Equity and fixed income markets remain quite volatile; as of the 30th of September, the S&P 500 was down roughly 23.7% year to date, with developed market equity indices posting similar losses. Meanwhile, fixed income markets offered little respite, with the Barclays U.S. Aggregate Bond Index down 14.6% over the same period. As we noted a few weeks ago, this is a strange situation, as bonds typically provide a counterbalance in times of falling equity markets. As a matter of fact, one must go back to 1994 to find another 9-month period in which both equity and fixed income indices lost value in tandem. To have both asset classes lose significant value over the same period is rare as it is unsettling. To be clear and as we will outline later in this letter, we have taken steps to mitigate this effect in our client portfolios, and this has been reflected in relative performance year to date.
There are no shortage of factors explaining the increased and unusual correlation between equities and fixed income at the moment. Most importantly, central banks around the world appear committed to stamping out inflation by way of tighter monetary policy. This drives up the cost of capital for sovereigns, corporates, and households and typically forces a repricing of risk assets. Whether it is a bond offering regular coupon payments or equity in a business which will not generate profits for some time, rising rates mean investors demand greater compensation to commit capital. The longer-dated the cash flows, the greater the compensation demanded, driving asset prices down. We are already seeing this phenomenon play out front and center in public equity and fixed income markets, as well as in more illiquid private ones.
Raising the cost of capital does not just impact financial assets but also flows through into the “real” economy, encouraging all parties to borrow less and cut back on spending. While this certainly helps reduce inflation, it also has the potential to push an economy into recession, especially if monetary policy becomes too restrictive. This appears to be a risk central bankers are currently willing to take. Indeed, tightening monetary policy to the point of a recession may prove the only way to get inflation under control. While central bankers may be reluctant to count “deliberately engineering an economic downturn” as a policy goal, the fact of the matter is the current policy trajectory in many major economies makes this a real possibility. As such, one must consider that falling asset prices are likely somewhat driven by markets pricing in recession risk, or, at least, a slowdown in global growth.
While we do not wish to delve into every possible factor that may be weighing on asset prices, we would like to explore one scenario that gives us pause. Consider a situation in which central banks around the world tighten policy to such an extent that one or more major economies tips into recession, but this fails to meaningfully tame inflation. Basic economic logic would consider this an impossibility: by all accounts, reduced demand resulting from a recession should bring price pressures under control. However, if the true issue is a question of supply (whether of goods or services), reducing demand may not have the intended effect of significantly reducing inflation.
While some discount the likelihood of such a scenario, we believe that some of the ingredients may well be present. Whether it is the rejiggering of supply chains to optimize for stability over cost or increased negotiating power for labor, we have seen many signs in recent years that supply of goods and services may prove more constrained for longer than expected. What’s more, there is increasing evidence that there may be a dearth of basic inputs into the economy when compared to future needs. Whether we are talking about energy, base metals, or even agricultural commodities, it appears as though the past decade-plus of underinvestment in these spaces may finally be beginning to catch up with the global economy, creating a “molecular deficit” of sorts. This is further exacerbated by a more tense geopolitical climate, which may cut off, or at least shift, the traditional sources for these commodities. Given this backdrop, we would not be surprised by a scenario in which tighter policy brings on a recession, but commodity prices remain buoyant. History would suggest this to be a plausible scenario; of the nine U.S. recessions since the beginning of 1960, six ended with the Bloomberg Commodity Index higher than when the recession began:
This relationship is most consistent during the “stagflation” of the 1970s, a period in which similar supply shocks were encountered, albeit for different reasons. While we are not necessarily suggesting that conditions may exactly repeat that challenging period for the global economy, we do believe parallels may arise. The vague prospect of stagflation redux, though far from an inevitability, likely represents another explanation for the skittishness we have seen in markets recently.
To be clear, we have no interest in being overly negative: it is not our intention to explore these unsettling circumstances and their potential consequences needlessly. Rather, we believe that it is important both to understand what may be driving this market decline and to consider what risks may lie ahead. Such risks are frequently interconnected, making the spectrum of outcomes seemingly quite wide from here. At the same time, we entered this year looking at equity valuations that, in certain market sectors, priced what we saw to be quite optimistic outcomes. Taken together, the volatility we have seen thus far is in some ways unsurprising as these sectors recalibrate to reality, and, given the increased uncertainty about the path forward, are likely to persist. However, it is important to note that this is when the most compelling long-term investment opportunities typically present themselves.
Undoubtedly, allocating capital and managing risk against a backdrop like this is challenging to say the least. That said, we are confident in our positioning of client portfolios, not only in the context of current conditions, but for whatever may lie ahead. As has been the case for quite some time, we remain defensive when it comes to allocating to risk assets. On the equity side, as we noted recently, this has meant owning cash-generative businesses with minimal leverage at undemanding valuations. In many cases, these businesses are beneficiaries of the current inflationary environment, whether through significant pricing power or a connection to solving the “molecular deficit” we previously discussed. Looking to fixed income, though these assets have not provided the typical protection expected during market volatility, our shorter maturity positioning, combined with outright interest rate hedging, has helped at least blunt some of the headwinds faced in this environment. Taken together, when compared to major market indices in both equities and fixed income, we feel that this strategy has served us well year to date, allowing us to approach the current volatility opportunistically.
We would be remiss not to note another facet of our positioning: our elevated level of cash and short-dated fixed income instruments. These holdings obviously reduce market exposure, which has been a benefit so far this year, and higher interest rates mean there is less of an opportunity cost from being positioned this way than in the past. That being said, we recognize that it can be frustrating at times to see capital sitting on the sidelines. This frustration may well be compounded by the dramatic price movements we have seen as of late and has led to the misperception that certain high-profile stocks (fill in the blank) must be attractive at current prices. Unfortunately, the reality is slightly less satisfying: though market valuations have come off their recent highs, many commonly used valuation metrics are still elevated versus history.
Source: Bloomberg (as of 30 September 2022)
Given that we remain of the view that market volatility may persist longer than some believe, it is our opinion that the opportunity set is beginning to become quite interesting, and likely to become even more so over time. As such, we feel it best to stick to our discipline and remain deliberate in the pace of putting new capital to work.
Taken together, we recognize that this is a difficult environment for any investor. Given this, we feel it is of the utmost importance that we keep lines of communication open. As we have requested in the past, we ask that you make us aware of any changes to your financial situation and/or investment objectives that may impact how your portfolio is to be managed, and if you desire any reasonable restrictions to how your accounts are invested. On a more general basis, if you have questions about our views on the market, our current positioning, or where we are beginning to see opportunities, do not hesitate to reach out. We very much welcome the opportunity to share our team’s views in greater detail.
As always, we greatly appreciate your support and trust.