A Lot Can Change in a Quarter

Market Commentary | April 1, 2022

Since the end of the Cold War in 1991, the world has become increasingly interconnected. Globalization has increased direct trade among economies and led to greater movement of people and ideas across national and cultural borders. Technology has shrunk the world through faster communication, and globalized production has helped bring down the price of goods in many developed economies. This has increased financial flows to emerging markets with manufacturing capacity, helping develop their domestic economies. Over this same period, democracy has been on the rise globally.[1]  

This globalization trend has slowed in the last decade, with many countries shifting toward protectionist policies in light of increasing tension between the US and China, and accelerated recently by recent pandemic concerns and disrupted supply chains. In the past month, Russia’s invasion of Ukraine fractured already fragile supply chains, worsening inflation and renewing cries in the US and other countries to “bring back” domestic production. Even though the global economy and financial markets have successfully navigated different political landscapes over the last century, we expect a less-interconnected world to slow progress – for investments, for poverty and pandemic alleviation, and for innovation. If the US can work with allied nations to rethink supply chains, that slower growth may be accompanied by greater price stability and security for domestic consumers and financial markets.

Ernest Hemingway quipped in his novel, The Sun Also Rises, that change often happens in two ways, gradually, then suddenly. In January 2020, it would have been impossible to interpret the scattered reports of a virus in China and accurately envision how dramatically the world would change in just a few months. We have seen a similar pattern unfold in the first quarter of 2022. Russian troop accumulation on the borders of Ukraine, and other concerning incidents in recent years, acted as gradual warning signs. Still, the shift to a new world – in some ways a retreat to a prior world of East-West conflict – has happened suddenly. Geopolitical uncertainty has ratcheted upwards, and in financial markets, that uncertainty typically leads to lower prices.
 
In the first quarter, the S&P 500 declined by -4.6%, and the technology-heavy NASDAQ declined by -8.9%. Tech companies, which have led market returns in recent years, have declined disproportionately as they tend to be more sensitive to the rising interest rates that are necessary to reduce commodity inflation. International stocks have seen declines as well, particularly in countries that depend on food production from Ukraine and are impacted by rising energy prices resulting from coordinated sanctions on Russian exports. The MSCI EAFE international stock index declined by -5.9% in Q1.
 
Inflation concerns have continued, and markets anticipate significant increases in interest rates to address it. This led to highly unusual losses in the broad bond market, with a decline of -5.9% in the first quarter as measured by the Barclays US Aggregate Bond Index. While shorter-term bonds fared better, the expectation of rising interest rates creates a headwind for existing bonds issued previously at lower yields. Investors watching the bond market also noted that the yield curve briefly inverted this week – meaning that the yield on the 2-year Treasury was greater than the yield on the 10-year Treasury, indicating concerns about long-term growth. Headlines often raise alarmist concerns that a yield curve inversion immediately signals an upcoming recession. While we are tracking whether this trend repeats or persists, a momentary inversion like we saw this week has not provided a definitive signal historically.[2]

The past two years have demonstrated the dramatic impact when global supply chains are disrupted by differing public health policies or halted by sanctions on authoritarian aggression. Recent headlines have specifically highlighted the risk of food shortage since more than 50 countries rely on Ukraine and Russia for more than 30% of their wheat supply; Russia also supplies more than 25% of certain fertilizers that are used by other agricultural producers.[4] Putin also made additional threats this week about shutting off gas supplies to European customers. Naturally, the topics of energy independence and food independence are driving discussions about changes to current supply chain relationships.
 
A more secure supply chain doesn’t mean every country forging ahead alone. During the globalization trend, the focus was on off-shoring – or locating production in the region with the cheapest labor costs. During protectionist phases, the focus shifts to on-shoring – or each country locating production domestically for security reasons regardless of higher prices. As policy is re-evaluated in the US and globally, a third option emerges as a likely middle-ground approach: ally-shoring.
 
Ally-shoring is the process by which a country rethinks manufacturing and critical supply chains by sourcing essential materials, goods, and services among trusted democratic partners.[5] According to the Brookings Institute, ally-shoring achieves two key foreign policy goals. First, it supports deeper economic integration with key partners. Second, this creates options for countries seeking an alternative to the authoritarian “offerings” such as China’s Belt and Road Initiative, or Russia’s dependency-inducing energy deals. Rerouting supply chains will take many years and billions of dollars of infrastructure investment – and coordination amongst allies. However, over time this policy could reduce the dilemma of sourcing commodities and products from countries that use those profits to finance their aggression toward the US and our allies. This approach would not fully offset the economic downsides of a less globalized world, but it offers a path forward that is more economically viable than full-scale protectionism and increases the security of our supply chains.

Whether at the national policy level or within our personal lives, it is important to periodically step back to evaluate and affirm our current trajectory. What worked previously may still be a prudent strategy looking forward, even if the world has changed around us. The stock market is currently in a period of re-evaluation, and current trends imply a world that may be smaller and more localized. Investors are facing a riskier landscape across asset classes and as supply chains and trade relationships are restructured. Even in this environment, we see tailwinds for a broad range of companies and industries, from alternative energy and food security to conventional energy and defense. Diversified portfolios will benefit as innovation in these areas comes to market and inflation uncertainties ease over time.
 
There is no one-size-fits-all strategy. As we talk with clients, we want to ground decisions in an understanding of their specific circumstances and goals – including when circumstances and goals change over time. For some clients, this has meant recent conversations about inflation concerns and their long-term liquidity, while other clients have capacity and desire to add to current growth investments at lower market prices. It is in these moments, when the global landscape feels muddled and risky, that understanding our own financial resiliency can support a clear and personalized path forward.

We are grateful to our clients for their continued trust and engagement with our North Berkeley Team, and we welcome all questions and conversations as we move further into 2022 and an ever-changing landscape.

Resources

[1] Global Share of Democracies. Based on the classification and assessment by Boix et al (2013). Our World in Data

[2] Economic Forecasts with the Yield Curve (2018). Federal Reserve Bank of San Francisco

[3] National Averages for Gasoline and Diesel Prices US Energy Information Administration (EIA)

[4] Back to the Future: What Cold War II Will Do To The World Economy. David Rosenberg. March 17, 2022.

[5] Rebuilding America’s economy and foreign policy with ‘ally-shoring’ (June 2021) Brookings