Ukraine, Inverted Yield Curve, & Your Portfolio
Enjoy this week's edition of the Planner's Beta
Beta (n) - climber's jargon that designates information about a climb
Are you looking to improve your financial literacy or better understand what is moving the markets? Stay tuned to watch this market update!
Hello, my name is Nate Baim. I am the founder and financial planner at Pursuit Planning Investments, LLC, a financial planning firm devoted to helping Millennials and Gen X-ers plan their life pursuits. I periodically release a market update, and these videos serve two purposes. First, and most importantly, it provides you a way to better understand and grow your knowledge about investing and how markets operate. And its second purpose is to give an update to help you understand the critical items on investors' minds, which are moving markets. Ultimately, I hope these insights allow you to reflect on your personal financial and investment plan. Of course, this video should not be construed as investment advice. Before changing your portfolio, you should carefully consider your situation, goals, and financial plan.
When investing, I encourage folks to maintain a balanced perspective. And so, each time I provide these updates, I provide reasons for optimism and concern.
For Optimism: Corporate earnings are currently robust. And expectations are that corporate profits will continue to grow through the remainder of this year. Why do we look at corporate earnings? Corporate earnings drive valuations and market performance. Because companies operate within the broader economy, it is essential to review economic growth expectations. Currently, the US labor market and economy are showing strength. Because we are on the downhill side of the pandemic, we have reason to be optimistic. However, some other items in the economy are causing investors to be concerned about economic growth.
First, inflation is high. If you've been shopping or filled up your gas tank in the last month, you've likely noticed how expensive things are. Inflation is the overall increase in the price of goods and services. And inflation is increasing, and it is not yet clear if it will be with us for longer than two or even three years. Interest rates are starting to increase. Now, this is a double-edged sword. Rising interest rates cause business expenses to go up (thus impacting earnings). But as savers, increased interest rates can be beneficial. As savers, if interest rates go up, we may be able to receive a higher return on specific investments or savings vehicles. We should also watch the flattening and inverting yield curve. I'll go into more detail about what that means. But, when we start to see a negative or inverted yield curve, that may be a precursor for difficulties in the broader economy.
And, of course, there is increased geopolitical uncertainty. If you asked economists and market forecasters what would be the most important news item of 2022, Russia invading Ukraine would probably not have been on the list. And it's been regrettable and personally concerning to see what is happening in Ukraine. But, as investors, we need to approach this with an open mind, and we need to evaluate the potential consequences to portfolios with a level head.
Let's first dive into the data surrounding reasons for optimism. In this graph, we're looking at economic growth broken down by quarter, the year over year gross domestic product percentage change. GDP measures the value of goods and services produced within a country over a specified period. The higher the GDP, the more goods and services delivered, indicating economic activity. And if GDP is growing, that shows that the economy is expanding.
On this graph, we can see that going back to the 1970s, the historical average for yearly GDP growth was 2.8%. We can also see that from 1970 to the present day, the average GDP growth rate has been slowly declining. And this is typical to see for developed economies such as the United States. GDP shrank precipitously at the start of the pandemic, and there was a quick rebound shortly after the steep contraction. The reversal was powered by increased spending from the federal government, lax monetary policy from the Federal Reserve, and the reopening of the economy. In Q4 2021, the last data point from the government, the economy grew at an annual rate of just under 7%. This rate is solid when compared to the average historical rate.
Now economists are notorious for making inaccurate forecasts. But that doesn't mean we ignore their estimates. Their estimates should be just one data point to help us better understand economic expectations. Economists are forecasting the GDP of the United States will grow by 3% this year. GDP has been strong. And in addition to economic growth forecasts, the labor market shows strength.
Currently, there are more jobs available than there are job seekers. And the number of people unemployed for greater than six months is beginning to fall in line with historical averages. With such a strong labor market, we should continue to see wages increase. These increasing wages will likely help bring disenfranchised workers back into the workforce.
As with anything, too much of one thing can be harmful. And this is true with wages. Economists are watching closely to see if wage increases are increasing prices quicker. If the economy has entered a wage-price spiral aggressive action will likely be taken from the central bank to control inflation. More on this later.
Earnings, or a firm's income, drive the value of that company. Strong earnings growth is typically associated with a strong stock market. As we can see here, the historical average going back to the early 1990s, earnings growth for the S&P 500 was 7.6%. Post the bottom of the pandemic, earnings growth hit 43.1%, a historical high when looking back to the 1990s.
Now we don't expect this kind of growth to continue. In fact, for 2022, economists and analysts estimate earnings will grow around nine or ten percent. This is still very strong and higher than the historical average.
It is crucial to remember that healthy growth rates don't mean that the S&P 500 is set to increase for this year. First, many variables impact earnings growth rates. To illustrate, a few reasons the market may not grow include growth rates may decline due to deteriorating conditions regarding the Ukrainian crisis, worsening inflation, a new variant of COVID, and accelerating compression of valuation ratios. Those are just examples of what could pump the brakes on this and turn expectations around rather quickly. And one of the variables which have investors concerned is the yield curve.
Let's step back and try to understand the yield curve. A yield curve is a graph that compares different similar quality bills', notes', and bonds' interest rates over different time horizons. Usually, when we talk about the yield curve, we refer to one based on federally issued Treasury bills, notes, and bonds. Investors look to the yield curve to understand which part of the business cycle economy is in. Typically, a steep yield curve is associated with the economy being in the business cycle's early stages. This is when the economy grows quickly, unemployment is coming down, and companies are performing well. When the yield curve is flat, the economy is in the maturing phase of the business cycle, where growth is starting to slow. And finally, when the yield curve is sloped downward, this typically serves as a warning sign that the economy may soon enter into a recession. But this doesn't mean the yield curve is a perfect predictor of when to time a recession. Using the yield curve to make tactical portfolio decisions may prove harmful.
