Markets Anticipate a Cleansing for the Post-Pandemic Economy
Enduring the market volatility over the past quarter has been difficult. We have not seen a stock market “bear market” since 2008. Not since 1970 has the market experienced such a turbulent first half. Not since 1931 have stocks and bonds, the mainstay asset classes of diversified portfolios, declined so significantly at the same time.
As unsettling as the last three months have been, it is always helpful to look back at history for context. The Wall of Worry chart shows how the S&P 500 index of the largest U.S. stocks has steadily increased in value over time through cyclical and secular bull and bear markets since 1928. Along the way, we’ve identified 108 worrying reasons for investors to sell stocks and exit the market. It illustrates the belief that it is more important to be in the market than trying to time the market, especially if you have the advantage of investing for the long term.
Of course, as humans, we are hardwired to be emotional. That instinct has served us well since the dawn of time to avoid threats in our environment to our species. Yet that “fight or flight” impulse does not always lead to successful investment outcomes, tempting us to try to time markets. It is for that reason that we have developed what we consider to be an unemotional, disciplined, objective, model-driven investment process, which we have applied over the last 35 years to several market cycles in an effort to navigate the inevitable investor tendency of oscillating between excessive greed and fear. We have seen market volatility before, and we take seriously our responsibility to help you through the emotional noise of 2022.
Readers of our quarterly letters over the last year and a half will remember our concern that inflation could remain elevated — challenging the Federal Reserve (Fed) to achieve its dual mandate of price stability and full employment. During the second quarter of 2022, capital markets moved aggressively and quickly to discount the expectation that they would have to march up interest rates — so much so that a short and mild recession to cleanse some of the excesses of the post-pandemic economy is likely over the next 12 to 18 months. This spate of market volatility is unlikely to subside until it is clear that inflation is peaking and that expectations of future inflation remain anchored near the Fed’s target of 2%.
To understand where we are headed next, let’s revisit the forces that led to this outcome. Then, we’ll explain how your investment portfolio has entered this period from a position of strength and highlight some of the opportunities we are beginning to see across the public and private markets.
How We Got Here
2020 – Present
In 2020, the coronavirus pandemic led the administration to “lock down” the economy to contain the spread of the virus until effective vaccines could be broadly adopted. Overnight, we experienced a short but sharp recession and breathtaking job losses. Unlike the 2008/09 Global Financial Crisis, where policymakers did too little too late to stop a subprime mortgage crisis from causing a prolonged and deep global recession, the Fed was determined to be aggressive in an effort to bring relief to the pandemic-stricken economy.
The Fed acted quickly. It reduced interest rates to zero, making a commitment to “not even think about raising interest rates before 2023”. In addition, it expanded its balance sheet by buying bonds – not just U.S. Treasury bonds, but municipal and corporate bonds as well, as it wanted to ensure that no area of the economy would suffer distress. These actions flooded the capital markets with liquidity and set the stage for the U.S. Treasury to implement fiscal stimulus to replace the lost income and jobs of an economy in lockdown. The balance sheet of the Fed rose from under $4 trillion to over $9 trillion by late 2021, and, in 2020 and 2021, five rounds of fiscal stimulus (with all but the last bill passed by Congress in a bipartisan way) led the fiscal deficit to climb above 20% of GDP – a level not seen since the Second World War. Many economists now estimate that these coordinated efforts put three times as much money back into the economy as the coronavirus pandemic took out.
In August of 2020, the Fed doubled down on its approach to create a strong, broad-based recovery. At that time, it stated it would “[let] the economy run a little hotter than usual” before removing these emergency measures, as inflation had persistently undershot its target rate of 2% for more than a decade.
This unprecedented policy response set the stage for a roaring, high-pressure recovery — the economy surpassed its pre-pandemic levels quickly and unemployment fell to historic lows below 4%, creating a backdrop for corporations to generate record profits. Unfortunately, the policy response also led to the highest inflation rate in 40 years — it has skyrocketed to more than 8% with no signs of peaking yet. According to statistics put out by the Federal Reserve and the Bureau of Labor Statistics, this level of inflation has not been seen since the early 1980s, and these price increases have broadened across all sectors in the economy as demand and supply imbalances have spread. Wage inflation has annualized at more than 5% in recent months, raising the specter of an inflationary psychology taking hold that will prevent inflation expectations from remaining well-anchored near the Fed’s target of 2%. Let’s look at both the demand and supply of the economy to understand how these concerns have escalated so quickly.
