Thursday, May 12, 2022
The last four months have been among the most difficult periods investors have faced since the financial crisis of 2008.
The last four months have been among the most difficult periods investors have faced since the financial crisis of 2008. While rising interest rates have hurt equity investors, they have also hurt bond investors by almost as much. In this unique period of financial stress, it is prudent for investors to step back and assess the overall health of financial markets the way Palisade analyzes a company’s balance sheet. We believe the current liabilities, or negatives, for the market are:
We believe the current assets, or positives, for the market are:
Current inflationary pressures resulting from the strength of the U.S. recovery have been exacerbated by the Russia-Ukraine war and the COVID-19 virus outbreak in China. We’ve always known China’s importance to the global supply chain, but we have been surprised by Ukraine’s smaller but industry-specific role in the supply chain as well. Additionally, the war has caused a spike in energy prices that also contribute to inflationary pressures. For China, the draconian government response of locking citizens in their homes has not been effective in slowing the spread of the latest contagious version of the virus, though this action has certainly impacted the production of goods available for sale in the global markets. Resolutions for both the war in the Ukraine and the Chinese COVID outbreak (both of which will result in reopened factories) are impossible to predict exactly, but it seems that time will ultimately resolve both situations.
The Federal Reserve has aggressively raised interest rates in two ways: by raising short-term rates from 0% to 0.75% and by “talking” interest rates higher. The Fed has also announced its intention to reduce its historically large bond portfolio of $9T through quantitative tightening. These moves are meant to cool down inflation, but unfortunately have also adversely affected the prices of both equities and bonds. For equities, higher rates have lowered valuations and especially hurt long duration, speculative, and highly valued companies. The bond market has usually been a place to offset weakness of risk assets, such as equities. That has not occurred this year and defensive benchmarks such as the Bloomberg Barclays U.S. Aggregate Bond Index are down 9.5% (roughly half the level of equity benchmarks). If inflation pressures subside, the Federal Reserve will be given breathing room to slow or stop raising rates, but as noted above, it’s difficult to predict exactly when this will occur given significant current global events.
Turning to the positives in the market, we are optimistic that lower equity prices could be a catalyst for more merger and acquisition activity. Prior to recent weakness in equity prices, potential acquirers complained prices were simply too high. Now that equities have declined, companies looking for acquisitions can make deals that are beneficial and accretive for their shareholders. At the same time, increased M&A activity can also benefit target companies as buyers need to pay a premium to entice shareholders to tender their shares.
We believe markets are deeply oversold in the short-run and, therefore, a rally around 5% is possible. However, we don’t think this is a major change in the negative downtrend and any rally is unlikely to last. We think equity markets could go lower by late summer ahead of mid-term elections. If the election were held today, the party controlling the House and the Senate would likely lose and the uncertainty of policy changes could, perhaps, result in the final leg lower for equities. If history is any guide, that final dip has historically been a very good entry point for equities. With the election about six months away, that may be enough time for inflationary pressures from supply chain disruptions to subside and for interest rates to stabilize.
Please do not hesitate to contact us with questions or concerns.
Very truly yours,
Chief Investment Officer
The information contained herein reflects the view of Palisade Capital Management, L.L.C. and its affiliates (collectively, “Palisade” or the “Firm”) as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. All information provided herein is for information purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no assurance, representation, or warranty is made concerning the accuracy of the data presented. In addition, there can be no guarantee that any projection, forecast, or opinion in the letter will be realized.
The Bloomberg Barclays U.S. Capital Aggregate Bond Index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities.
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Palisade is an SEC registered investment management firm established in 1995. Based in Fort Lee, NJ, the Firm manages a variety of assets for a diversified client base, including institutions, foundations, endowments, pension and profit-sharing plans, retirement plans, mutual funds, private limited partnerships, family offices, and high net worth individuals. Registration with the Securities and Exchange Commission does not imply a certain level of skill or expertise.
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