Since the 2007-2008 Financial Crisis, the Federal Reserve has largely pinned interest rates to the floor – with the brief exception just before the pandemic. Free money was nice. Borrowing at 0% for cars and 2% for homes spurred economic growth and fueled increases in asset prices. What’s not to like?
It turns out that printing money causes prices to rise. Many years of near-zero interest rates and constant bond buying (known as quantitative easing) combined with excessive fiscal stimulus pushed out during the pandemic finally reached the inflationary tipping point. And, when inflation was already high, it got worse with the war in Ukraine pushing up prices further in energy, food, fertilizer, and other commodities.
The fact that we hadn’t seen any meaningful inflationary threat for 40 years provided a lot of rope for policy makers and politicians. It’s hard to truly expect inflation when half the population has never seen it and the other half has mostly forgotten about it. For inflation to rise and persist, it must be seen as credible and durable by enough people.
Paul Volcker, the Fed Chair from 1979 to 1987, was largely credited with killing the 1970s era inflation in the early 1980s, achieving hero status after the fact. But, back then, inflation was even higher and lasted many years. This time around, inflation hit 8%, and current Fed Chair Jerome Powell is running the Volcker playbook of jamming up rates to beat back inflation. After a slow response to inflation in 2021, the Fed has “front-loaded” rate increases in 2022 with multiple 0.75% hikes after regular meetings. The fed funds rate currently sits at just over 3.0% and is forecasted to rise to around 4.25%-5.0% in early 2023. One more 0.75% hike is expected at the Fed’s next meeting in November before the wind-down processes begins and the terminal rate is in sight.
The aggressive front-loading process of raising rates essentially erased the 15-year free money era in a matter of months. As shown below, the 2-year U.S. Treasury rate of 4.2% as of 9/30, which temporarily hit 4.3% prior to the end of the quarter, is the highest since August 2007. One year ago this rate was only 0.29%. In theory, the economy should be strong enough to withstand current interest rates. The rate environment of the last 15 years was highly unusual and the Fed likely should have responded sooner with higher rates after the pandemic.
Above: The 2-year U.S. Treasury rate jumps in late 2021 from 0.29% just as the Fed pivots from the end of easy monetary policy to 4.2% at 9/30/2022.
In 2022, rates have normalized faster than most would have imagined prior to this year. Financial markets have suddenly reset, reversing 15-years of low rates in under a year, and the process was painful but necessary. The good news is that long-term expected returns for both stocks and bonds are significantly more favorable.
Higher interest rates drastically enhance the outlook for bonds
Equities have disappointed investors in 2022, but the real story is about bonds and interest rates. Bond values move inversely to movements in interest rates. Substantial increases in interest rates in a short amount of time has punished bond values. The U.S. Aggregate Bond Index declined 4.8% for the quarter and is now down 14.6% for the year. The longer the duration, the greater the pain. Shorter duration bonds are down less since bonds are redeemed at par value and proceeds can be reinvested at higher rates. The fed continues to “out-hawk” themselves with aggressive rhetoric about further rate increases in order to lower economic demand and curb inflation.
Higher rates equate to a very respectable risk-free rate for the first time in 15 years. As we saw above, U.S. treasury yields now provide the best return over expected inflation in more than a decade. (Inflation, as measured by the Consumer Price Index over the trailing 12 months is 8%, but expected inflation is the difference between traditional U.S. treasuries and U.S. inflation protected treasuries, and is only 2.1%[1].) A good indicator of a bond’s expected return is the current yield, and high-quality yields are now approaching 5%. Assuming interest rates stay about the same and defaults remain low, a high-quality bond portfolio should return about 5% over the next year.
More pain for equities, but valuation is now enticing
Equities finished lower for the third consecutive quarter and retested the bottom set in June at the end of September. The S&P 500 declined 4.9% during the quarter and 23.9% in the first three quarters of the year. The tech-heavy Nasdaq declined 3.9% in the quarter and 32.0% so far this year. Smaller companies in the US, as defined by the Russell 2000 Index, fell 2.2% during the quarter and 25.1% so far in 2022.