The Fed may affect the demand side of the economy by setting interest rates and using its balance sheet to control the cost of Main Street financing of mortgage loans, auto loans, student debt, and the cost of capital for corporations. Twice last year, despite clear signs that the economy was recovering briskly with unemployment falling, the Fed chose not to begin tapping the brakes on the economy; it feared that first Delta and then Omicron variants of the coronavirus would lead to an economic lockdown. In addition, it was reluctant to take the punch bowl away before the party got started, as it had in past cycles, because, in its view, the sparks of inflation looked temporary, and it feared slowing the economy down prematurely. When it became clear that epidemiologists viewed Omicron as a step towards the pandemic becoming endemic, and that widescale lockdowns were unlikely to recur, it also became clear that the Fed may have been playing with fire in the first quarter of 2022.
These concerns were exacerbated by developments on the supply side of the economy, factors that are out of the Fed’s control. China’s “zero COVID” policy mandates stringent restrictions for potential contacts of positive coronavirus cases. This effectively put its economy into complete lockdown again — shutting the port of Shanghai and exacerbating the severe supply chain disruptions with which the global economy was already grappling. In addition, the outbreak of the war in Ukraine, with no clear end in sight, has disrupted that country’s production of commodities (especially those that are used to produce other commodities, such as fertilizer, so vital to the world’s food supply), and put further upwards pressure on oil and gas prices.
As a result, the economy is now likely to experience at least a short and mild recession over the next 12 to 18 months. We know this because during the second quarter of 2022, capital markets moved to discount that the Fed would have to increase interest rates aggressively to restore current demand and supply imbalances. Recession’s red lights flashed beyond the stock market, closing in on bear market territory, signaling concerns about future corporate profitability:
- The bond yield curve, hovering around zero, briefly inverted, signaling the Fed had made a policy mistake;
- credit spreads widened to above 5%, signaling concerns about higher defaults down the road); and
- the prices of many industrial commodities corrected sharply. These commodities are a proxy for the health of the international economy, including copper, zinc, iron, ore, and nickel, among others.
In fact, the recession may already have started: U.S. GDP contracted in the first quarter and the Atlanta Federal Reserve’s GDP Now indicator — which tracks GDP in real-time — is hovering just above zero. Two consecutive quarters of contracting GDP are often a harbinger for the National Bureau of Economic Research to officially identify a recession – though their official dating might not occur until enough time has passed to properly evaluate the economic context, sometimes a few months. This is why we always like to remind our clients in our belief that capital markets lead the economy, not the other way around.
It is likely that the Fed will move aggressively to prevent inflationary psychology from becoming entrenched as it did during the 1970s. That decade was characterized by low rates of economic growth and high rates of inflation (“stagflation”) — despite imminent mid-term elections, with the Fed’s independence and inflation-fighting credibility on the line (something that took four decades to earn). As of the third week in June 2022, expectations are for the Fed to raise short-term interest rates to 3.4% by the end of 2022 and up to 3.8% in 2023. The Fed has also announced that it has begun reducing its bloated balance sheet as well. The Fed is clearly anxious to reach a more appropriate level of interest rates from the emergency measures it took in 2020 quickly and in big steps — it has already raised interest rates by three-quarters of a percentage point in June, the largest interest rate increase since 1994.
There are several reasons to believe that the economy may withstand this aggressive policy-tightening without a deep and protracted recession like we experienced in 2008/09. First, consumers are still flush with cash with strong balance sheets, a residual from all the fiscal stimulus that was applied. Second, the banking system is much safer than it was in 2007 — it is well-capitalized and in a strong position to absorb losses. Third, corporations will enter the downturn in a healthy condition after a record period of profitability. Fourth, today’s labor market dynamics suggest that much of the adjustment of a slowing economy will fall disproportionately on job vacancy rates decreasing, rather than the unemployment rate increasing. Today there are two job vacancies for every unemployed person as a result of the post-pandemic economy’s inefficiency at matching job-seekers with actual job openings. Normally there are two job-seekers for every job opening, leading to unemployment rising quickly as the economy slows. Fifth, and finally, increased productivity growth could ensure corporations continue to make profits even though the cost of their capital will continue to rise. We have written before about what could drive this productivity growth, including: automation; artificial intelligence; virtual communication; and robotics.
There seem to be challenging times ahead as the markets continue to digest the impending cleansing of the excesses of the post-pandemic economy, and I find it helpful to recall what President John F. Kennedy once said:
“When written in Chinese, the word crisis is composed of two characters. One represents danger, and the other represents opportunity.”
