Back to the Future
“History doesn’t repeat itself, but it often rhymes.”
- Mark Twain
In financial markets, 2022 will be remembered as the year that the Federal Reserve (the Fed) ended the age of free money. Investors understood that interest rates near 0% could not be sustained. The worldwide stock of negative-yielding debt dropped to below $700 billion in December from a peak of $18.4 trillion two years ago. The market hoped that this era would end on a gentle path with slowly rising rates that would allow for an elongated period of adjustment. That expectation proved completely incorrect.
Elevated inflation forced the Fed’s hand. The bank responded with the most aggressive tightening of financial conditions in the modern market era. It may be tough to remember, but the Federal Funds rate was 0.25% in February 2022. It stands at 4.50% today, a level not seen since 2007, and it is expected to reach at least 5% in the next few months.
This adjustment has been extremely painful for fully invested portfolios. Equity markets corrected quickly and were down more than -18% for the year in the US. Even worse for a diversified portfolio, fixed income, usually a source of stability in trying times, performed terribly. The rapid rise in rates hurt the market value of low yielding debt resulting in a -13% return for the US aggregate bond index. The worst fixed income returns in a generation. Many rate sensitive asset classes also had a difficult year and will likely experience further headwinds.
However, this painful end of the free money era will create opportunities for investors. The rapid adjustment in fixed income has provided a buying opportunity. With taxable investment grade yields largely above 5% for the first time in over 15 years, fixed income is actually providing real income. There is still the risk that rates rise further, but it seems that bond markets have largely priced in the change to the macro environment.
Equity markets will likely remain choppy this year as companies struggle to produce sold earnings growth in a tough economic backdrop. However, with the forward price/earnings ratio of the S&P 500 hovering around 17x, we are starting the year closer to longer-term average values. After a year of returns driven almost entirely by a rapid adjustment in the P/E ratio, future equity returns will be driven by earnings.
A world where returns will be driven by income from bonds and earnings from stocks instead of central bank policy is a welcome return to a more normal financial universe. Returns will no longer be driven by the abundant availability of cheap capital.
Markets in 2022
Financial markets have been dominated by the Federal Reserve’s drastic actions to tame inflation. The historic rise in interest rates drove rapid corrections in equity and fixed income market prices:
Valuations in fixed income and equity markets are now more attractive as the dramatic change to interest rates expectations has been absorbed by investors. With the forward P/E ratio for the S&P 500 down to more reasonable levels and the yield on the US aggregate bond index up to almost 5%, the major asset classes are more reasonably valued. Fixed income seems relatively attractive versus stocks since equities remain heavily exposed to declining future corporate earnings growth in 2023:
As we enter 2023, consensus expectations are for disappointing corporate earnings in the US, a resilient consumer that can mitigate the impact of a possible recession, a steady drop in inflation, and a Federal Reserve that pauses rate hikes early in the year. Our main concerns center on consumers and their ability to spend. With wage growth slowing and credit card balances rising, the consensus expectation may be challenged. The Federal Reserve will likely want to raise the overnight rate to a level above inflation by the middle of this year. That path has largely been priced into financial markets.
Back to “Normal”
Since COVID-19 forced a complete global economic shutdown in March of 2020, investors have been trying to understand the enduring changes that the pandemic has brought to the economy and markets. As we near the third anniversary of the initial lockdowns, most activity seems to be returning to pre-COVID trends. A fascinating example is e-commerce.
E-commerce sales as a percentage of total US retail sales have grown steadily since the early 2000s, but they spiked in 2020 as our lives moved entirely on-line. Since vaccines were widely issued in 2021, the percentage has retreated back to the pre-pandemic trend. This has had a major impact on firms that bulked up on cloud services, e-commerce support, and warehouse space on the assumption that the spike represented a permanent shift in long-term trends. This return to trend seems like an appropriate metaphor for broader economic and market activity. Across the board, we are returning to many pre- COVID norms.
In regard to trends in financial markets, the correction of 2022 has re-set valuations and changed the long-term expectations for index returns. JP Morgan publishes an exhaustive annual analysis and forecast of long-term (7+ years) capital market average annual return assumptions. Several other firms including BlackRock, Goldman Sachs, AQR and others produce similar reports with broadly similar results. Below is a summary of the JP Morgan estimates and how those have changed over the past year.
The difference is striking and consistent across all asset classes. A difficult 2022 has adjusted return expectations back to historical averages. Although these expectations may prove incorrect, they indicate that financial markets are returning to an environment driven by fundamental factors and not ultra-low interest rates. This is a solid backdrop for owners of diversified portfolios.
When it comes to specific areas we are emphasizing in portfolios the four following themes appear attractive:
• Fixed Income: After years of being underweight, we anticipate moving towards our long-term strategic targets. Bonds provide real income to portfolios and cushion returns in challenging times
• US Value Equities: We anticipate maintaining a healthy allocation to value equities which still appear attractively priced versus growth even after dramatic relative outperformance in 2022.
• International Equities: We have been underweight developed international and emerging market equities for several years but believe we may be at an inflection point after fifteen years of US outperformance.
• Private Credit, Real Estate, and Energy Transition: The floating rate nature of most private credit has made yields in that space even more attractive than usual. Interest rates will force an adjustment to real estate cap rates presenting opportunities to deploy capital into projects at better pricing. Recent government efforts to subsidize the transition of our electrical grid will present attractive potential investments with enhanced economics
The Road Ahead
“Roads? Where we’re going, we don’t need roads,” is a memorable quote from the 1980’s hit Back to the Future. Unfortunately, we don’t have a time machine powered by a flux capacitor, but as we contemplate 2023 and beyond, we suspect the traditional rules of the road will begin to reassert themselves after more than a decade of 0% interest rates.
January has already provided several surprises, as markets have rallied in the face of conflicting fundamentals. China’s sudden exit from their zero-COVID policy, decelerating inflation readings and hope that the Federal Reserve is near a peak in rates has outweighed disappointing corporate earnings and contractions in manufacturing activity and other leading economic indicators. We still suspect that the year will be volatile and that market sentiment can change quickly in the short-term. There are more twists in the road ahead.
We hope you have a great start to the new year and look forward to visiting soon.
President & Chief Investment Officer
VP, Head of Private Markets
VP, Head of Public Markets