“Everyone thinks the Fed can handle this…but that hurricane is right out there down the road coming our way.”
- Jamie Dimon, CEO JP Morgan, June 2, 2022
Residents of the Gulf Coast know that the Fourth of July holiday signals the start of that time of year when we must keep an eye on the tropics. What may appear to be a mild line of thunderstorms can quickly morph into a destructive tropical cyclone. It is best to enter this period well stocked with essentials and prepared to endure sudden storms and unpredictable forecasts. Given the state of the markets and the economy it is hard to ignore Mr. Dimon’s observations and take stock of the forecast map.
The major driver of market volatility has been historically high inflation and the aggressive Federal Reserve (the Fed) response to it. Markets expected the Fed to start raising rates slowly in 2022, but robust inflation has forced the central bank to move much, much faster than anticipated. After two recent 0.75% (75 basis point) increases, the upper bound of the Federal Funds rate stands at 2.5% as compared to 0.25% in January. This has forced equity investors to quickly adjust the discount rates applied to corporate earnings and has driven the 20% correction in the S&P 500 we have seen in the first six months of this year.
The same forces pushing equity markets lower have also impacted the fixed income market. As rates rise the market value of a bond today declines, and aggressive Fed tightening has produced significant, almost unprecedented, losses in usually stable fixed income markets. This is an especially difficult environment for investors since the core of a diversified portfolio, stocks and bonds, have both declined at the same time.
Despite difficult financial markets, the broader economy seems to be weathering the storm so far. The employment picture remains strong with unemployment low, jobs available, and wages rising in support of solid consumer spending. The inflation headwind is real. Fuel and food are taking up a growing portion of wallet share, but the consumer has entered this period with stronger balance sheets and more savings than previous slowdowns, which. could support continued consumer spending through this period.
However, this does not appear to be a storm that will pass quickly, and we will be forced to navigate rough seas for at least the next few quarters. It is important to stay vigilant at times like these and react if required, but it is also key to avoid compounding a difficult forecast with rash decisions.
June 30, 2022 marked the worst first six months performance in decades across stock indices. The S&P 500 experienced its steepest first six months decline since 1970 with every sector delivering negative returns. The Dow Jones Industrial Average suffered its worst decline since 1962, the tech-heavy NASDAQ experienced its largest decline on record, and the Russell 2000 (a proxy for small-mid cap stocks) experienced its worst decline since the index’s inception in December 31, 1978. Bonds did not offer a safe haven: the Bloomberg US Aggregate Bond Index dropped 4.7% in Q2 bringing the year-to-date return to -10.4%. The stocks of companies which are not yet generating positive earnings suffered the most as investors continued to question valuations derived from future cash flows.
Uber’s CEO Dara Khosrowshahi summarized the environment for high growth companies without positive earnings in an email to employees in May:
In times of uncertainty, investors look for safety. They recognize that we are the scaled leader in our categories, but they don’t know how much that’s worth. Channeling Jerry Maguire, we need to show them the money. We have made a ton of progress in terms of profitability, setting a target for $5 billion in Adjusted EBITDA in 2024, but the goalposts have changed. Now it’s about free cash flow. We can (and should) get there fast. There will be companies that put their heads in the sand and are slow to pivot. The tough truth is that many of them will not survive.
Based on Uber’s enterprise value of approximately $47 billion on June 30 at a share price of $20.46 (a decline of 67% since its high in 2021 of $63.18), the company is now trading at 9x 2024 adjusted EBITDA. Although Uber has not yet generated meaningful free cash flow, its valuation is looking more reasonable. Of growing concern, however, are the increasing warnings from stalwart S&P 500 companies that have long generated strong free cash flow. Management commentary around inflationary pressures, reduced hiring, margin contraction, forced inventory markdowns, and slowing consumer demand are reverberating through this quarter’s earnings releases. Walmart issued a business update on July 25 that captures the pressures of the quarter: food inflation in the double digits is affecting customer’s ability to spend on general merchandise categories, which is requiring more markdowns to move through inventory. The result was Walmart’s revision of full-year 2022 guidance downwards to an 11-13% decline in operating income and earnings per share.
While recession fears are understandable given the negative headlines, timing market peaks and valleys is extremely difficult and more likely to detract from overall portfolio performance than add to it. Volatility and market pullbacks create opportunities for active management, and we continue to favor weightings towards US value equities within our diversified portfolios. A wide valuation disparity persists between cheap stocks and expensive stocks with the ratio between the cheapest and most expensive stocks remaining near historical highs on a price to earnings basis. Given these relative valuation metrics, we believe it is likely that value stocks are poised to continue to outperform growth stocks over the foreseeable future. The continuing headwinds in Europe and emerging markets have led us to lower international exposure across the board and favor active management in these geographies.
In the eye of the storm
As we survey the damage already caused by the past six months, it is helpful to 1) review previous storms to assess how far along we may be in this process 2) review the fundamentals of the market to determine current conditions and 3) discuss the future tracks that the situation may take and consider potential responses.
