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.