Thirteen years of ultra-low interest rates, mild inflation and above-average returns lulled many investors into a peaceful, passively-invested state of complacency. But in 2022 markets delivered a “wake up” call. The S&P 500 (-20%) and NASDAQ (-33%) officially entered “bear market” territory and posted their worst annual performance since 2008. Bonds had their worst year ever. The Bloomberg Global Aggregate Bond Index fell 15.3%.
The markets’ decline was driven by surging inflation, geopolitical upheaval and aggressive interest rate hikes from the Federal Reserve (FED). Investors had been anticipating two or three ¼ point (0.25%) interest rate hikes from the FED in 2022. But between mid-March and mid-December, the FED delivered the equivalent of eighteen quarter-point (0.25%) hikes to the Federal Funds Rate (FFR)–a historic pace of monetary tightening prompted by the highest bout of inflation in 40 years.
The combination of these events caused interest rates to become unhinged. Last January, a one-year US Treasury Bill earned just 0.4%. By November, an equivalent one-year US Treasury Bill earned 4.8% (highest yield since 2007). With the emergence of this suddenly viable “risk-free” alternative, valuations applied to other, riskier assets–like stocks–had to move lower in order to entice investors to accept the incremental volatility.
In aggregate, our clients outperformed the indexes–primarily as a result of entering the year cautiously positioned and growing our allocations to cash, energy and gold. Energy was the only positive sector in the S&P 500 last year, up over 50%. Our clients held outsized positions in oil and basic materials throughout 2022 which contributed to our performance. As interest rates rose, we purchased US Treasuries for our clients to lock in attractive yields.
It is our view that today’s lower equity market valuation adequately discounts the move higher in interest rates. What is not priced into the market at this point is the risk of lower earnings. If the FED remains committed to their 2% inflation target, an economic recession seems probable. Even in a mild recession earnings could decline 10 to 15%. To account for this possibility, we have taken a “middle-of-the-road” stance toward equities. Most customer accounts are currently 40-60% invested in stocks, depending on individual factors. This approach allows us to quickly pivot–either offensively or defensively–depending on the direction of upcoming economic data, corporate commentary, and FED guidance.
Despite our near-term caution, there are pockets of opportunity. We are keenly monitoring the value of the US Dollar which appears to have topped versus other major currencies. This is a tailwind for US multinational corporations and emerging market economies. This should also be positive for basic materials, gold, and the companies who mine these metals. Momentum in the energy sector can continue for several reasons: (1) China’s economy is finally re-opening after three years of stringent “zero-covid” policy which ought to boost demand for oil and natural gas; (2) Most domestic energy companies have adopted shareholder-friendly capital return policies (dividends and buybacks) rather than accumulating debt to fuel production growth; and (3) The need to refill our Strategic Petroleum Reserve–down 42% or 266 million barrels since January 2021–likely keeps a high floor under the price of oil this year.
Inflation’s quick decline from 9.1% in June to 6.5% in December is encouraging, but sustainably achieving the FED’s 2% inflation target may be a challenge. Inflationary impulses like a weakening US Dollar, declining labor force participation, and ESG/carbon-reduction commitments are unlikely to abate in the near-term. Moreover, the pandemic and war in Ukraine have exposed vulnerability in globalized supply chains. Domestic supply of essentials (food, medicine, energy, technology, etc) has quickly and correctly become a national security priority. But in developed economies everything costs more due to higher wages, taxes, environmental standards, social costs (pensions, healthcare, welfare, disability, etc) and strict regulations. If globalization slows or reverses, we could lose a major deflationary force–one responsible for consumer durable goods prices falling by 40% between 1995 to 2020.
On the bright side, we are blessed to live in a country with a resilient and robust culture of entrepreneurship and innovation. This spirit persists with little regard for the level of interest rates or macro-economic conditions. Reshoring essential supply chains should ultimately spur domestic economic growth while creating good, high-paying jobs. Technological innovation remains a disruptive and deflationary force–enabling us to do more with less. The devastation seen in many companies' stock in 2022 does not match the resilience of their business model or their prospect for profit in the years and decades ahead. We remain vigilant to uncover and identify “hidden gems” that could multiply our clients’ capital when this cycle turns.
We have guided clients through multiple bear market cycles spanning decades–helping to build generational wealth for many long-term customers. While each bear market’s cause and progression is unique, their end is usually the same: panicked capitulation. Our long-term clients have benefited from these rare but important opportunities to buy equities during severe market dislocations. Should the pain of ‘22 turn to panic in ‘23, we want to be poised and well-capitalized. We have been here before, and we are well-situated again this time around.
In the meantime, we are pleased to earn a risk-free yield over 4.5% in short-term US Treasuries which remain high on our list of preferred investments. Even uninvested cash balances are yielding around 3.5% in money market funds–the highest rate in decades. Check the interest rate your bank or credit union is paying on deposits. Most banks are paying significantly lower rates on savings. It may be beneficial to move funds into your investment account to earn higher yields. Adding investment capital now becomes an opportunity to accumulate quality assets at lower prices.
Thank you for your continued trust and confidence in us. It is never taken for granted. We are as committed as ever to helping our clients navigate any challenging market environment. We will remain humble, nimble and open to new developments that could alter our outlook.