I’m starting to go a bit farsighted, so I had to triple check that both equities and bonds actually finished positive in the month of May of 2022! The old adage that “markets don’t go up in a straight line, nor do they go down in a straight line” rings true once again. Bear market rallies are a frequent feature of sustained market declines.
- Despite this modestly positive recent performance, the sloppy, choppy mess continues in capital markets as investors grapple with a series of challenges driven by tighter monetary policy. This includes a dramatic decline in money supply growth in February and March, outright contraction in April, sustained inflation exacerbated by the Russian invasion of Ukraine and China’s bizarre Covid Zero policy, and recently the more fragile forward trajectory of the economy and corporate earnings.
- Coming into this year, the clear challenge was how significantly both bond and equities would adjust elevated valuations to a new reality of higher inflation and the Fed tightening monetary policy. Importantly, the Fed is not tightening because of Philips curve theory, like in 2017 and 2018, but because of surging real economic inflation. Unfortunately, the adjustment so far this year has been particularly painful for investors stuck in portfolios consisting primarily of equities and bonds (aka 60/40) with the S&P 500 down -12.8% and the Bloomberg Barclay’s Agg down -8.9%…the time for alts is now!
- Given the starting point valuations for the S&P 500 TR (21.2x 2022 earnings) and bonds (10-year Treasury Yield at 1.5%) at the end of 2021, the hangover from spectacular equity returns in 2019, 2020 and 2021 has so far been just three turns of multiple compression (from 21.2X to 18.2X). In comparison, during the benign Fed tightening period of 2017 and 2018, equity multiples briefly compressed five full multiple turns. For bonds, we have only experienced a whopping rise of 1.36% in 10-year Treasury yields.
- Thus, when one steps back and reviews the current volatility in markets and equity bear market behavior, is it really that surprising? We entered this year at the highest valuations since the dotcom bubble era with still exceptionally low interest rates. Markets went from one of the greatest greenlight-go risk-taking environments in history to grappling with a massive and rapid sea change in monetary policy; the highest inflation in 40 years and now the highest probability of a recession since the pandemic. We were due for a “Galactic Mean Reversion between financial assets, the real economy, and labor” and boy are we getting it!
- Despite the pain in 60/40 portfolios this year, until very recently, markets have been adjusting to elevated inflation driving the Fed to provide this guidance: They plan to take the Fed Funds rate to 2.5%–3% and drain up to $95 billion/month from their balance sheet (4.5X in $ amount, 3.7X relative to nominal GDP terms and 2.9X relative to money supply of the last quantitative tightening). All the Fed has actually done so far is hike by 75 bps and drain $51 billion from their balance sheet….so BE CAREFUL!
- The past few weeks, however, markets have started to adjust to the potential for two very different economic scenarios beside a smooth landing where inflation gradually recedes, and the US economy can comfortably avoid recession.
- Scenario 1: In this scenario, inflation remains far stickier and takes multiple years to return to 3%, let alone 2%, as the Fed may talk a good game, but they do not have the will to do what it takes to break the current inflationary cycle now fully embedded in the labor market (also known as a wage spiral).
- Scenario 2: Despite the mighty U.S. consumers’ balance sheet wealth and current hyper tight labor market, the Fed ultimately does whatever it takes to break the current inflationary spiral. This leads to even tighter financial conditions, which cause both businesses and consumers to pull back on investment and spending, and we enter at least a mild recession with declining corporate earnings like the post-dotcom bubble years.
- When we hear experts try to make the argument that these problematic developments are priced in, we shake our heads in wonder at either their overconfidence or naivete. Nothing is ever certain in capital markets and pretending it is can be very dangerous. Put another way, hope is not a highly viable investment strategy. Everything may be priced in, but we wouldn’t bet on it. If we get the sustained inflationary environment, interest rates will inevitably go substantially higher which in turn will lead to more significant multiple compression and duration pain. If we experience a recession, then future earnings will be much lower than expected and we could get further multiple compression into lower-than-expected future earnings. Even if we get a soft landing, bond yields are still way too low for investors to achieve their income goals through vanilla fixed income; and equity multiples are still way too high to have any confidence in future meaningful equity market appreciation anywhere near the past 10, 20 and 30 years.
- In an environment where the economic and market environments have never been trickier or more confusing, following the KISS principle (Keep It Simple Stupid) is the way to go:
- Don’t be a hero: Protecting capital is mission #1 and the potential to generate a mid-single digit return with stable NAV should be chased like an oasis in a desert (Commercial Real Estate Debt).
- High five the Fed: Focus on strategies seeking consistent and stable cash flow with the potential to increase over time as the Fed hikes aggressively.
- Focus on strategies that can potentially take advantage of higher tradable security and private lending yields: Private lending yields lag securities both on the way down and up. Now that yields have risen in securities for a sustained period, private lending yields have finally risen meaningfully as well, which could potentially lead to higher returns over time. Examples include CLOs and Commercial Real Estate Debt.
- Reduce real estate equity risk: After enjoying massive returns for 10 to 12 years in real estate equity investments, investors should at least consider rolling up the capital structure from equity to debt to better protect those gains and mitigate downside. As commercial real estate lending rates rise, it may lead to more return potential for lenders at the expense of equity owners. Try to be on the right side of this cash flow transition.
- Find income potential: If one has an appetite for income and total return but can tolerate more risk and volatility, focus on securities that generate a high dividend yield and trade at a discount to NAV.
- Monetize volatility: Continue to focus on strategies that can monetize heightened levels of market volatility (multi-strategy and tactical asset allocation).
- Fight inertia: Take a few thoughtful steps to manage the current environment.
- Don’t fight the Fed: Lastly, remember that buying dips work well in secular bull markets for equities and/or bonds, but in bear markets, it can lead to substantial capital impairment.
Since economic and market outcomes have arguably never been so broad and the probability of a smooth landing has become uncomfortably low, embrace strategies with attractive income and total return potential, low volatility, low beta and low duration. Embrace alternatives because the time for alts is now!
