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Global equity markets continued their sell off during the second quarter as economic conditions around the world deteriorated.  An aggressive Federal Reserve raised the Fed Funds rate to pre pandemic levels, causing more drops in bond prices.  With inflation continuing to rise, the Fed seems willing to risk a deep recession to get rising prices under control.  Stocks entered bear market territory during the quarter, with a 20% pullback from their highs.  The yield curve inverted during the quarter, signaling that a recession is likely.  Most economists have stopped talking about whether a recession is likely and are now discussing how bad the recession will be.  In fact, we could very well already be in a recession now, as GDP contracted in the first quarter.  A repeat of this in the second quarter would meet the definition of a recession.  While a recession is not a certainty, it is looking more likely than not that we will see one.

A lot happened during the first quarter, and most of it was bad. Stocks had negative returns, despite a 10% rally the last two weeks of the quarter, as fears rose about slowing economic growth. The bond market also had negative returns as interest rates spiked due to rising inflation. The Russian invasion of Ukraine added a new level of uncertainty to the markets as economic sanctions and fears of spreading hostilities spooked investors. In this letter we will discuss inflation, the war, and Covid, which together create the Three Headed Monster that is affecting the economy and the markets.

During 2021, the U.S. economy continued to improve after last year’s contraction, taking the stock market along for the ride.  Stocks benefited from the growing economy, low interest rates, and strong corporate earnings.  The bond market gave back some of their gains from 2020 as interest rates rose from levels near zero.  The stock market is ending the year at record highs, which is interesting given some serious issues that we are dealing with as an economy.  Rising inflation, the ongoing pandemic, a shortage of workers, and supply chain problems are among the issues that could derail economic growth in the new year.

Volatility in the markets increased during the third quarter as fears rose that soaring Covid cases could slow the economic rebound we have been experiencing for the past year and a half. Consumer confidence numbers took a nosedive in September, and with consumers accounting for two thirds of U.S. economic activity, worries have risen that we are facing economic headwinds. In addition to the potential of a slowing economy, the increasing fear that inflation might be getting out of hand has also weighed on investors. It is an interesting time right now and economic and market uncertainty is climbing.

The economic recovery in the U.S. since the lockdown of 2020 has been quite remarkable. Last year’s recession was short but very severe. While we can always debate the level of Government stimulus necessary in times like this, there is no denying that flooding the economy with money helped bring us back to growth. The question now is when to end the stimulus and how to ween the economy off Government spending.

Despite an increase in volatility, stocks ended the second quarter with solid gains as the global economy continued to recover from the Covid pandemic. The bond market recovered some of its first quarter losses with a nice rebound during the second quarter. Strong corporate earnings across the board and rising consumer confidence continue to fuel stock gains, and consumers are on a spending binge after last year’s lockdown. While most economists expect this growth to slow down sometime in 2022, right now optimism abounds.

The one thing that is currently causing anxiety among investors is the threat of rising inflation. Inflation has been low for such a long time that many have forgotten what terrible economic damage can be caused by rapidly rising prices. The risk to the bond market is fairly obvious. Rising inflation leads to higher interest rates, which leads to lower bond prices. Bonds have benefited from forty years of dropping interest rates, but with rates effectively zero, we are likely to see rates move higher as economic conditions improve.

Equity markets have gotten off to a strong start in 2021, reaching record highs as the U.S. economy continues to recover from the pandemic. Stocks benefited from ongoing vaccination efforts as well as from government stimulus money being distributed to individuals, businesses, and local governments. The bond market, which benefited last year as interest rates dropped to near zero as the economy slowed, declined as interest rates rebounded with the improving economy.

We are in a very interesting time right now. The U.S. economy is recovering, but it is not an equal recovery across the board. Lower wage industries, who bore the brunt of the economic slowdown last year, have been much slower to recover. Likewise, minority and female employment remains more depressed and slower to recover. As of now, the economic recovery continues to be dependent on fiscal and monetary support. We need to see a broader recovery to allow economic growth without the use of government help.

If you are like most people we know, you are very glad to be reaching the end of this year. During the past year we have experienced a global pandemic, massive social unrest, a contentious political atmosphere, an economic recession, the largest quarterly drop in GDP in history, and an end to the longest running bull market in American history. While there is no guarantee that things will be better in the upcoming year, sometimes the expectation of better times, along with an effective vaccine against Covid, can lead to better outcomes. The U.S. stock market defied the carnage of 2020 by rebounding after the lockdown, helped by the largest post-election rally since 1932. Bonds also posted gains as interest rates plummeted due to severe economic contraction. It was a very strange year indeed.

The Covid-19 pandemic continues to be the dominate news maker in the U.S. and around the globe. Equity markets rise and fall with positive or negative vaccine news, or news of a spike or reduction in cases and deaths. Most medical experts agree that even with the successful development of a vaccine we are still likely a year away from mass vaccinations, and that’s assuming people are willing to get vaccinated. Polling suggests that up to one half of Americans indicate they will not take the vaccine, ultimately delaying a complete economic recovery. During the third quarter, stocks rose and are now positive for the year, although they experienced a sell off in September as worries grew of lingering economic problems. Bonds were also positive during the third quarter, adding to their gains year to date.

After a dismal first quarter for global stock markets, the second quarter was a welcome reprieve. Equity markets staged a fierce rally during the second quarter as investors bet on a quick resolution to the Covid-19 pandemic. However, stocks returned to selling pressure the past two weeks as cases have begun to spike across the U.S., leading to fears that the economic recovery will not be as smooth as many hoped. The unpredictable nature of Covid-19 makes forecasting very difficult and it is likely that a true recovery will not be seen until a vaccine is readily available. When the economy does recover, many industries will be forever changed and will be faced with a new normal.

Since our last letter to you at the end of December, the world has changed with breathtaking speed. As the COVID-19 pandemic has raced around the world, economies have ground to a halt, equities markets have plunged, lockdowns have become the new normal, and everyone’s lives have changed dramatically. From our perspective as money managers, you really could not imagine a more disruptive event. When we experience disruptive events like this, we always look for similar events in the past to get an idea of what it might look like. For this pandemic, there are really no parallels. We have basically shut down our economy for a sustained period of time. That’s never been done before. Adding to the economic shock is the collapse in oil prices, which, if not for the pandemic, would be the major news event so far in 2020. We normally do not like words such as “Plummet”, “Plunge”, and “Crash”, but all three seem appropriate for describing the markets and the economy this quarter.