At a client webinar this past Thursday, LNWM CIO Ron Albahary, CFA® and Debra Wetherby, founder and managing director of Wetherby Asset Management (LNWM sister company) discussed concerns regarding inflation, rising US interest rates, and the ongoing invasion of Ukraine in context of our investment philosophy and process. Below is a summary of key points.

When people hire us as their wealth and investment managers, Ron noted, they are hiring a distinctive thought process, which has certain key components that are especially applicable during times of turbulence and turmoil. Those components include the following:

PERSPECTIVE. While the media headlines would make you think otherwise, the fact is that recent economic developments are not unprecedented. Oil prices, inflation, and interest rates have been at current or higher levels in the not-too-distant past without damaging the US economy. The Fed funds rate, for example, was considerably higher in 2019 than now. And in 2008, inflation spiked to 6% in 2008 while oil prices hit $140/barrel.

Also noted was that what we’re experiencing today does not seem like a repeat of the 1970s as some pundits claim. Back then, the bulk of the baby boomer generation was in their 20s and 30s, borrowing heavily to start households. Throughout the 70s decade, consumer demand (aka consumption) was rising 5% a year, which is actually much higher than the level of consumer spending increases currently. Another major difference is that the US economy is about half as dependent on oil as it was in the 1970s, and in the past decade we have become the world’s largest producer of oil.

This is not to say things are hunky-dory. Despite the Federal Reserve’s optimism about the health of the US economy, our investment team is seeing indications that the risk of recession is higher. Small business hiring plans seem to be stalling and layoffs are on the rise, while things like the quit rate of workers in construction is falling. We believe that the credit markets offer more insight into what is happening with the economy than the equity markets. Currently, the yield curve on US Treasury bonds has flattened and could potentially turn negative — short rates higher than long rates — an event that has preceded virtually all recessions in the recent past.

THIRD-ORDER THINKING. It is important to recognize that current events are reported on using what we call first-order thinking: A is happening which will cause B. Much of the financial news is reported in this simplistic cause-and-effect way, leading readers to draw conclusions based on a very limited information set. For the invasion in Ukraine, 1st order thinking might be: Russia is threatening not only Ukraine but Europe; the EU will respond by increasing spending on defense.

Second-order thinking looks past the immediate developments at the intermediate-term trajectory. The economic implications for the EU can be many, including not only higher defense spending but also even stronger focus on developing renewable energy and sustainable and regenerative agriculture, which are both in the interest of national security given the desire to eliminate reliance on Russia. Additionally, as they proved during the pandemic, companies in Europe, the US and elsewhere have the ability to deal with challenges in new and innovative ways, and this can spur outcomes not yet realized. The world does not stand still when threats are on the rise.

Third-order thinking is strategic and long-term. It is the level we try to apply in creating portfolios that are managed to preserve capital and grow wealth over the long term and oftentimes, over many generations. Applying third-order thinking to the Ukraine invasion, we see the potential for a shift from globalization to regionalization. Companies are starting to rethink supply chains and make them more secure by diversifying production away from one or two main suppliers often located across the globe. A shift to regionalism has the potential to make things more expensive in the short-to-intermediate term, contributing to inflation settling in at a higher level than we have seen prior to 2021 although not necessarily at the recent highs. But eventually, supply chains that are closer, more reliable and secure can help keep inflation in check.

REAL WORLD PRAGMATISM. The portfolio(s) we create for each of our clients are based on an Investment Policy Statement that is essentially a “business plan for investing” because it is strategic and reflects the actual needs and goals of each client as they operate in the real world. We find that our industry tends to take an academic or textbook approach to investing that can lead to a disconnect with client concerns and goals. That’s because investment theory tends to focus on maximizing return and/or beating benchmarks, with risk as a secondary consideration, especially behavioral risk. We think that is absolutely backward.

Mathematically, losses are far more damaging to a portfolio than gains are beneficial — the laws of compounding clearly illustrate this. With that said, calibrating risk first doesn’t mean being risk-averse; it means investing so that each of our clients is taking the risk they need, can tolerate, and for which they can be appropriately compensated. If we manage risk effectively for each client, our clients are not likely to panic during market downturns and force losses to be realized at market lows. That is a major behavioral risk that can derail decades of wealth accumulation.

Currently, we are facing a greater than usual level of uncertainty (aka risk) as indicated by market volatility and very wide divergence in opinion on Wall Street as to market direction. We do not place much value on Wall Street forecasts because of they are often wrong, but the disparity in outlook is telling. Instead of focusing on forecasts, we spend our time and energy building LNWM portfolios that are  diversified so they can navigate through periods of higher uncertainty and risk. At this time, for example, we have asset classes in our portfolios that should benefit from inflation. Other elements provide stability (cash, fixed income,  and diversifiers such as hedge funds) while others can allow our clients to benefit from growth and innovation.