Q1 2022 Firm Commentary
The first quarter of 2022 began on a choppy and downward trend as the Dow and S&P 500 closed down 4.6% and 4.1% respectively, and the Nasdaq lost 8.94%. For the three major averages, despite a nice March rally, this was the worst quarter since the first quarter of 2020, which marked the start of the Covid pandemic in the U.S. and saw the S&P 500 tumble 20%. It has been a remarkable run for the market with eight straight quarters of positive returns, so it’s not surprising that we would have a negative one to start the year. What is surprising is the why, as some contributing factors we anticipated, albeit with a bit more volatility than we would have thought, but others were unexpected.
The start of a rate hike cycle from an increasingly hawkish Federal Reserve, stubbornly high inflation, Russia’s invasion of Ukraine, and Omicron’s spread in China, all contributed to the struggles for equities in the quarter. March was a bit of a bright spot, though, as the major averages enjoyed a solid two-week rally in the back half of the month. The S&P 500 and Nasdaq rose more than 3% in March, while the Dow added 2.2%. The recovery hinged on several factors, namely investors beginning to look past the invasion, some clarity around central bank actions, and some technical buying, as there is still a lot of money on the sidelines. Moving forward, we will see how the economy performs. If it continues to slow, interest rates keep rising, and inflation continues to run hot, it will continue to be a challenging set-up for equities and bonds. Alternatively, since the market is a forward-looking indicator, much of this bad news may already be priced in.
With the Russian invasion of Ukraine, the price of oil barreled (no pun intended) to $130/barrel, although it has subsequently declined back to $100/bbl as President Biden has declared to release 1mm barrels/day from the Strategic Petroleum Reserves, an unprecedented act to help defray some of the inflationary impact on consumers. OPEC has also committed to producing more oil to help defray the impact sanctions are having on the release of Russian oil. The most recent cause for the market’s worry though, has been the bond market. Bonds appear to be signaling an impending recession as the US Treasury yield curve has flattened and parts of the yield curve have inverted, signs that have historically signaled upcoming recessions. That said, based on the historical analysis below, it appears to be a mixed bag as to when S&P has peaked and the number of months until recession begins.
Despite all this negative noise circulating in the markets, there are also positive signs to point to in the economy: unemployment is running close to historical lows, wages are rising, mask mandates are being eliminated throughout the country and we are all able to begin moving towards a “new normal.” Americans are traveling again, individuals are eating indoors, and sporting event venues are back to full capacity. However, we are not fully out of the woods as new variants continue to emerge and individuals adjust to a new way of life.
Many companies that we own continue to profit handsomely and grow significantly by virtue of price increases and expanding market share, as well as pent up corporate demand. However, some of this growth is beginning to slow as inflation, that is running at 40-year highs, begins to take a bite out of consumers pocketbooks. As we can see in the below chart, despite a significant rise in average hourly earnings, increasing inflation in many parts of the economy have actually resulted in negative real average hourly earnings.
We will have to wait and see how these trends play themselves out over the coming quarters but believe there will be some moderation as inflation hopefully stabilizes in the second half of the year as the Fed tries to navigate a soft economic landing. We also continue to witness similar trends from the end of last year such as the fact that corporate planning, capital expenditures, and new projects remain in limbo as some factories struggle to stay at full operating capacity as employees continue to the leave the workforce at staggering rates. We still don’t have a full grasp on how the war in Ukraine and global sanctions on Russia will further disrupt global supply chains in the short-term. However, in the mid to long-term we believe this significantly increases the urgency and strategic importance of local manufacturing of, at a minimum, food, energy, and other materials to ensure our independence by minimizing the impact of global disruptions on the goods and services that are essential to our daily lives.
Our focus on your family’s financial well-being has been a respite from this day-to-day dystopia, and we are especially honored during this time for the trust and faith you continue to place in us.
The recent slowdown in growth along with global uncertainties surrounding Russia’s invasion of Ukraine and the impact of a more aggressive Federal Reserve posed a challenge to markets in the first quarter around the world, both equity and fixed income. US Stocks (as measured by the S&P 500 TR Index) were -4.60%1 and Developed International Stocks (as measured by the MSCI All Country World ex-US TR Index) were -5.62%.1 US Bonds (as measured by the Barclays Intermediate Aggregate Bond TR Index) finished -5.93%1 and interest rates rose from 1.51% on the 10-year Treasury to 2.34% by the end of the quarter.1 As a refresher, generally bond prices and interest rates move in an inverse relationship so as rates rise, bond prices decline.
Rising interest rates presents a host of challenges for the markets going forward and we need to be mindful of these increasing risks while investing for the long term. Equity valuations, which are merely reflections of a company’s projected future cash flows discounted back to present value, are often impacted by higher interest rates as the elevated discount rate reduces the overall price. As interest rates rise, bond prices fall and investors with exposure to bonds may overreact when they open up their statements and feel the urge to sell to avoid further losses. Rising rates also has implications for the real estate and housing markets as mortgage rates rise thereby reducing demand and causing additional hardship for existing homeowners who may want to sell or refinance.