Equity drawdowns have been slightly more substantial overseas. The war in Ukraine and European energy concerns going into winter have weighed on European markets. Growth in China has slowed due to zero-covid policies and other socialist programs that have focused on expanding the middle class. However, one of the biggest headwinds to international equities has been the incredible strength of the U.S. dollar. International assets are held in local currencies and lose value when converted back to a dollar that has soared to a 20-year high according to the US Dollar Index. Developed international equities declined 9.4% during the quarter and 27.1% for the year. Emerging market equities fell 11.6% and 27.2% in 2022.
Domestic equity valuation peaked in the third quarter of 2020 in terms of the price-earnings ratio, and that ratio has been improving since then due to the continually expanding corporate earnings combined with the lower price. Earnings are expected to grow in the third quarter by about 3%, but forward guidance is uncertain and expectations for the fourth quarter and beyond are declining. Tighter monetary policies and a stronger U.S. dollar that reduces revenues that U.S. corporations earn abroad (U.S. goods become more expensive) could cause earnings to contract in coming quarters. We anticipate earnings deterioration in 2023, but valuations in some corners of the market are still quite enticing. Below is the S&P 600 Small Cap valuation going back 20 years. These companies are now trading at valuations lower than at any point over the last 20 years. It’s a similar story for domestic mid-sized companies. While the large cap S&P 500 trades in-line with historical averages, it is considerably cheaper when stripping out the nearly 20% of the index assigned to a select group of technology stocks that remain more expensive. Overall, the last two years have seen considerable multiple compression, meaning that equities now trade at a lower multiple of expected earnings. (meaning that we think stocks are rather inexpensive.) Historically, valuation has been shown by many studies to be the single best predictor of long-term returns, although it has no bearing on the timing of returns.
Above: The S&P 600 Small Cap valuation trades at 10.4x the next 12 months earnings compared to the average of 16.5x over the last 20 years. These companies have never been cheaper over the last 20 years based on a forward price/earnings valuation metric.
Global Asset Allocation Strategy
The Global Asset Allocation Strategy remains neutral after substantially reducing risk on 1/3/2022. After entering the year with excess cash, this cash was redeployed into equities at lower prices in the first half of the year. We are patiently waiting to buy during periods of sustained equity weakness should they occur. Moreover, we are actively considering moving assets from bond alternatives to actual bonds based on expected returns for these asset classes. The bond alternatives have produced a great deal of relative outperformance compared to bonds so far this year. However, going forward, we forecast better returns ahead for bonds based on significantly higher yields and the fact that the Fed is in the later stages of the rate hiking cycle.
We are also weighing the possibility of extending duration within bond portfolios. There is a chance that the Fed could actually reduce interest rates sometime in 2023 if inflation and the economy weakens faster than expected. Current duration is exceptionally short, at 2.5 years. This has drastically mitigated the bond carnage this year from rising rates, as short-term bonds are more defensive in a rising rate environment. In summary, the shift to bond alternatives and short-term bonds has significantly mitigated the pain that would have otherwise been felt from rising rates this year. But, we need to be focused on what lies ahead and traditional bonds are positioned to outperform.
Equity exposure has slightly outperformed domestic and global benchmarks this year mainly due to a technology underweight. Equity holdings currently emphasize quality and value over growth. Equities continue to be slightly overweight high-quality domestic small and mid-sized companies based on favorable valuation trends and projected returns. We would love to add further exposure to high-quality small and mid-sized domestic equities at lower pricing if we get that chance.
The strategy has exposure to many asset classes and can be rebalanced at any time to take advantage of opportunities. Although equities briefly fell below the June bottom at the end of the quarter, the strategy has remained conservative and is holding dry powder in case we do see a lower bottom.
Focused Equity Strategy
In the third quarter, growth actually outperformed value by a little bit, though for the year growth has significantly underperformed value. The S&P 500 is down 24% year-to-date through September 30, while the S&P Growth sank 31% and the S&P Value dropped 17%. For the quarter, those returns were -5% for the S&P 500, -3.9% for Growth, and -5.8% for Value.
