDP, and Ukraine makes up an even smaller portion. US exposure to Russia in terms of total trade is a very low 0.1% of GDP. The EU on the other hand sources roughly 1.5% of their total goods trade with Russia. The main exposure is that commodities are a global market with Russia accounting for about 10% of global oil production and the EU has become ever more dependent on imports for energy. EU imports have long represented over 90% of its oil consumption, while the natural gas import share has increased from roughly 50% in 1990 to also over 90% today. By contrast, the US has moved from importing over 50% of its oil & petroleum during the 2000s to being a net exporter today. So in theory the first order effect from rising energy prices should be modest to the overall US economy. Still, the second order effects of a shock to the already tight global energy market is what could be disruptive...

We believe we are in a transitory environment that will be increasingly challenging for bonds. With potential rate hikes in the future, it is important to have realistic expectations about bond returns as they are likely to be low in 2022. The image below illustrates the inverse relationship between bond prices and bond yields. Although the bond market is less volatile than the stock market, bonds also fluctuate in terms of price. You can see we have been in a 36-year bull bond market that has brought yields to record lows.

Although bonds typically provide portfolios with a safe haven from market volatility due to their low correlation to stocks, they don’t provide much protection against inflation. In fact, inflation is a major driver of volatility within the bond markets. With the Federal Reserve likely to raise interest rates multiple times in 2022 to combat inflation, investors have been concerned about a potential decline in bond performance. In fact, the Barclay’s Intermediate US Aggregate Bond Index was down -1.54% last year...

Market and Economic Observations

December 10, 2021

Covington recently presented their observations on the market and economy at our annual shooting event held at Pike Run Country Club. Please find our presentation commentary below...

Markets underwent a volatile session today on news that the WHO is monitoring a new covid variant detected in small numbers in South Africa called B.1.1.529. The new variant is purported to contain multiple mutations with increased antibody resistance and rattled markets on a thinly traded day with several of the cyclical & travel related parts of the market getting hit hardest.The development of rising covid cases is a risk to markets but the trend of the world economy recovering from covid is still intact even as new variants create speed bumps in the process. The Delta variant created a hiccup in the recovery earlier in the year but the economic risk ended up being minimal. With winter approaching I would guess that the world will continue its rolling two month cycles of rising and falling covid cases with a combination of antivirals and boosters eventually smoothing infections similar to the flu.

The WHO has said it will take weeks to understand how the new variant may impact transmission or react to vaccines. But for some perspective, South Africa still has very low vaccination rates with only 41% of the population receiving the jab. In most of the developed world vaccination rates are greater than 70%. Also, only ~ 80k tests per day are being administered in South Africa which means the sample size will need to be much larger before data is concrete. And while the new variant is worried to be more transmissible, death rates in South Africa are still very low which is encouraging . We’ll see if that holds in the coming weeks...

Last week, we had the pleasure of hosting our first board of directors meeting for the Laurel Highlands Workforce & Opportunity Center in their new building located at 310 Donohoe Road, Greensburg PA. My wife and I founded the non-profit organization to remove the barriers of structural poverty for individuals who are under and/or unemployed, or are in transition of employment. Our vision for the center is to serve as a hub of human services that will provide for the betterment of the human experience.

It is our hope to simultaneously address the labor needs of the businesses located in Westmoreland County. Our efforts will be collaborative, multi-faceted, and modeled after Bill Strickland’s Manchester Bidwell Center. To accomplish our mission we plan to leverage the talent and skills of our Board of Directors. Anne Kraybill, Executive Director of the Westmoreland Art Museum will be developing our arts program along with developing a music and video learning program with Endicott Reindl of the Westmoreland Symphony Orchestra. Dr. Christine Oldham, retired Superintendent of the Ligonier Valley School District, will be developing our curriculum and oversee our third-party childcare program. Dr. Dan DiCola will be our medical director and be developing our medical training programs. Tay Waltenbaugh will be supervising our social services programs, and Greg Daigle, while serving as our Director of the Center, will coordinate our manufacturing training programs for local businesses. Michelle Mcfall will serve as our student recruiter and Melissa Hipple will be serving the center as our medical program instructor...

Covid has disrupted supply chains in two major ways: surging demand for imported consumer goods in the west, and a decline in workers required to maintain and operate these supply chains. Over the last twenty years supply chains have relentlessly been pushed towards efficiency with the adoption of Just-In-Time(JIT) inventory management in addition to the integration of global component sources. This Evolution has dramatically increased efficiency but has come at the cost of fragility. Covid constantly flipping the on/off switch on these supply chains has exposed this weakness. Shipping is the nexus of the issue. It usually takes 40 days to transport a container from a factory in China to a store in the US. At the moment it takes 73 days meaning goods ordered today may not arrive by the Holidays. Consequently, price of shipping has jumped. Both the Shanghai Shipping Exchange Containerized Freight and the Baltic Exchange Freightos Container indexes are reading at historic highs. Just recently the port of Los Angeles announced they are going to start running at 24 hours a day to ease the cargo backlog but this won't solve the problem overnight. ..

A few weeks ago we sent out a letter followed by a note conveying that after an exceptionally strong 18 month stretch of performance in markets with little-to-no volatility we would be transitioning into a period where market price action would normalize and volatility would likely rise. However, we still see long term equity market performance remaining strong supported by the fundamental backdrop.