History can help give us a sense for how this market correction compares to past experience. Since World War II, the average equity market decline in periods of severe stress has been -36% from peak to trough and has taken 14 months. These scenarios include periods such as the 2008 financial crisis that were far more dire than our current situation, and a quick review of the past would lead one to believe that we are through most, but not all, of the adjustment that is likely to occur. With significant uncertainty around inflation, interest rates, the war in Ukraine, and China’s zero COVID policy, it seems that risks are still oriented to the downside.
While painful, the market seems to be reacting rationally to the changes in environmental conditions. The sell-off has been reasonably orderly and appears to be a reaction to the increase in interest rates. As the 10-year real Treasury yield has increased, the forward price to earnings multiple (P/E) has declined. This implies that investors are properly accounting for the higher cost of funds and adjusting the price they are willing to pay (the multiple) for future earnings. Another way to analyze this move is to take the forward earnings yield, the inverse of the P/E ratio and a proxy for the yield on the stock market and subtract the real yield on Treasury bonds. This spread is a picture of the additional return investors require to own equities versus safer bonds. The fact that the spread has remained flat means that investors are appropriately adjusting their valuation metrics for recent interest rate moves. This is painful to endure, but not a surprise given the rapid rise in rates.
There are two weakness with this analysis: 1) it assumes that the additional return investors require to own stocks will remain constant and 2) it also assumes that earnings, the E in the P/E, will come in as forecasted. Both assumptions could falter as the storm continues to rage. In times of stress investors often require extra return to own stocks, and it is unlikely that earnings growth can reach current targets due to margin pressure associated with inflation. If one or both of those assumptions prove incorrect, we will see additional turbulence.
We also need to address the status of international markets. Non-US markets, as measured by the MSCI All-Country World ex US Index, have slightly outperformed the S&P 500 so far this year by 1.8% in US dollar terms. As measured in local currencies they have done even better, declining only -11.6% for local investors. This is due to the higher weights in energy, financials, and mining sectors and a much lower weighting in technology in equity indices outside the US. The rally in the US dollar versus other global currencies explains the gap between local and dollar-based returns.
This solid relative performance masks significant issues in Europe and China. China is set to continue its zero-COVID policy, which entails aggressive citywide shutdowns at the first hint of new cases. This policy will continue at least through the national party congress in November when Xi Jinping will be re-elected to a third term in office. He will become the first leader since Mao to serve more than two stints in that role. This means Chinese economic growth will likely continue to be limited by the spread of new COVID variants that appear increasingly transmissible.
Europe faces an energy crisis due to the sanctions it has imposed on Russia. Even if the war in Ukraine is brought to an acceptable conclusion quickly, which seems very unlikely, sanctions will remain in place as punishment. Europe has not yet sanctioned natural gas sales from Russia as they rely on Russia for 40% of their gas supplies and have limited options to secure replacement volumes. Russia will use this dependence to punish Europe for supporting Ukraine. Vladimir Putin is unlikely to cut off supplies completely because Russia needs the cash generated form the energy sales, but he will supply less than Europe needs. Gazprom announced in July that it would be reducing flows to Germany to 20% of its capacity from an already low 40%. These actions will keep prices high and possibly fracture the EU consensus supporting Ukraine and sanctions. Both outcomes benefit the Russians. Shortfalls in natural gas in Europe will limit industrial production increase the costs across the board, and harm consumer sentiment. Europe is facing a very difficult winter in 2023.
That brings us back to the US market and the next stage of this storm. While equities face headwinds from pressure on corporate earnings, fixed income markets may be a bright spot. Bond markets appear to have fully digested the new path for short term interest rates. While there may be another leg up in longer term rates, we are reaching a point where municipal fixed income will add stability to portfolios and provide more cash flow than we have seen in quite some time. We are also exploring potential investments in taxable and high yield bonds that have reached levels that are starting to appear attractive.
The Cone of Uncertainty
The national weather service publishes their hurricane forecasts with a cone of uncertainty around forecasted storm tracks. The width of the cone increases over time around a base case due to the difficulty in assessing the evolution of tropical storms given the complexity of the variables involved. Forecasting financial markets is a similar process.
Our base expectations at this stage are that US equity markets have seen most of their correction but still face headwinds on earnings and profit margins. US fixed income, especially municipal fixed income, has reached a level where it should start to add income and stability to portfolios. International markets face additional pressure related to a strong dollar, inflation, and challenging energy markets, especially in Europe. For those reasons we continue to favor the US. In private markets we have seen cash flows and valuations hold firm through this period, adding value to portfolios able to have an allocation to alternatives. We expect that trend to continue.
The month of July was a reminder that markets can course correct quickly on limited data. The S&P 500 rallied over +9% in the month even though corporate earnings reports and economic statistics provided a mixed bag of trends: some negative, some positive, some neutral. It is a good example of why a long-term portfolio needs to largely stay invested. It is also important to remember that at the end of June the ten-year return on the S&P 500 was +12.96% even after the difficult first six months to 2022. Staying the course does provide long-term success.
This unusual period of slowing GDP growth, high inflation, a strong labor market, an aggressive Fed, and significant geo-political issues is a challenging one. We continue to go slow on making major changes but are scanning the path ahead for risks and opportunities.
We hope you are having a great summer and remind you that we are available to visit at any time to discuss these fast-changing forecasts.
President & Chief Investment Officer
VP, Head of Private Markets
VP, Head of Public Markets