1st Quarter 2022 AM Newsletter

April 11, 2022   ·   By cfgadmin   ·   Comments Off on 1st Quarter 2022 AM Newsletter   ·   Posted in Q3 2020 Creative Newsletter

April 11, 2022

War! What is it good for?

“Absolutely nothing!” as the 1960’s protest song goes, and we agree wholeheartedly. However, we live in a world where humankind seems destined to manufacture reasons for conflict. As Fukuyama said, some men “will struggle for the sake of struggle… And if the greater part of the world in which they live is characterized by peaceful and prosperous liberal democracy, then they will struggle against that peace and prosperity,” Hopefully, the group struggling for peace and prosperity will prevail and sanctions that have isolated Putin will work. Of course, we are not military strategists so we do not profess to know how the Ukrainian conflict ends. However, given the small number of pundits that predicted Putin would invade the Ukraine, we tend to think the experts are less informed than Churchill was when he described Russia as “a riddle, wrapped in a mystery, inside an enigma”. Thus, our inability to foretell the exact outcome of the Ukrainian/Russian War is not novel.  Fortunately, for all of us, long-term investment success is less predicated on Nostradamus-like soothsaying and more upon trend identification, fundamental valuation work, and probabilities.

Thus, what we do think is important for us to do for our clients, is to identify trends that may arise from this conflict and how to position for those probabilities. Most everything else is outside of our control. For instance, the movement towards energy and supply chain independence in Europe appears global in its scope now. NATO also seems to be strengthening along with the European Union. The globalization movement appears as if it is under attack which bodes poorly for commodity prices and supply chain inflation. Couple this with the push towards reduced carbon emissions and you can see why we have been adding commodities. Did we know there would be this big of a move? Not necessarily, but we did think it made sense to tactically add to an area underweighted by many because of the perception the next ten years will be just like the last ten years. Physical assets have been underinvested for years now, so the upside optionality and diversification appeal of commodities is something we felt compelled to own. Throw in the fact that Russia produces around 10% of the world’s oil supply and both Russia and Ukraine together account for about 1/3^rd of the global wheat supply, and our addition to commodities seem prescient. However, please know this is more of a reflection of a humble risk management process focused on probabilities in an increasingly byzantine world where energy security remains vital to government interest.

On the subject of valuation, we have alluded to paltry fixed income expected returns for years now and how we didn’t like the risk associated with owning long term bonds. Simply put, the price of fixed income is high and the yields are low. The first quarter of this year has proven this point as the Barclays Aggregate Bond Indexⁱ was down 6%. Only one of our bond funds didn’t outperform the index as we have emphasized reduced risk in the bond funds we have used. The one bond fund that didn’t beat the index this quarter missed by 26 basis points but has beaten the benchmark over the 1, 3, 5, 10, 15, and 20 year time frame. Thus, we are okay with slight short-term underperformance as it is a small part of our bond portfolio in place for when the stock market corrects and money runs back to Treasuries. This strategy worked very well in the first quarter of 2020. Let’s just summarize that in hindsight our tactic to shorten duration, purchase commodities, and build cash in our fixed income allocation over the past several years has served our clients very well this year.         

Fundamentally, equities present different considerations for us than fixed income. Since many equities have provided strong returns for several years their valuations are not necessarily cheap. However, there are many areas in the equity world that are arguably more attractive from a long-term perspective than fixed income. Of course, rising interest rates typically do not help both equity or fixed income valuations. Thus, we continue emphasize being choosy with equites as short-term volatility may occur. As we have alluded to in the past, there are sectors that are arguably a good value such as healthcare, real estate, commodities, energy and international, that interest us. We tend to lean into those areas when the price is low as the upside probabilities can be significant in those areas. Regardless, with our conservative leanings in other areas of the equity and fixed income market we oftentimes can weather a little short-term wiggle in valuations.

Finally, war is among the conditions that moves us out of the quantifiable risk zone and into the domain of freeform uncertainty, i.e., away from probabilities. Thucydides noted that “For war of all things proceeds least upon the definite rules.” It is wisdom such as this that infuses our thought process and impresses upon us the need to build resilient, diversified portfolios with different components that will zig when other parts zag. We choose investments that are not 100% correlated so the probability of a one-for-one lock step move is minimized. Investments are chosen simultaneously for opportunity and ballast. It is also why we very seldom invest entire portfolios in all passive strategies.

Hopefully, this quarterly letter will help forestall any desire to react emotionally to geopolitical headlines. The sights and sounds from the Ukraine will certainly stay with us as the horror of what humankind can and will do to itself is oftentimes jarring to our collective psyche but we can’t just wish it away, unfortunately. We are forced to diagnose and analyze a highly volatile situation with a sober perspective that seems to inadequately capture the depth of emotion present. In other words, investments seem to pale in comparison to the needs of a nation under attack. It seems insensitive to mention that since 1940 the S&P 500ⁱ has averaged a positive 5.3% performance one year after the start of a geopolitical conflict and that the returns are even better for crises that start in a bull market but it is something we must note because frankly there is always something to cause worry when it comes to investing. It is our job to identify trends, values, and probabilities as part of your long-term strategy as that is the only way we know to fight inflation against the crosscurrents of change present today.

P.S. Right now there are at least ten other conflicts happening in addition to the Ukrainian conflict. It kind of goes without saying but we should probably always be praying for peace and humming sixties antiwar songs.