Considering the ongoing market volatility and growing economic uncertainty, our Investment Committee wanted to reach out with a brief update. More than two years after the start of the Covid-19 pandemic, investors are understandably growing tired of enduring unprecedented events. The “sell everything” mentality beckons, with equity, bond, and commodities markets (including so-called “safe haven” gold) all down sharply. At times like these, it is important to remember that the market is not the economy, but merely investors’ best guesses at what economic conditions might be going forward. Sometimes—particularly when investors become fearful—the market begins to reflect only the worst economic expectations. Compounding these concerns is the unusual pressure investors are feeling in both equity and bond markets, which are typically negatively correlated in times of stress, with high quality fixed income investments providing a ballast during the turmoil. Right now, rising interest rates—precipitated by the Federal Reserve’s pivot to tighter monetary policy—are predictably putting downward pressure on bond prices, while also chipping away at the growth-oriented momentum of equity markets. Market participants ultimately compete for capital, and the relative safety of a Treasury bond yielding 3% might outweigh the far-off growth prospects of a richly valued tech stock amid heightened volatility.
In the face of stubbornly high inflation, however, rising interest rates are a necessary evil. In its plan to raise short term policy rates and reduce the size of its balance sheet, the Federal Reserve is seeking to strike a delicate balance between effectively countering overheating consumer prices and not stymying economic growth unnecessarily. Importantly, the labor market, along with consumer spending and credit, thus far all appear resilient despite inflationary headwinds, granting policy makers some extra room to maneuver. The secondary cooling effects of higher interest rates on equity markets could prove beneficial as well, removing some of the “froth” accumulated during the post-pandemic recovery. In terms of valuations, the S&P 500’s trailing price-to-earnings (P/E) ratio has retreated from its peak of more than 27x—set a little over a year ago—to a more reasonable 19x, slightly below its 5-year average leading up to the pandemic.
But like most broad corrections, the good often gets tossed out with the bad, and there are many high-quality companies likely now trading for less than their intrinsic value. We are always on the lookout for best-in-class firms with strong balance sheets, durable pricing power, and business models capable of withstanding the full spectrum of economic environments, and we construct defensive portfolios with the knowledge that volatility can at times be sharp and swift. While continued cautiousness may be warranted for the near term, market turbulence has undoubtedly uncovered opportunities that could make for attractive long-term investments. We remain optimistic for the health of the economy and potential for capital appreciation coming out of this “reset” period, grounded in disciplined, fundamentally-driven investment strategies with appropriately long time horizons.