Looking at this graph of yield curve steepness, we can see the steepness of the yield curve over time. We can also see when the yield curve was inverted and when recessions occurred. You can see the recently inverted. Does this mean we are about to go into recession? How should we be thinking about a yield curve inversion?
We should not use the yield curve steepness to make day-to-day investment decisions. There is typically significant lag between the time the curve inverts and when a recession begins. Looking at the six recessions since the early 1980s, some yield curve inversions occurred anywhere from 9 to 23 months before, during which markets may have performed well. Thus, yield curve inversions are an imprecise tool that should not be used as a market-timing indicator. It should be used as one tool of many to help inform us about future decisions regarding your financial plan.
The yield curve inversion should put us on heightened alert to review your investment allocations (making sure the investments are aligned with your values and goals). The inversion should alert us to prioritize the establishment of an emergency fund or paying down high yield debt.
The yield curve has its purpose. Again, it should not be used to make day-to-day stock-picking decisions. It should be used to help us think about and prepare for a potential coming recession.
Now, another reason for concern, of course, is inflation. If you've filled up your gas tank recently, you know what inflation is and have an acute awareness of what it does to your budget. What we're looking at here is the year-on-year change in the consumer price index. The CPI is a commonly cited measure of inflation. The CPI measures the change in prices of a basket of goods and services used by the typical consumer. The CPI is broken into two parts, core and headline. Core CPI excludes food and energy prices (a more volatile component that adds noise to the data). Inflation currently is running at about 7.9% for the headline number and 6.4% for the core number.
If we glance to the left of this graph, we can see today's inflation figure is the highest over multiple decades. Today's inflation is primarily due to supply chain disruptions and demand and supply imbalance. Lax central bank policy and fiscal stimulus also contributed to today's inflation. And economists don't expect inflation to reach below 3% until the first half of 2023. There is a risk of elevated inflation continuing past 2023. And the central bank is well aware of this risk.
The Federal Reserve, also known as the central bank, is responsible for setting policies that create stable prices and full employment. Now that the economy has reached full employment, the Fed is focusing on reigning in inflation. The Federal Reserve influences inflation by setting interest rates. The central bank does this primarily by buying and selling bonds. The Fed is taking action to increase interest rates. They will raise rates by selling bonds into the open market. Selling bonds causes money to be more expensive. As money is removed from the economy by selling bonds, interest rates will increase. Increased interest rates make it a little more difficult for companies to receive credit (loans), increasing their financing costs. Ultimately, this means that the Fed is pumping the brake on an already hot economy, and it hopes to temper demand for goods and services. In theory, tempering demand for goods and services will bring the supply-demand relationship back in balance and ultimately slow down the increase in prices.
One special note is that the Fed has been very purposeful in communicating its expectations of where they think interest rates will go over the next year. And the Fed has been transparent that they hope to increase rates by about a quarter percent per meeting throughout this year. The Fed is starting to consider increasing the rate at which they are raising rates, And if the Fed ends up growing rates at a higher clip, that could mean they're concerned about prices going out of control. Recent fed meeting notes and comments from board members indicate the Fed is seriously considering increasing rates at a quicker clip. If the Fed surprises the market in any way, it could result in increased market volatility.
Now, what does geopolitical uncertainty mean for investors? First off, the situation in Ukraine is profoundly worrying from a personal level. It's tough to watch the news and see the families and the children having to leave their homelands and for many other people to stay and defend their homes. As investors, when we are making decisions about our hard-earned money, we must approach such developments with a level head.
From an investment planning point of view, the crisis in Ukraine is and isn't a concern. It is a concern because the United States and its NATO allies could potentially be drawn into a wider conflict with Russia. And although the likelihood of an open conflict with Russia still seems relatively low, there is a potential for escalation. Wider war could have a significant impact on portfolios.
We can look to the past to help us become informed on how geopolitical events impact portfolios. Geopolitical risk is ever-present. And crises happen often enough so that we can begin to draw some insights. Over the last two decades, we can see that the market can sometimes initially perform poorly after a surprise event. But over the long run, the market tended to rebound after three, six, and twelve months. We can see in this graph the blue line where there was the surprise Iranian drone strike that had happened at a Saudi Arabian oil processing facility. This 2019 event caused concern in the market initially. But even after three months, the market improved.
As we can see with each of these events, including the Russian annexation of Ukrainian Crimea, one year after that event, there was an increase in the S&P 500 total return index. The exception was 9/11. And this serves as a reminder that geopolitical shocks aren't the only thing driving the markets. After 9/11, there were broader economic issues that ultimately led to the decline in the S&P 500 total return. As with anything related to investing, there are no guarantees. But being presented with such data should challenge any preconceived notions you may have about geopolitical shocks. Ultimately, such data should motivate you to carefully consider your actions in response to market surprises.
Let's take a step back and look at the S&P 500 going back to 1928. Over time, we can see that there have been crises throughout history, and they can have an immediate impact on the stock market. But that doesn't necessarily mean that they ultimately caused the stock market to crash permanently. Long-term investors ought to carefully consider making significant changes to their investment portfolio solely because of a crisis.
Now that doesn't mean that you keep your head in the sand. You should still consider new developments or work with somebody to help you evaluate how changes in the wider environment may impact your financial plan.
Again, my name is Nate Baim. Thank you for listening to this market update. If you're a current client of Pursuit Planning Investments, we greatly appreciate working with you. And if you came across this video and are looking for insights and what to do with your financial plan, feel free to reach out to me via my website at planyourpursuit.com. Thank you again, and I hope you have a great rest of your week.
Have something on your mind? Schedule a free call with Nate.
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