As the old saying in the financial markets of “Don’t fight the Fed” goes, when the Federal Reserve is withdrawing liquidity from the economy and selling financial assets, it’s a good idea for investors to follow their lead and trend towards a more cautious approach. Moving forward, as the Fed reverses their accommodative position, we will have to wait and see how this all plays out. We continue to believe the highest probability is that one of the following scenarios will ultimately occur: either the Fed will raise interest rates and push the economy into a recession which will in turn lead to a reversal and a lowering of rates, or the Fed is so behind the curve and inflation is worse than expected that they will have to continue to raise interest rates more than the market anticipated.
We have been surprised by the rapid trajectory of inflation. Obviously, we weren’t expecting the Russian invasion which has added to the problem due to the additional supply shock it created within the food and energy markets. However, if we look at where rates and inflation are despite the Fed’s hawkish rhetoric, we are currently in an environment that represents some of the most dovish the fed has been since the early 1970’s. The Fed has a clear mandate to tighten yet they have a poor track record of doing so into a decelerating economy. If they tighten while the PMI (Purchasing Managers Index) is rising, we believe they have a decent shot making headway to reduce inflation, although if they are tightening into a slowing economy as they did in 2018, we believe it is a potential recipe for disaster. Since inflation is higher now, we don’t know how far they will ultimately raise rates, but we would take the under on whatever the consensus is for where they end up.
Inflation, from where we sit, is a result of all the fiscal and monetary stimulus as well as supply chain and commodity shortages. If we add the war to the mix, we believe it is not an easy problem to solve in the short-term. Unfortunately, the Fed cannot print commodities or fix supply chains. They can try to reduce demand but this risks putting the US into a recession. They want to slow demand but they also don’t want to cause a recession, so in our opinion, they are caught between a rock and hard place, and we are not optimistic they will be able to navigate a soft landing. As evidence of this conundrum, we can see the elevated levels of CPI (Consumer Price Index) relative to its 50-year average.
Total US Public Debt Percent of GDP
Source: St. Louis FRED 1/1/1966-10/01/2021
M2 Money Supply 1980 – 2022
Source: St. Louis FRED 11/03/1980-4/04/2022
So, in our humble opinion either interest rates go up, the government’s interest obligation on its debt goes up, and the money printing machine continues, or the Fed is able to maintain liquidity and ultimately doesn’t raise rates as much or actually starts to cut rates because even modest increases in interest rates and slowing of quantitative easing will cause reduced consumer demand and disrupt the bond markets, causing a recession and the need to stimulate again.
At some point it’s fair to believe the economy will stabilize (it always has in the past). However, with the enormous amounts of stimulus injected into the economy, unsustainable US debt levels, and an evolving construct in workforce and consumer behaviors – what that “new normal” will be is still very much evolving. There is, and always will be, something to analyze and dissect on a day-to-day basis when it comes to markets and investing, but we will not be distracted.
Inflation is the major issue for the economy right now. Consumer prices are +7.9% YOY as of the end of February, while Producer prices are +13.8% YOY, and the Fed’s favorite indicator, the Personal Consumption Expenditures index is +6.4% YOY, all the highest in 40 years and trending in the wrong direction. As we have previously stated, this trend, which began emerging in earnest in the fourth quarter of 2021, has forced the Fed to reverse course. The Fed funds rate rose 25BP at the most recent FOMC meeting earlier this year, and the rhetoric from many Fed governors over the past few weeks has become more hawkish with talk of at least one if not more 50BP increases moving forward and an unwinding of their $9Trillion balance sheet. All of this translates into a tightening rate cycle which will gradually remove accommodation from the economy in an effort to combat inflation. The net effect, however, may end up resulting in a slowdown in growth, consumer spending, and overall economic activity.
This unwinding comes in the face of a labor market that, from an unemployment rate, is back to pre-pandemic levels, where weekly jobless claims are at near all-time lows, and where corporate profitability continues to surge. At the same time, fiscal stimulus measures have ended, inevitably creating a furthering gap between the fortunate and less fortunate, and individuals are leaving the workforce at the greatest pace we have seen in years. As fiscal stimulus dies off, perhaps that will encourage this trend to stabilize and reverse since many businesses are suffering from staffing shortages and empty shelves, thereby impacting their bottom lines. How this all plays out for the markets, for the economy, and for corporate profits remains a significant wild card that we are watching closely and following our rules-based investment discipline so as not to let emotions take hold of us.