This contest between value and growth has been ongoing for many decades. Before this year growth had doubled the returns over value for five years. However, when we look at history, we find that there are periods of time where either approach takes the lead, extending over multiple years and even a decade or more. Growth outperformed value in the late 1990s, then value took the lead for the following decade, only to relinquish it again. Could this year be another inflection point in the debate? Only time will tell.
Focused Equity tends to have a value bias. Successfully executing a value strategy takes a different mindset from a growth strategy, since value seeks to profit off of a reversion to the mean, while growth likes to chase the trend. We seek to hold great companies for the long term, as we believe that will produce superior results.
In July, we sold Vmware, a software company that was in the process of being acquired by Broadcom. We felt that there was a meaningful risk of the deal being blocked for antitrust and geopolitical reasons, and we weren’t especially enamored with Broadcom. We use the proceeds to sprinkle a little into existing holdings, including Advanced Micro Devices, Nvidia, Warner Bros., and Cisco.
Then about a month later, we sold ConocoPhillips, an oil and gas company. We believed that oil prices, which were well above $100, had significantly exceeded the marginal cost of production, which we think is probably closer to $60. The marginal cost of production is the price of oil where the highest cost producer breaks even – any price higher than that incentivizes new producers to drill for more oil and increase supply. The price of oil can swing wildly around that number, but, in theory, should average the marginal cost of production over the long term, at any given level of demand.
We also sold Nutrien, a fertilizer company that sells potash, nitrogen, and phosphate, and has a chain of stores that sells fertilizer and farm products. The reasons were similar – fertilizer prices had spiked well above the marginal cost of production as a result of the war in Ukraine. However, we felt the prices were unsustainable over the long term.
With the proceeds, we bought Taiwan Semiconductor (TSM), the dominant merchant semiconductor manufacturing company. Other chip companies, including Apple, AMD, and Nvidia bring their chip designs to TSM, and then TSM makes the chips for them. They currently have the most advanced semiconductor manufacturing process in the world, having taken the lead from Intel a few years ago.
We also bought JP Morgan (JPM), establishing a new position in many accounts, though some portfolios already had it. JPM is a big bank, like our other bank investments, though with a bigger exposure to investment banking and securities markets. The stock was down not only due to a down market, but also due to fears about their exposure to international financial markets. However, their balance sheet is very strong and their hedging expertise is legendary. We don’t think they are going anywhere anytime soon.
We bought a small position in Agnico Eagle (AEM), a high-quality gold mining company based in Canada. We believe this fits nicely with our position in Barrack Gold, as together they are the cream of the crop in the industry.
Then we used S&P 500 SPDR ETF (SPY), which is a fund that mimics the S&P 500 index, to absorb excess cash in the portfolios (note some portfolios have the iShares S&P 500 ETF, or IVV). Since the market was down, we didn’t want to have too much cash and didn’t want to force investments into the portfolio that we were not ready to buy. We use this fund to absorb cash and will swap it out as needed.
Markets recalibrate to the new normal and set the stage for 2023
The market recalibration over the first 9 months of 2022 has been frustrating and painful for investors. Financial markets are currently pricing in a new economic backdrop with higher interest rates and inflation. However, there is a real possibility that the Fed is nearing the later stages of the rate hiking cycle and inflation should gradually recede. Equity valuation is low, setting up more favorable long-term returns.
“Seasonality” improves as we approach November and the mid-term elections. Historically, equity performance has been stronger in the months of November through April. Moreover, equities have risen in every single 12-month period following mid-term elections since 1942. The S&P 500 has averaged 15% in post-mid-term years since World War II[2].
Uncertainties heading into the election and earnings season will eventually become clear. Investors must remain focused on long-term performance and planning goals and remember that the market is always looking 6-12 months ahead. All eyes are currently on projected 2023 earnings, but soon the focus will be on 2024 and the earnings recovery.
Please follow up with questions at any time! We would be more than happy to discuss financial markets in greater detail!
[1] Federal Reserve Bank of St. Louis. Fred Economic Data as of 9/30/22. Both 5-year TIPS breakeven and 10-year TIPS breakeven rates at 2.1%.
[2] “After Punishing Year for Stocks, Investors Aren’t Betting on Post Mid-term Rally”. Hannah Miao. WSJ. 10/2/2022.