The End of an Unusual Era?

2022 will likely be remembered as a watershed year for investors everywhere – a year when the economy and markets began a bumpy transition away from an era of low inflation, low interest rates, and abundant capital. The adjustment in capital markets was violent, as Figure 1 illustrates. Rarely has so much pain been felt at once across so many asset classes.

Global stocks fell approximately 20%. While this was a meaningful drop, it is not unprecedented; the stock market has seen a dip of more than this magnitude in a calendar year before. Bonds fell nearly 15% — making 2022 the worst year for that market since 1949. The returns to a “buy and hold, diversified” portfolio of 60% stocks and 40% bonds were the worst since 2008. Though in 2008, bonds earned a positive 5% return –unfortunately, in 2022 there was nowhere to hide. Growth stocks led the stock market sell off, ending the year down over 30%, far underperforming Value stocks, which corrected by 8%.

“It’s only when the tide goes out when you learn who is swimming naked” – Warren Buffett

Speculative and under-regulated areas of markets were not immune to market adjustments. We have consistently urged investors to avoid cryptocurrency, non-fungible tokens, ARK Innovation growth stocks, and Special Purpose Acquisition Companies. As the year drew to a close, headlines emerged about alleged fraud committed by Sam Bankman-Fried as his FTX cryptocurrency exchange filed for bankruptcy.

2022’s dramatic reversal in the “bull market in everything” that took hold after the Global Financial Crisis ended in 2009 was triggered by sharply rising interest rates. The Federal Reserve (the Fed) tightened monetary policy more quickly than at any time since the early 1980s, dragging along other central banks across the world, to dampen resurgent and persistent inflation from causing future inflation expectations becoming unanchored from their target of 2%. Across the developed world, consumer prices are rising at their fastest annual pace in four decades, albeit showing signs of decelerating by the end of the year. The world is now braced for a likely recession that we have been warning about since the summer.

‍Managing Risk Ahead of Return Leads to Meaningful Capital Preservation

A key tenet of our investment philosophy, which we have applied over the last three decades, is to manage risk ahead of returns. In practice, that means we stay focused on what we can control, such as:

·      ensuring clients have cash on hand to meet spending needs so that they are not forced to sell assets at temporarily depressed prices and thus avoid the risk of permanently impairing capital;

·      diversifying our strategies to manage volatility;

·      adjusting strategies tactically to capture opportunities; and

·      minimizing implementation fees and taxes.

Over time, it is more important to minimize downside captured in bear markets than to outperform in rising markets. Wealth compounds geometrically not arithmetically, so the sequence and smoothness of returns generated have a powerful effect on the growth of a portfolio over time. Put another way, sequencing matters because if you make withdrawals to spend when the portfolio is artificially depressed, then you can't get that back because of the geometric nature of compounding. Our preservation of capital and cash helps minimize, if not eliminate, that effect.

Money management will teach you nothing if not humility, and it is always difficult to stomach a temporary period of declining performance, even when outperforming benchmarks. After outperforming in the rising markets of 2019 – 2021[1], we are proud of the meaningful capital preservation we have provided in the difficult markets of 2022. Our portfolios experienced less than two-thirds of the downside experienced by the public bond market and the stock market in 2022 for all strategies. According to eVestment, we outperformed more than 75% of the universe of competitors[2].

This performance is not limited to the past year. Our investment track record shows that our strategies have consistently outperformed their benchmarks and ranked within the top quartile over any time frame over more than the last decade. We believe that our unemotional, model-driven approach, which blends a series of forward-looking fundamental factors, such as relative value and momentum, underpin the consistency and repeatability of our approach.

It is worth repeating the several steps we have taken since the spring of 2021 (when our portfolios were positioned at their maximum aggressiveness in overweighting equities in the form of Growth stocks) to prepare portfolios for what unfolded in 2022:

(1)  We have been mindful to ensure that clients keep two years’ worth of spending needs in cash at all times, especially now that cash pays a decent return;

(2)  We switched our emphasis from Growth to Value stocks and to stocks with low volatility in defensive sectors like Consumer Staples and Utilities;

(3)  We moved underweight stocks in favor of fixed income, while reducing its duration (i.e., sensitivity to rising interest rates); and

(4)  We took advantage of the volatility to generate significant tax losses to protect future gains and improve tax efficiency of portfolios.

As Figure 2 shows, these adjustments helped to avoid the worst areas of market stress last year. Our strategies outperformed their respective blended benchmarks, and outperformance was even larger for investors in unconstrained

We took an additional step during the fourth quarter to prepare portfolios for the coming environment of lower economic growth and likely stubbornly high inflation and interest rates: within equities, we reduced our exposure to equities that we buy and hold for the long-term from 40% to 30% and tilted exposure to a high-quality factor[1]. As we discuss further below, we think we are likely moving to a new era of more expensive money, where simply “buying and holding” broad market indices is likely to be less productive than during the last ten years of declining interest rates and low inflation, and the need to be more selective about actively picking and choosing where to invest is going to be paramount.

This is especially so in private markets. Private equity and debt strategies are not immune to the economic challenges that public markets have already discounted; in fact, private market returns may be marked down, but not permanently. The advantage that these strategies have is that they have long time horizons and do not have to provide liquidity by selling their assets in a distressed environment. We believe that our existing commitments in private capital are well-positioned to navigate the current environment as we have always emphasized selecting managers who provide active management beyond the point of commitment, do not raise large funds as a means to simply gather assets, underwrite loans to a strict “no loss first” standard, are disciplined on valuations and growth expectations, and do not rely excessively on leverage.