This type of backdrop is exactly why we don’t try to predict what the markets will do in the short-term as it is a fool’s game in our professional option. Instead, we will continue to focus on long-term macro trends in our asset allocation and portfolio strategies, knowing that we are prepared to implement our proprietary risk management approach to seek to navigate whatever direction the market takes. As we have stated before, our goal is to minimize the impact of major draw downs and, as a result, be able to take advantage of them.
What Have We Done
From an asset allocation standpoint, our internal indicators have moved us into a more conservative posture, as we have seen declines in US Small Cap and Mid Cap and continued declines in Emerging Markets which caused a buildup of cash in the portfolios in an attempt to minimize the declines within our Managed Volatility Growth and Balanced portfolios.
From an equity standpoint, we have seen some significant shifts as our US portfolio has maneuvered between 25% cash and a fully invested allocation within the last month of the quarter. Our International strategies, on the other hand, have continued their downward trend and we have raised between 50-75% cash depending on the asset allocation model and implementation of either individual stocks or ETF’s. Despite these moves, we continue to focus predominantly on the long-term macro trends we believe will be paramount moving forward such as: decarbonization and green energy (wind, solar, rebuilding the electrical grid, and electric vehicles), technology and science innovation, digital transformation in consumer and business behaviors, infrastructure, and the reopening trade. More specifically, many of the companies in the sectors hardest hit by the pandemic, like hospitality, financial services, and consumer discretionary, are re-emerging, however, not all of them have fully reopened or recovered to pre-pandemic business activity. The past quarter, a more hawkish Federal Reserve and rising interest rates continued to produce a noticeable headwind to many of the high growth company stocks we own as valuations are most adversely affected by this. It has also caused increased trading activity in the portfolios as individual securities have triggered our sell discipline. We have been deploying capital selectively when we see opportunities based on our long-term macro trend thesis and in some of the companies where we believe post-pandemic realities are not currently reflected in their stock prices.
Both US and International markets remain challenging from an investment standpoint as many factors out of our control such as inflation, interest rates, and wars, are affecting valuations. However, as we look out over the longer term and past the current noise, we remain convinced that we are properly positioned and the companies that we own and the themes that we believe in, will be properly rewarded. In fact, we have used the market volatility as an opportunity to reallocate into quality companies that are in line with the long-term macro trends we believe will continue to materialize moving forward.
Finally, an area of the portfolios that we have addressed over the past few quarters has been the introduction of digital assets into our investment portfolios. Bitcoin is the first global, private (open source no govt involvement), digital, rules based monetary system in the world. Economically, everything we’ve seen in the last 12 months such as inflation, war in Ukraine, Russian sanctions, the Canadian trucker crisis, and CPI/PPI, have all have been bullish for bitcoin. Although they are unfortunate and unpleasant for the world, these events have underscored to many objective observers the use case for a global non-sovereign store of value digital asset like bitcoin.
While there has been heightened volatility in the asset class in the first quarter due to a reduction of risk across all markets, we continue to maintain our conviction in the long-term benefits and transformational aspects of this asset class in general and bitcoin in particular. We saw a number of positive developments in the quarter as it relates to cryptocurrencies in general from Biden’s executive order to “ensure responsible development of digital assets,” to Goldman Sachs making its first-ever over-the-counter (OTC) digital asset transaction with a bitcoin option on March 21, to ExxonMobil launching a pilot program in North Dakota to use excess natural gas to mine bitcoin and looking to expand to other countries around the world. Since mid-March, institutions have flooded into Bitcoin at some of the highest levels on record. These inflows are likely a result of anticipation regarding upcoming favorable US regulatory framework for Bitcoin. On top of this, Bitcoin’s supply dynamics haven’t looked this good since 2020. In the short term, Bitcoin is most at risk from down movements in credit and equities. In the long term, however, we believe Bitcoin is poised for a bright future as a storage of value asset.
We maintained our exposure throughout the quarter and will tactically look for opportunities to minimize the volatility. We believe we are still early in the use case adoption phase, and as bitcoin specifically begins to gain institutional and retail investor portfolio adoption, we believe we will see significant long-term appreciation in the asset. However, the volatility, in our opinion, will continue to be significant both up and down; it is the cost we pay for the long-term opportunity. This volatility is also something we are working to address and will be rolling out new investment solutions soon that will incorporate various risk management approaches that seek to minimize the drawdowns and enhance risk adjusted returns.