We will remain vigilant to both sides as our team calibrates our investment policy to the market outlook, staying grounded in our disciplined, unemotional, model-driven process.
Investment Strategy Update
First, we believe we have entered the bear market from a position of strength for several reasons:
- Our investment strategies have been absent from some of the highly speculative areas that have unraveled this year, including cryptocurrencies, non-fungible tokens (NFTs), Special Purpose Acquisition Companies (SPACs), “disruptive” innovation stocks at once-stratospheric valuation levels — such as Coinbase or Tesla — and the like. Readers of our research over the last few months will know that we have been warning investors about these fads for some time.
- For clients who are spending out of portfolios, we have at least 18 months’ worth of spending needs, net of portfolio yield, in cash and short duration fixed income in reserve. We believe this provides us with significant runway for this bear market to play out without permanently impairing your capital by selling assets at depressed prices to meet your goals.
- Though this is thin gruel, as it is always tough to digest a period of negative absolute returns, in our view, we have protected our strategies significantly from the decline in both bond and stock markets. Our strategies have drawn-down approximately half as much as the broader markets because we had already lowered both our bond and stock exposure’s sensitivities to rising interest rates over the last year. Earlier this year, we lowered the duration of fixed income further. Since spring last year, we have emphasized value stocks, whose valuations are less sensitive to rising interest rates — they have outperformed their longer-duration Growth brethren since. We also initiated a position to the U.S. Energy sector late last year, the only sector that has appreciated in price in 2022, highlighting its inflation-hedging properties.
- During the second quarter, we sharpened our Value emphasis further by increasing our exposure to a broad basket of stocks exhibiting the highest momentum over the last 12 months. This increased our exposure to the Energy sector, as well as the Health Care and Consumer Staples sectors. We believe stocks in these three sectors offer compelling properties during stagflationary environments because rising interest rates and inflation create a strong headwind for multiples. If multiple expansion does not contribute significantly to returns, then areas that will continue to outperform the broader markets will likely demonstrate sustainable dividends and strong underlying earnings power. We believe the key to that earnings power will be the ability to pass along inflation to customers through strong pricing power.
In our opinion, these moves imparted significant capital preservation for our strategies during the initial stages of this year’s bear market.
Here, we believe the danger lies in the pricing of stocks to bonds. Although we are not yet at a point where stocks look extremely overpriced relative to bonds, relative valuation did become more expensive toward the end of the second quarter. This was driven by two related, but somewhat independent, phenomena: 1) a sharp increase in bond yields (i.e., a sharp decline in bond prices), and 2) a further flattening of the U.S. Treasury yield curve. We are maintaining our overweight to stocks at this point, but should the situation change, we would reduce our exposure to stocks in advance of a deeper, more protracted bear market.
Current potential opportunities lie in cash, bonds, and tax-loss harvesting. Investors are finally being rewarded for saving and protection in cash and bonds. The 12-year period of financial repression where ultra-low interest rates have punished savers may finally be over. Second, given this volatility, we continue to aggressively tax loss-harvest positions to build up protection against future taxable gains. Our models are alert to other areas in the markets that are starting to exhibit a potential opportunity, such as corporate bonds, gold, several individual countries, and the U.S. Communication Services sector — and should our models confirm these opportunities, we may allocate funds there in the future.
Private capital plays an important role in Balentine portfolios in general and particularly so for intergenerational families. While we feel private capital provides unique sources of outperformance, an opportunity to capture an illiquidity premium, and diversification, the sector is not immune to the economy in general. As the likelihood of at least a short and mild recession begins to appear, we are seeing some signs of stress in a market that usually lags the fast-moving public equities market, especially within private equity strategies of venture and buyout.
In venture capital, we’re seeing indicators that investors are becoming more risk-averse, which could portend a recession. We are in continuous conversations with managers and founders in the sector. While the seed and pre-seed markets are still seeing some deals complete, the series-A and -B markets are at a standstill. There is also a bifurcation in technology companies that are profitable and growing earnings versus ones that are more of a promise of things to come. Few new term sheets are being offered to early-stage companies, and, when they are, investors are receiving more favorable terms for their investments and at dramatically lower valuations.
Some suggest that this dramatic repricing may mean that the coming year could offer one of the best venture capital entry points in the last three years. At Balentine, we recognize the idiosyncratic risk of investing in early-stage, venture-backed startups — that is why we have historically always taken an approach meant to give broad exposure to the market with the best managers possible and across multiple vintages. Here again, we are optimistic that this “spread with the best” approach will prove to be the right way to navigate what is shaping up to be some high seas over the coming months.