The prospective opportunity for fresh commitments to private capital is compelling. Some of the best vintage years have been generated when allocating to dislocated markets like the present conditions. Over the last few years, we spelled out four multi-generational themes that we believe are going to be persistently lucrative investment opportunities over the coming decades. These themes are the decarbonization of our energy complex, the revolution in healthcare, the rise of artificial intelligence/machine learning/robotics, and the persistent economic and demographic growth of the “sunbelt” in the southeastern United States.

Around these strategic themes, we will remain alert to opportunities that dislocated private markets may present, as we did during the pandemic in 2020 when we successfully took advantage of distress in the hotel industry. We are already reviewing a number of higher risk, “rifle-shot” co-investment opportunities presented to us by our managers. We have also created an access vehicle for clients to allocate to managers that are poised to take advantage of potential further stress in the credit markets in 2023 where a financing gap needs to be filled because companies and consumers may not be able to access the traditional bank lending channel.  

2023: Peak Inflation and Interest Rates?

Towards the end of 2022, several measures of inflation, including the Consumer Price Index, Producer Price Index, and the Personal Consumption Expenditure Index (the Fed’s preferred gauge) confirmed elevated inflation rates and decelerated price pressure. However, wage inflation remained sticky as the labor market showed no signs of sustained softness. In all previous tightening cycles, the Fed had to raise interest rates to a positive level in real terms (adjusted for inflation). Core measures of inflation are still running around 4.5%-5.5%, meaning the Fed will likely continue to increase interest rates to slightly above 5% before pausing to understand the effects of the last year of interest rate increases on the economy and inflation expectations. Monetary policy operates with long and variable lags, so the effects of 2022’s interest rate shocks are only just beginning to be felt on the broader economy outside of interest rate-sensitive sectors like housing, commercial real estate, and automobiles, all of which have already slowed significantly.

Figures 3 and 4 below show that inflation expectations over the next five years remain anchored between 2.0% and 2.5%, which means the markets believe raising interest rates to above 5% will help reduce inflation to the Fed’s target rate over the next five years. Any further deceleration in inflation will help to bring forward peak interest rates.

Our models are keeping us committed to our current stance across portfolios. Stocks remain extremely expensive relative to bonds, as evidenced by the spread between dividend and earnings yields vs. bond yields. While stock market multiples have contracted, earnings expectations still look vulnerable to being revised downwards as the likely recession unfolds. In bond markets, short-term rates exceed long-term rates, meaning the slope of the yield curve has been inverted in a significant and sustained way for several months, a reliable indicator that a recession is imminent.    

There are several cushions that may limit the impact of the likely recession. Consumers still have excess cash savings left over from the record fiscal stimulus in response to the pandemic. There remain more job openings than unemployed people, implying that though unemployment will likely rise, it won’t increase by as much as it has in past recessions. After a surge in COVID-19 infections, China finally seems set to reopen its economy, allowing supply chain disruptions to ease further. During this period of below-trend economic growth as the economy’s demand and supply side are brought back into balance by higher interest rates, we will remain alert to the opportunities that may offer outperformance relative to the broader indices. As a reminder, we look at the potential opportunities from sub-asset classes, such as corporate bonds, international stocks, U.S. sectors, and gold bullion.    

Today’s Starting Point: Looking Further Ahead to a New Era of More Expensive Money

After the significant moves in bond and stock markets in 2022, our 2023 Capital Markets Forecast is particularly germane. This annual publication estimates expected returns and risks over the next seven or so years from today’s starting point, and in this year’s edition we take a closer look at several themes:

 ·      In Resetting Perspective, we identify contributors to today’s high inflation, looking to similar periods in the past to provide ideas for what the market might do ahead. We remind readers that the economy and markets have endured similar circumstances before and that the recent era of cheap money and extremely low inflation is more of an aberration than the new era of more appropriately priced money and higher inflation. The thin silver lining is that the real rate of return to cash and fixed income have increased during this transition, making it more sustainable to maintain spending levels out of portfolios. The pressure for multiples to contract further within stock markets remains, especially in sectors that derive much of their value from profits distant in the future, and companies with the power to pass on higher prices to customers without dependence on excessive leverage are poised to outperform over the longer term. This is ultimately a far healthier environment for savers and investors where risks are not artificially depressed by artificially low, rock bottom interest rates, and over the long run should provide opportunities for investors to generate superior rates of return.    

·      As a result, in Quality as a Core, we expound upon why a strategic allocation to the Quality factor may be a strong lever to drive outperformance in an era of a higher cost of capital.

·      In Diversification, Access and Fees, we provide considerations for trade-offs in private capital to help clients reach their goals in a cycle where successful active management is likely to matter more than ever for clients to reach their goals.

In Closing

“Unprecedented events happen with some regularity, so be prepared” warns the famously successful investor, Seth Klarman. The events over the last three years especially have reinforced this concept. While no one can predict such events or their severity precisely, were main committed to constructing portfolios that weather the storm by staying focused on what we can control and by adhering to our disciplined process that we have applied over several market cycles. Managing risk in all its manifestations ahead of returns will remain key, as will the ability to withstand the emotional temptation to succumb to market timing when times seem toughest.    

Thank you for the trust you place in our team. As always, we welcome any questions you may have at any time.

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[1] For our SGA and GTAA strategies

[2] In our GTAA strategy

[3] A quality factor is a diversified basket stocks tracking the global equity index with an emphasis on those stocks with stable and consistent top and bottom-line earnings, high pricing power, and low leverage on their balance sheets.

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