One my favorite things about living in Colorado is the access to backcountry hiking. I love the serenity and challenge of being immersed in wilderness, far from crowds, and self-reliant. While inspiring, this hobby comes with risks. Hikers must know how to navigate changing weather conditions, deal with potential injuries or setbacks, and keep themselves safe from germs or animals. Indeed, on a hike last fall I twisted my ankle and had to hobble out a few days early. Our market and economic outlook for 2022 could be compared to a backcountry hike in the mountains – the scenery is nice but there are risks. Investors have a favorable economic backdrop with almost all developed economies in expansion. However, bad weather threatens with inflation at a 40 year high¹, the potential for higher interest rates and stock market volatility, high valuations for stocks and bonds² and the continuing impact of COVID-19 on labor and supply chains.³ Investors can adjust their equity and bonds holdings to respond to these threats and consider alternative assets that may provide protection from down markets while offering growth.

In 2021 stocks and real estate continued their strong performance from 2020. Bonds struggled as investors began to demand higher interest rates for higher inflation.

The stock market’s strong performance in late 2020 and 2021 showed the optimism investors felt about economic growth. Their faith seems justified - most major economies have been growing rapidly since fall of 2020 and are now in the Mid-stage of the economic cycle. Historically this phase is consistent with positive but slowing economic growth, pressure on margins, and a moderation in retail spending.⁴ We anticipate that growth rates and retail sales in developed countries will moderate. This change in growth can be difficult for investors to navigate. Some may fear an imminent recession while others hope the blistering growth of the Early phase will continue. The middle road of slowing growth is positive but can be murky. A note about China’s position as in recession - China is unique because it entered an economic contraction as a result of their zero-tolerance policies to combat COVID-19.⁵ These draconian measures have created notable supply chain problems, lowered consumer spending, and a significantly reduced commerce across the country.

The mid cycle phase is prone to higher stock market volatility as investors grapple with slowing growth.⁶ Historically the stock market has experienced the greatest number of stock market pullbacks (as defined by declines of -10% to -20% from a recent high) in this part of the economic cycle.⁷ The good news is that stocks have performed well in subsequent quarters. The chart below shows how the stock market has performed after experiencing a notable drop within the year. In most of the years the stock market ended the year with a positive return. We think the stock market could follow a similar pattern this year. Stocks have stumbled since the beginning of the year with the S&P 500 down 6% as of February 7.⁸

Another headwind for stocks this year is the Presidential Election Cycle. This theory assumes that shifts in presidential priorities and actions have a consistent influence on the stock market. Proponents note that the second year of a presidential administration has often experienced the lowest stock market returns.⁹ This may coincide with stalled Presidential proposals and low approval ratings in the second year. The good news is that the third year of a Presidential cycle has been the best as incumbents work to pass legislation that will help them get re-elected. The chart below highlights the consistency of pullbacks during the second year of a Presidential cycle as well as the strong subsequent performance.

Investors are rightly focused on the persistently high inflation data first reported last fall. In the US inflation has been 7% year-over year ¹⁰ - the highest investors have seen in 40 years and well above the Federal Reserve’s target of 2.5% to 3%.¹¹ The US Federal Reserve has been trying unsuccessfully to increase inflation since the 2008 contraction. It printed money, lowered interest rates, and bought assets – but with no real inflation. What caused inflation to increase now? It seems the combination of monetary stimulus from the Federal Reserve, cash payments to individuals and families, restarting frozen supply chains, and persistent labor shortages were more than enough to spike prices. We expect that slowing economic growth and retail sales will ease some of the inflation pressures. However, we also believe that inflation will remain at a higher level than it has been in the past. We believe higher wages paid to employees will force employers to eventually raise prices to maintain profitability.

Investors can respond to these threats and market volatility by applying time-tested principles and adjusting their portfolios for bumpier weather. With the strong performance of stocks in 2020 and 2021 some investors may have an over-allocation to stocks. Rebalancing to their equity targets is a good way for investors to take profits and avoid taking too much risk.¹² Bond holdings are vulnerable to inflation and rising interest rates. Inflation reduces the value of their interest and principal payments and higher interest rates can reduce the value of their bonds. To address this threat investors can reduce the average maturity of their bond holdings and utilize managers and bond sectors such as Floating Rate bonds that do better in a rising rate environment. Finally, alternative investments can offer investors different ways to grow and protect their investments. We utilize private equity to tap into fast-growing private companies. Hedged investments can provide some protection from down markets while offering upside. Managed Futures can benefit from volatile markets and provide returns that are not as correlated to stock or bond markets.

One lesson I’ve learned hiking in the mountains is that storms and challenges are inevitable. Keeping a cool head and using your tools and training can get a hiker through tough spots. While market volatility can be distressing, we believe that solid economic growth should help markets move through it. Historical trends support this with stocks doing well in early phases of interest rate increases and the second year of a Presidential cycle. We encourage investors to take action to adjust their portfolios and consider alternative investments that can do well in bumpy markets.