That volatility came to fruition as several cascading news headlines have come down in the last week beginning when Evergrande, a large property developer in China, announced that it would likely not be able to pay its financial obligations. Evergrande is widely reported to have around $300bn of liabilities, own 1300 real estate projects in 280 cities and is associated with 3.8million jobs per year. So it’s reach is wide and because of this the fear was that it would have a bleeding effect throughout markets. Because of China's opaqueness it is really hard for outsiders to gauge what is truly happening inside the country but I can give at least my view on what the fallout from Evergrande will be. I think the Chinese government will allow Evergrande to fail but use the country's trillions in reserves to limit the contagion of Evergrande’s liabilities. This will begin with containing the domestic financial risk in China to make sure the collapse does not become systematic. However, I doubt the Chinese government will be as benevolent with foreign holders of Evergrande debt. This view is supported as Chinese high yield bond indexes spiked but investment grade indexes barely moved on the Evergrande news. This indicates that investors in adjacent Chinese debt products do not expect the contagion to escalate into a widespread credit crisis. Also, the nature of China’s centrally planned economy limits the flow of capital outside the country and Chinese investors in Evergrande expect to be reimbursed...

Incredible to think about, but the S&P 500 has advanced over 18% year-to-date and roughly 30% over the last 12 months. From the post-pandemic low last March equities have rallied over 100%. I made the graphic above before the recent 2% sell-off, but nevertheless equities have bounced back much faster than any post-recession period in history. What’s more is that this rebound has been absent of virtually any volatility. The S&P 500 has notched over 45 all-time high closings so far in 2021 while going over 10 months without a 5% pullback. 

Recently our President sent out a letter conveying our premonition that markets would be undergoing a “transition period” whereas they would adjust to peak growth rates & liquidity, and also to reinforce why our investment strategy and philosophy is well positioned to move into this new phase (His letter is available here). When stepping back and taking into account the big picture of equity markets performance in the last 18 months we think it would make sense for markets to digest this strong performance and for volatility to increase. But despite this, looking forward earnings are projected to be strong and while perhaps tightening, liquidity will still be abundant and characteristic of past early tapering periods (see our note on this here)...

In anticipation of heightened volatility, I wanted to touch base with you as I see the current economy and markets at an inflection point. Year to date global equities have continued their strong momentum from last year with many indices posting double digit gains so far in 2021. The S&P 500, the market index comprising of the largest US companies, has notched over 40 closing all-time highs in 2021 with one of the strongest recoveries coming out of a recession on record.

If you recall, early in this market rally from the March 2020 lows the central narrative surrounding the economy was that markets were disconnected from fundamentals and thus ripe for a “double-dip” sell-off. This did not end up being the case as economic data on almost every front has come in stronger than expected and 2021 corporate earnings are projected to come in 21% higher than 2019 levels. In fact, economic data has come in so strong that now inflation and overheating are a central risk to markets. And while the virus is still moving throughout the world, the vaccine rollout continues to progress, and the world is reacclimating to daily life.

Volatility has also been relatively tempered as the S&P 500 has gone over 200 days without at least a 5% drawdown from its peak. This market action has historically been an exception, not the rule...

Earlier this year stories started to break that the Biden Administration was planning to raise the capital gains tax rate on wealthy Americans to 39.6% and recently whispers are floating around that the new rate could be even higher. Rumors of rising taxes usually invokes an anxious response by markets especially after a strong run like we have had. But the effect to the overall market from the capital gains hike may not be as significant as people think as it will only affect a minority portion of today’s equity accounts. In 1965 80% of US corporate equity was owned in taxable accounts. Today only roughly 30% is owned in taxable vehicles with much of the US holdings shifting to tax deferred accounts which are not affected by capital gains taxes. Foreign investment has also eaten up a large share of domestic equity holdings as the US runs ever growing trade deficits...

Inflation continues to be the hot topic in financial markets and is shaping up to be a defining macro story of the next decade. One aspect of the inflation debate which we did not touch on in our Inflation Fixation note is what about the monetary and fiscal stimulus? US Government spending in response to fighting Covid was the highest since World War 2 at over 30% of GDP with more spending in the pipeline. The spending is high in a vacuum but it is also coordinated throughout the World by both Central Banks and Governments. What’s more is we have a new Presidential regime which has made spending a pillar of its social policy signaling that austerity is probably not in the cards.

Could this combination of a hesitant Fed, aggressive stimulus injection, and ambitious future spending goals signal that the Fed will be behind the ball on curbing inflation? Or will the structure of the economy and a calibration of supply chains revert the World to the muted inflation regime of the last decade?..

Maybe some would say a good problem to have when considering where things were a year ago, but a primary risk to markets now is that the economy is overheating. We have made note of the inflation readings that have jumped meaningfully over the past several months, but why could this signal a risk for markets? Because it raises the possibility of Central Banks pulling back some of the stimulus which has helped support markets since last March. In response to the inflation jump Fed officials have been adamant about portraying the price spikes as transitory. But at the same time have begun to discuss the possible tapering of asset purchases leading many investors to bring forward their expectations for the first rate hike. In our view this will be the key source of volatility for markets in the second half of the year, particularly in August during the Feds annual Jackson Hole meeting where Chairman Powell is likely to signal a tapering of the Feds bond buying program...