War, What Is It Good For?

We want to start by acknowledging what is currently taking place in Ukraine. Like most people, we are horrified to see what is going on in the news. A recent headline, “Russian Troops Have Left Zhytomyr Highway Littered with Shot-Up Cars and Dead Bodies of People Who Tried to Escape
the War,” particularly hits home for me as part of my family was originally from Zhytomyr. We can all hope for a quick resolution to the situation. To do our part, Scharf Investments is donating $5,000 to World Central Kitchen to help the children affected by this war.

For investors, it has been a tumultuous quarter. From the beginning of the quarter until March 14, the Nasdaq plummeted 19.5%, the S&P 500 fell 12.2%, the MSCI ACWI Index fell 12.5%, and the Russell 1000 Value Index dropped 5.7%. The high-quality nature of our portfolio showed its resilience with your equity accounts down 5.3% over the same time period, which is less than the four benchmarks.

Stocks rallied in the last few weeks to finish the quarter down 8.9%, down 4.6%, down 5.3% and down 0.7% for the Nasdaq, S&P 500, MSCI ACWI Index and Russell 1000 Value indexes, respectively. By comparison, our equity composite was down roughly 1.1% net of fees. Bonds had one of their worst quarters in over a decade with the Bloomberg Aggregate Bond Index down 5.9% and the Lipper Balanced Index down 5.0%. Our balanced composite was down approximately 1.7% net of fees on the quarter.

Inflation Up, Consumer Sentiment Down

There is a lot of noise out there right now. Investors are faced with war, lockdowns in China, rising inflation, continued supply chain problems, falling consumer sentiment, rising gas prices, to name just a few things. One concerning data point comes from the University of Michigan consumer sentiment index, which sank to its lowest level since 2011. Falling real incomes and surging fuel prices were key drivers of the pessimism with the expected year-ahead inflation rate at 5.4%, the highest since November 1981. More consumers mentioned reduced living standards due to rising inflation than any other time except during the two worst recessions in the past 50 years. Nearly
one-third of all consumers expect their overall financial position to worsen in the year ahead, the highest recorded level since the surveys started in the mid-1940s. Given these data points, it seems clear that the Federal Reserve is going to need to act on the inflation front.

Fed Late to Take the Punch Bowl Away?

Bill Dudley, a former Federal Reserve Board Member, thinks the Fed has waited too long to raise rates. He believes the Fed will need to increase rates sharply, which will likely trigger a recession. The graph below helps to show one reason why. With official inflation levels around 7.9% year-
over-year, the U.S. federal funds rate is the furthest it has been below CPI since 1951. This has led to the increased inflation expectations and falling consumer sentiment shown on the previous page.

In today’s hot labor market, seasonally adjusted unemployment has fallen to 3.6%. To bring down inflation, Dudley believes the Fed will need to increase unemployment at least back to the “natural” rate of unemployment of roughly 4.4%. Said another way, the Fed will need to trigger the loss of 1.3 million jobs just to bring the labor market back to “equilibrium” in order to bring down inflation expectations. Dudley also points out that over the past 75 years, whenever the unemployment rate has increased by 0.5 percentage points vs. the prior 12-month low level, a recession is either already underway or about to start.

With unemployment already so low (3.6%) and inflation already so high (7.9%), the Fed is in a tough spot and engineering a “soft landing” won’t be easy. The fact that the Fed doubled its balance sheet in response to the pandemic certainly complicates things as does the war in Ukraine.

Yield Curve Flashes Warning Signals

One market indicator that agrees with Mr. Dudley is the recent inversion of the yield curve. Historically, this has been one of the best warning signals of future recessions. What is the yield curve and what does it mean to be inverted? The yield curve is a graph showing the relationship between short-term and long-term interest rates of U.S. Treasury notes. To compensate for the extra risk that investors are taking by lending for a longer period of time, long-term rates are usually higher than short-term ones.

The graph on the following page shows the difference between the 10-year and 2-year Treasury yields. When the line shown in the graph is below zero it means 2-year yields are above 10-year yields. In Wall Street speak, the curve has “inverted”. Today’s inversion of the yield curve is a reflection of market expectations that the Federal Reserve needs to tighten monetary policy by aggressively raising short-term interest rates. The Fed needs to do this in order to slow down an “overheated” economy in which inflation has been running persistently high. This bond-market phenomenon has been a reliable recession indicator as inversions of that part of the curve have preceded nearly every recession over the past 40 years. The graph above illustrates this point.

On a more positive note, some market pros believe the 3-month yield to the 10-year yield is a more accurate recession forecaster, and that curve has not flattened. That spread has actually widened, a signal for better economic growth. In addition, after the five instances where the 2-year and 10-year yields inverted since 1988, the S&P 500 had a median return of 15.8% over the next 12 months.

Regardless, an inverted yield curve should be taken as a sign that the Federal Reserve’s efforts to counter inflation by raising short-term interest rates may be nearing a tipping point which could result in slower economic growth over the next 12-24 months. For stock market investors, the emergence of an inverted yield curve is akin to seeing dark clouds on the horizon. It is a time to be prepared for a possible change in the weather. Our expectation is that the growth rate of the economy is most likely to decelerate in the year ahead, and there is a greater chance of a recession in the next year or two. We cannot forecast when it is going to happen, but we can strive to own very high-quality businesses with consistent earnings power and strong balance sheets. Owning high-quality businesses with pricing power is one of the best ways to keep up with inflation, and our experience has been that owning high-quality businesses also provides resilience when storms eventually arrive.

In fact, since 1988, the median return for the S&P 500 in the first 3 calendar years after an inversion was negative 2.5% annualized compared with a median positive 12.9% annualized return net of fees for our equity accounts over the same time periods.

A Final Word on Valuation

An old rule on Wall Street is the “rule of 20”. This says the market is fairly valued when the price-to-earnings ratio (or “P/E”) equals 20 minus the inflation rate. With CPI inflation expectations near 6%, the implied “fair” P/E for the S&P 500 is roughly 14 times (20-6) compared to the current P/E of roughly 20 times. This would imply the current P/E is still too high despite the recent decline in stocks. Even if the Fed manages to bring inflation expectations down to 4%, that still implies a “fair” multiple of roughly 16 times, or 20% below where it is today. That says nothing of the risk that S&P 500 earnings would decline if the Fed were to inadvertently cause a recession. During the last 4 profit recessions, S&P earnings fell by roughly 25% from peak to trough. Thus, the S&P could have around 40% downside in a Fed-induced recession. By comparison, our portfolio already trades at a P/E of under 16 times with a much more resilient earnings profile.

The war further complicates the Fed’s task of engineering a soft landing as it will increase inflation expectations and cause further supply chain issues. We believe investors would do well to remain cautious and de-risk their portfolio if they are still holding any speculative darlings of the past. For our part, we continue to emphasize high-quality companies with strong balance sheets trading with good favorability ratios. This has served us well in the past and should serve us well in the future. As the late Edwin Starr would say, “War, what is it good for? Absolutely nothing.” Say it again, Edwin, say it again.