The impact of inflation has created one of the most complicated investment environments in decades. This is the worst first six months since 1970 for the S&P 500, 1962 for the Dow, and forever for the NASDAQ. As inflation has taken center stage, markets have retreated globally and across asset classes. Investments that many have traditionally turned to during downturns, like CDs and Treasuries, haven’t held up as well this year because of inflation. Investors’ outlook for the rest of the year depends on how quickly the Fed is able to contain inflation and how much the economy slows as a result.
The Fed is attempting to slow the economy without plunging it into a recession. The next few months will bring greater visibility on just how much the economy will slow, the outcomes of several monetary policy decisions, and an update in corporate earnings, each of which has the potential to keep markets turbulent. Still, it’s also possible that the slowing of the economy could mark the bottoming in financial markets and a transitional period toward ultimately better returns. The good news for investors is that markets haven’t always done poorly after suffering big losses in the first half of the year. History has shown they have often done the opposite. For example, when the S&P 500 fell at least 15% during the first six months of the year, as it did in 1932, 1939, 1940, 1962, and 1970, it rose an average of 24% in the second half, according to FactSet.
The good news is that some pockets of relief are on the horizon today. As we have written about this year, many of our companies have low leverage and strong balance sheets with sufficient cash to provide some cushion in a slower growth environment. Given high-profit margins, substantial revenues, and significant free cash flow, we think the higher-quality companies we invest in can weather a slower growth environment.
At the individual company level, many management teams are finding ways to navigate the current complicated landscape as new challenges emerge. For example, Deere & Co is the leading agricultural equipment manufacturer. It has made significant technological advances in its equipment that should drive higher unit sales, prices, and margins over the next several years. Despite persistent supply-chain and pandemic challenges, agriculture fundamentals remain solid, and full-order books have kept production lines busy. Amid near-record profitability levels for farmers and robust commodity prices, the outlook for the quarters ahead is bright.
Historically, commodity-related equities serve to benefit portfolios during periods of higher inflation. Energy markets tend to fare well, but industrial commodities also perform well. While we are not overweight in this sector, the reality of the supply/demand situation in the world suggests there is also a place for companies tied to traditional energy and other commodities in well-diversified portfolios.
We are also actively making new additions to the portfolios. For example, this year, we have added nine high-quality companies to our small-cap portfolio alone. Consistent with our long-held investment criteria, these nine additions are high-quality, reasonably priced businesses with durable income streams and pricing power that create shareholder value.
While bonds are at meaningfully higher yields than earlier this year, we advise clients to avoid any sudden major re-allocation to bonds. Instead, we recommend incrementally increasing your bond exposure by reinvesting proceeds from maturing bonds and accumulated cash into new high-quality issues with short, laddered maturities.
Despite this challenging environment, we remain confident in our ability to help our clients meet their long-term financial goals. We realize the angst from volatile times like this and appreciate your trust. Communicating with you remains a top priority, and we encourage you to contact us with any questions or comments you may have.