As we mentioned last quarter, bonds remain the final hurdle for investors to digest in a higher inflation and interest rate environment. Traditionally, bonds are used to diversify away risk and to act as a ballast to investor’s portfolios, and that works well in a stable or declining interest rate environment. However, as rates rise, bonds become more of a liability in investor portfolios, and we have systematically reduced our exposure to bonds across the entire rate curve to seek to protect client capital. Since the early 1980’s interest rates have declined from the mid teens to near zero today. As a result, bond prices which tend to move in an inverse relation to yields, rose to historic highs. With the unwinding of fiscal and monetary stimulus, rates should move higher; how much is yet to be determined. Regardless of how the Fed proceeds, we acknowledge that we are in for an abnormal bout of volatility as the market adjusts to a new normal. The fact of the matter is that trying to make money based on guessing what the Fed is going to do is a losing strategy as the Fed can change direction quickly to respond to financial conditions and has often done so in the past. Maybe this time is different, and inflation will finally force some degree of responsibility back into monetary policy, or maybe it won’t. The conundrum facing the Fed this time around is that they will be challenged to normalize rates (~6.5% on the 10 year Treasury historically), due to a combination of debt, demographics, and the wealth effect. With 130% debt to GDP and the US and world relying on the dollar as its reserve currency, even if we perform some sort of operation twist, we will have a hard time seeing rates normalizing above inflation. Ultimately, this plays into our thesis that the Fed will have no choice but to continue to debase the dollar keeping the US in a negative real rate environment. Historically, this has been a bullish backdrop for asset prices. We believe stocks, commodities, real estate and digital assets should all do well as bond holders either suffer losses or own an asset that is producing a negative real return. We will continue to actively monitor the situation, but the risk-reward characteristics of bonds, in our opinion, are not currently attractive.
What Comes Next?
The world is facing several key turning points (inflation, supply chains, monetary policy, war) and these combined effects are impacting equities, bonds and commodities in a way we have not seen in the past 30 years. While 2022 has started out as we assumed it would: a challenging environment for risk assets and increased volatility, especially in the first half, we should not be overly surprised since in the past 42 years, the S&P has experienced average intra year declines of 14% yet produced annual returns that were positive in 32 of those 42 years.2
Although we didn’t have one last year and 2020’s Covid crash was fierce but short lived, we did suffer our first 10%+ correction in the S&P (-12.5% peak to trough) this year as well as in Small and Mid Cap, and International markets, that bottomed in mid March and roared back into quarter end and wouldn’t be surprised to see more of these short lived corrections throughout the remainder of the year. In addition to the overhangs/potential headwinds mentioned earlier, we also have mid-term elections this year which may have a significant impact on Government policy and spending. However, once we have greater clarity around Fed policy and the election, we believe the markets should settle down which could lead to further gains into year end. As evidenced in the chart below, despite a history of elongated rate hike cycles over the past 45 years, markets have, on average, traditionally produced positive returns.
Effective Federal Funds Rate
S&P 500 Return through Rate Hike Cycles
Source: JP Morgan Asset Management 05/1983-04/18/2022
Despite this backdrop, the long-term structural characteristics of our investment themes remain intact and continue, in our opinion, to gain steam. We believe the market will return to a focus on fundamentals and that stock selection will be more important than in prior years. It seems unwise to try to guess what the Fed will do in 2022, but one thing seems pretty certain – the great liquidity spigot that overwhelmed fundamentals and propelled meme stocks and others up significantly in 2021, will almost certainly not be flowing this year. While this has and will continue to likely present a challenge in the first half of 2022, it does not necessarily mean that equity markets need to go through a serious decline. There is still ample liquidity sitting on the sidelines and sloshing around in the economy, and eventually it will need to find a home. What seems more likely is that assets get re-rated as investors preferences shift from a world dominated by narratives to a world in which fundamentals suddenly matter again. In fact, we are already seeing signs of this as many of the frothy tech names and posterchildren of COVID-era liquidity (Zoom, DocuSign, and Peloton as examples), are being re-rated in real time. Companies with pristine balance sheets, dominant market share, and pricing power appear to be more stable.
As a reminder of our core investment principles, we don’t try to predict the future, we prepare for it. In other words, we use our Dynamic Cash Allocation® to adjust our risk exposure between cash and investment assets. This systematic rules-based approach eliminates emotion from our investment process, allowing us to focus our attention on asset allocation, long-term thematic trends, and individual investments. With the enormous amount of government stimulus over the past two years, and pent-up demand as a result of Covid, economic growth remains robust and operating leverage in our portfolio holdings is high. This combination usually results in productive equity markets.
We remain confident heading into the new year that our conservative, rules-based approach will help us continue to navigate the impending uncertainty. As we have mentioned before, we believe that many financial firms will not be properly positioned for what lies ahead. In our opinion, traditional forms of risk management, such as portfolios that rely heavily on bonds, or equity strategies that take a buy and hold approach, may not provide the risk-return characteristics investors have come to rely on.
Please feel free to share this market commentary with those you believe would benefit from it and know we will do our best to be available to assist anyone you refer to us. As always, we know and respect the enormous amount of trust and faith you have placed in us, and we assure you we are more than up to the task. Please feel free to reach out at any time – we are all here for you and eager to assist however we can.
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