2023 Is Here Already, What’s On The Horizon?
This question posed is profoundly difficult, if not impossible for even the smartest and most informed to answer with great accuracy. Consider the forecasts from market pundits who one year ago all falsely prophesied stock market gains for 2022. Nobody foresaw inflation running up to double digits, the given Fed response (4.25% in rate hikes just this year), and the worst bond market in U.S. history.
With only a few market trading days remaining in 2022, that’s year-to-date through Christmas, the S&P 500 is down more than 18%, after counting dividends. The bigger story and reason for the stock market decline and heightened volatility is the historic meltdown in safe assets, namely high-quality bonds, off more than double digits as well. There have been few places to hide for conventional investors.
The financial markets continue to be held hostage by the CPI/PPI historically high inflationary numbers (currently in the seven to eight percent range), and Fed policy to get the original Fed inflationary mandate back to two percent. These efforts are balanced by the second Fed mandate of maximum employment. Generally, the U.S. economy is regarded to be at full employment when we have unemployment at five percent at less. We are currently at 3.7% unemployment, suggesting that the labor markets continue to be strong. With the economic lag of this horrific tightening cycle, we should soon see GDP economic growth slow from Q3’s 3.24 percent (just reported) growth to something much slower…or no growth at all, even declining economic activity and possibly recession. Following the decline of the first half of this year, another pullback would be a rare “double-dip,” something that most economists say is likely to occur.
The Bond Market Likely Has This Wrong
From 1926 to present, long-term US Treasury yields have averaged about 2.3% more than CPI inflation. A historically normal market is where investors must be compensated something north of the inflationary prints and taxation on bond interest. The bond markets began to diverge from this normal relationship after the Fed eased Fed Funds to the zero bound, in an attempt to revitalize economic activity during the pandemic. In hind sight, this lasted far too long. Inflation came forth, and previously thought “transitory inflation” proved not to be so transitory. Combined with aggressive fiscal policy and supply chain disruptions, too many dollars chasing too few goods pushed the Consumer Price Index (CPI) to 10 percent year-over-year price increases. Last month the PPI, (wholesale or raw materials prices) year-over-year number fell to 7.4%, still worrisomely high and above expectations. CPI came in at 7.1%, slightly below forecasts.
What makes the bond market wrong, using the historical analysis above, is simply to add today’s inflation numbers (CPI), 7.1% in November to the historical 2.3% necessary yield adage, and we get 9.4%…so in a normal bond market, in the absence of Fed manipulation or quantitative easing (now tightening) long dated treasury bond securities should be yielding near 10% to provide nominal yields that protect one from the ravages of price increases. Both buy side and sell side research amongst biased bond analysts are suggesting that yields could be correct, but that only works if CPI inflation is normalizing dramatically fast (back to 2%) …most unlikely in our view. The cliché that the trend is your friend until it ends, is something to hold onto given the dramatic rise in inflation that caught nearly all prognosticators off guard. Combined with secular trends of the move from global trade (think China) to nationalism, government response to climate change, the emergence of a possible commodity super-cycle, tight labor markets, aging populations with large numbers of workers exiting the labor force, it is difficult to see inflation declining quickly, given that two-thirds of all inflation, long-term, has come from unit labor cost increases.
The positives that we take from this as investment consultants and investors is that bond yields today are fantastically higher (consider Fed Funds at 4.25% now) than where they were a year ago (Fed Funds at 0% last December) on a percentage basis. Think mortgage rates. If you believe that there might be more trouble for the stock market with further Fed hikes, it makes sense for some to alter their asset allocation or slices of their investment pie, to incorporate more bonds because they are safer and yield considerably more than just a year ago. We think short-term bonds are more appealing. If we are wrong, we still get the bond returns that we lock in during the purchase by simply holding them until maturity and reinvesting later at even higher yields.
Again, for us, the opportunity lies in yields that are now more than two or three times that from a year ago. Here is a wonderful illustrative example. We own a high-quality, investment grade, diversified fund which currently yields more than 10%. These bonds in aggregate have less than 3-year maturities. Many of the issues have adjustable rates. Another type of bond that we like is short-term “TIPS,” (Treasury Inflation Protection Securities) where the principle compounds with the CPI rate. For this year, unthinkable a year ago, TIPS earned 8% in 2022 just from the appreciation from the CPI inflation component, and US government guaranteed.
I recently heard the question posed of when would be a good time to extend bond maturities or duration (defines interest rate risk exposure). The best place to start with this analysis would be to wait for a “normal” market in which the bondholder is compensated for inflation. Just simply add the current CPI number, now 7.1, to the ten-year US Treasury yield and you have a close approximation. Given this historical relationship between inflation and yields, the bond market is currently broken. Some might add that the market is discounting a recession, but that doesn’t necessarily mean that yields come down, especially given still stubbornly high price increases, in raw materials, labor, and commodities.
To clarify and conclude…the bond market appears to be wrong because yields are still way to low and likely going higher, given the Fed’s staunch speak regarding fighting inflation and the still elevated inflation numbers.