In the buyout space, many managers are wrestling with having paid extremely high multiples for assets and applying copious amounts of debt — the cost of which is now rapidly rising. This pinch, of paying high and borrowing with low financing costs that are now fading, has led some to forecast distress and the potential for fallout in the sector. In our view, technology has the greatest challenges, mirroring the public markets, but we see additional concerns in healthcare. Of course, within each segment, each company has a story — for technology, companies with strong earnings and good margins continue to command high prices, unlike their low-margin, unprofitable counterparts. At Balentine, we have been intentional in creating portfolios of buyout private equity that are purpose-built to weather a full economic cycle, meaning we expect — and in some instances, welcome— a recession.
This intent is evident in our recommendation of J.F. Lehman — a private equity manager with a track record of buying low-multiple industrial, aerospace, and environmental service companies that have high free cash flow and reasonable leverage. We approved their fund V in 2019, and they are back in market with their fund VI. As we always do, we re-underwrote before doing so, and we continue to find their approach and thesis attractive. We look forward to presenting clients with this opportunity shortly.
As a reminder, our private capital portfolios are diversified beyond venture capital and buyout in private equity. For example, we recommend even our most aggressive private capital portfolios have secured debt with our partner Monroe, which could seem sleepy at times, but we believe a floating 7% – 8% yield in a first lien security provides meaningful diversification in a time when multiples are resetting, and interest rates are rising.
We also recommend allocations to real estate and infrastructure, which tend to have inflation-linked cash flows, providing additional diversification in inflationary times. We are in the middle of our first close on our Decarbonization 2022 fund, which we feel has a meaningful allocation to infrastructure. We are also re-underwriting Harbert U.S. Real Estate VIII, which should be deploying capital into real estate at a very opportune time.
We feel our disciplined and demanding underwriting of managers, in which we always seek the most favorable terms and fees on behalf of our clients, will serve us well in the coming environment. We tend to partner with private capital firms that have managed through recessions. Adams Street, Pantheon, Harbert, and J.F. Lehman began investing well before the dot.com craze in the late 1990s, whereas Fulcrum, Monroe, and Panoramic began investing in the early to mid-2000s. These managers have learned from market downturns and lessons are codified into their culture and approach — in particular, they are typically disciplined when the world around them loses its discipline, which we believe becomes invaluable during times of stress and tough decisions around capital rationing and pivoting business plans.
The result is that over the last 36 months, while we have not been in the blockbuster deals on the headlines of the Wall Street Journal, we have been steadily plodding along at 2-3x return on equity for our clients, meaning high teens IRRs, that can help families, like the tortoise, win the race. As the market starts to show signs of stress, we believe our choices have been validated.
Our team has had the privilege of guiding clients through several bear markets over the last 35 years. We have been here before and are ready for both the challenges and opportunities ahead from a position of strength. As before, we will lean on our unemotional, quantitative, objective, forward-looking models, and steadfast, disciplined underwriting of managers in private capital to inform our decisions. These private and public capital approaches have stood the test of time and give us confidence that our past performance will repeat in the future.
We have been working in wealth management long enough to know that managing money will teach you humility if not anything else, especially in fast-moving capital markets like we have had to endure this year. We know we’re not going to get everything exactly right. However, we feel that we are entering this period of economic cleansing from a position of strength. We are mindful of dangers and alert to the opportunities as we continue to help you balance risk so that you avoid the permanent impairment of capital and meet your goals over time.
 The stock market plummet and quick recovery in March and April 2020 caused by the decision to put the economy into lockdown to prevent the coronavirus pandemic from overwhelming our health care system does not count as a loss in value of 20% or more for a sustained period.
 At the end of the letter, we have included links to some of our research insights from the past two years that you can peruse to get a deeper understanding of many of the topics discussed.
 The Financial Review, “Powell says Fed ‘not even thinking about thinking’ about rate hikes”
 The Federal Reserve Bank of Cleveland, “Average Inflation Targeting in a Low-Rate Environment”
 Even if the more volatile food and energy components of the Consumer Price Index are stripped out, core inflation is surging above 6% today.
 As I explained in this webinar presentation to Vistage International earlier this month
 The Federal Reserve Bank of Atlanta’s GDP Now Tool
 See “Wither Stagflation?” on our website at www.balentine.com for further details.
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