Perspectives on… The Evolving Economic Environment

Over the past several weeks, coinciding with a relatively abrupt return of volatility in the global stock and bond markets, we have received numerous, thoughtful, questions from clients regarding the current state of the world economy and the range of potential asset market implications. We hope that the below commentary provides a look inside our investment process at Red Oak Financial Group and how we are thinking about the evolving economic environment.

Prior to addressing those questions, it is important to reiterate that, in our view, investing is a long-term pursuit. Market volatility, although uncomfortable at times, is a naturally occurring and inherent component of investing in assets with long-term positive expected returns. If stocks and bonds displayed volatility akin to risk-free assets (such as short-term Treasury Bills), their expected returns would also likely resemble those of risk-free assets. We continue to implore you, especially in volatile times, to zoom out, maintain a long-term focus, and avoid attempting to time the market.

Our economic views are, in large part, informed by the information we receive from our primary economic data provider Hedgeye Risk Management. Looking back, 2020 and 2021 were extraordinary years in several respects (obviously). Federal Reserve monetary policy, federal government fiscal policy, corporate earnings, and the rebound in economic growth were all abnormal from a historical perspective. Interest rates have been suppressed by Federal Reserve actions, government deficits were large, corporate earnings and economic growth (as measured by Gross Domestic Product) were historically high. Since April 2020, we believe these factors combined to create a stock market environment that produced relatively high stock market returns with volatility that was considerably lower than the historical average.

In 2022, we anticipate a normalization in all the aforementioned variables. Monetary policy is projected to “tighten” as the Federal Open Markets Committee (the interest rate setting group within the Federal Reserve) begins to raise the federal funds rate. The fiscal deficit will likely be considerably smaller in 2022 than the prior two years as policy makers are unlikely to extend pandemic-era stimulus programs. Corporate earnings and economic growth are also projected to slow in 2022, albeit that both metrics may remain at a high level relative to the past several decades. With these factors in mind, and an understanding that some degree of forecast error is natural and to be expected, we anticipate the rate at which these different metrics normalize will be the primary determinant of cross-asset class (stocks, bonds, commodities, currencies) performance in 2022. As several of these key drivers of stock and bond market prices mean revert, we may experience a normalization in market volatility.

We have been, and will continue to, monitor the evolving economic environment, the potential asset market implications, and make proactive asset allocation adjustments based on those observations. For your part, sticking to your long-term and risk appropriate asset allocation is of critical importance. Portfolio drawdowns can be perplexing and frustrating, but try to remember that short-term volatility is the “cost” of long-term returns.

Aaron