With Roughly Another 100 Basis Points Of Tightening To Go According To The Fed’s December Dot Plot, What Happens Next Year?
With the next FOMC meetings in February and March, we may get the last of this cycle’s tightenings. But with much higher mortgage rates we have and will continue to see a dramatic slowdown in the housing market, vehicle purchases and luxury goods. 10 of the last 13 tightening cycles ended in recession, and with the dramatic nature of these hikes in this cycle, recession is significantly probable during the second half of 2023.
What To Do With New Or Existing Portfolios
As a firm we don’t feel like we need to do much. Several years ago, we made an unconventional move away from the traditional 60/40 allocation to stocks and bonds to something like a 50/25/25 portfolio…stocks, bonds, and alternatives to equities and fixed income…so let’s examine each component.
Last year we witnessed a profound divergence in the performance of high P/E versus low P/E stocks. To contextualize, consider year-to-date returns of the Vanguard Admiral Growth versus Value mutual funds. Growth is down about 33% this year with Value down about 3%. (Source: WSJ December 28, 2022, Vanguard Growth and Vanguard Value Mutual Funds) We have had a bias towards value and believe this discrepancy will continue. Consider that a single dollar invested in 1926 in large value stocks has grown to $35,000, yet only $7,000 for large growth. For smaller companies the divergence is greater. (Source: 2021 Yearbook, Roger Ibbotson and Associates, SBBI) Prior to 2022 growth outperformed value for quite some time, but now higher yields have applied extreme pressure to growth valuations, the P part of P/E. Along with value we like higher than average quality, higher dividends, higher performing (free cash flow), strong balance sheets, defensive names, and natural resource-linked equities.
With the Fed Funds rate now at a range of 4.25 to 4.5%, bonds offer much more than only a year ago with a 0% Fed Funds rate. In this space munis should be considered, but only if the taxable equivalent yields favor tax-exempts over comparable taxable bonds. The short end of the curve favors taxable in most cases. We like anything CPI-linked and/or adjustable rate. With the prospect that we get at least another one percent in rate hikes through, call it May, and inflation is slower than expected in abating, maturities should remain inside of three years. With a slowing economy in 2023, we like the idea of upgrading credit quality with our bond holdings.
We began to venture more into “Alts” when the Fed drove interest rates to zero. During 2022 we greatly benefited from our Alt exposure. Specifically, we have owned BDCs (Business Development Companies) which invest in middle-market private businesses through a diversified portfolio of adjustable-rate loans bundled into one fund. We continue to like energy, energy MLPs, and algorithm-run mutual funds that engage in trend-following in the commodity space utilizing futures contracts, in a diversified fashion. I believe, like Goldman Sachs, that we may be in a commodity super cycle that lasts ten or more years. With supply chain disruptions, odd weather patterns, nationalism, and volatility, we continue to see pronounced trends in certain metals, agriculture, livestock, and financial markets that capture these movements. For the much more aggressive investor a very small weighting in crypto currency could prove advantageous given the meltdown in 2022. Consider that Bitcoin, the stalwart, which prior to 2022 bested every asset class for ten years in a row, declined more than 70%. We know of a closed-end fund that trades at a 50% discount to the underlying asset values, and owns nothing but Bitcoin. In other words, you can purchase one Bitcoin through this fund for about $8,500, yet Bitcoin traded at a recent peak of $68,789 (November 2021). The latter trade is not for every investor nor the faint of heart! For those who loath the idea of crypto, precious metals continue to deserve a significant weighting in client portfolios.
Considerations Before Year End
With the last trading week upon us, it’s a wonderful time to take inventory of your holdings to determine if your asset allocation is suitable for you, given your time horizons, risk tolerance, return expectations, and other factors. Consider a Roth conversion if you’ve had anything in your IRA drop precipitously and you’d like to see it rebound free of taxation. The last thing to look at this week (as we have) is to make sure you have not had large capital gains transactions or mutual fund distributions that you will be taxed on in April. If you have any losses in your portfolio and find yourself in this predicament, consider swapping a loser for a like security in order to offset your gains. This will save you from unnecessarily paying additional taxes next year.
The Formula For Prosperity in 2023 And Beyond
I wish there were a simple formula to make 10% or more without any or little risk, ha! Consider that for most of the commentary that I have read regarding financial markets for next year is terribly negative. The prospect for recession is high. While most Wall Street market strategists are seeing small forecasted gains next year, that’s because most have to if they want to keep their job. But given all of the other largely negative sentiment that is abounding, I find it refreshing, since these people are likely on the sidelines already. Still, we believe that, like 2022, 2023 will require creativity, patience, diversification, and an unconventional approach. On the positive side, for some, we are allocating more aggressively to fixed-income where returns should be much easier. The stock market will again be a stock pickers market rather than blindly investing in a market index. We continue to find great value in alternatives as well. Please call, email, or come see us if you would like to have us review your approach or portfolio. Through our Wealthcare acquisition we now have access to a wonderful software program, the GDX 360, that gives us the ability to match long-term lifestyle and investment goals with portfolio construction and allocation.