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.
We will begin with Covid because that is where many of our troubles started. Ironically, for the first time in two years, Covid has become less of an issue as cases and deaths have dropped significantly. The pandemic has disrupted almost every facet of our lives, and from an economic viewpoint, has caused tremendous damage and uncertainty. Another wave would cause additional damage to an already weakened system.
The seeds of our high inflation were planted during the pandemic. As demand for almost everything dropped in 2020, supply chains were severely disrupted. When demand picked up again very rapidly, supply chains were unable to rebuild at the same pace. More demand than supply leads to inflation. Additionally, generous government stimulus, combined with a shortage of workers, and we end up here. Most economists feel that inflation will subside as we move into next year, but many things could prolong the pain. The Fed, by their own admission, was too slow to raise interest rates and is now trying to get ahead of inflation with higher rates.
The war in Ukraine, in addition to being a humanitarian disaster, affects the global economy in multiple ways. The price of oil has skyrocketed as energy markets have been disrupted. Raw materials used to manufacture fertilizer have also skyrocketed, leading to increased food prices and fears of shortages. These two items also lead to higher inflation across the globe. A war in Europe also increases fears that fighting will spread to other countries and eventually involve forces from NATO and the U.S. While unlikely, history teaches us that big wars always start out as small wars.
There are several important things to watch as the year unfolds. The yield curve in the U.S. is very close to becoming inverted. The last eight times this has happened we have had a recession within the next eighteen months. Since 1970, oil shocks, like the one we are seeing now, have almost always led to a recession. Even with the sell off we have had this year, stock and bond markets remain overvalued relative to historic valuations.
The good news is that challenging times always lead to good investment opportunities in the long term. Conditions can change quickly and bad times, like good times, never last forever.