Undoubtedly, the past year proved a challenging one for risk assets around the globe. Despite some recovery in the fourth quarter, most major indices ended 2022 with noticeable losses, in some cases the worst since the Global Financial Crisis in 2008. This was certainly true for the S&P 500, which lost 18.1% on a total return basis. Major indices around the world experienced similar drawdowns, and as previously noted, fixed income assets failed to provide their usual safe haven from equity market volatility, with the Bloomberg U.S. Aggregate Bond Index shedding roughly 13% of its value for the year. Simply put, this was a year that offered even the most prudent of investors few places to hide from market dislocations, and even fewer to generate a meaningful real return.
In recent letters, we have noted several of the factors that likely contributed to making this such a difficult year. Obviously, inflation has been a major force weighing on markets for quite some time now. While the price of goods and services had already been rising due to disrupted supply chains and labor markets, the situation was further exacerbated by the Russian invasion of Ukraine, which drove up the price of energy and many commodities, as well as by ongoing pandemic restrictions in China, which further impacted the availability of manufactured goods. Undoubtedly, this forced many consumers around the world to rethink and reconfigure their consumption patterns, and often forced them to defer more discretionary spending. At the same time, many businesses found themselves paying higher costs than ever for inputs (if they could obtain them at all), forcing difficult decisions between passing costs along to customers, or accepting narrower margins. Though the uncertainty all of this creates was on its own enough to impact markets, there were undoubtedly wider implications.
With inflation an issue for consumers and corporates alike, it quickly became clear that central banks around the world had little choice but to tighten policy in 2022 in an attempt to get price spikes under control. That said, it quickly became apparent that many market participants were not expecting how dramatic this monetary policy shift would be, with the Federal Reserve raising base rates the fastest since 1981:
Source: Bloomberg
Indeed, this kind of rapid policy tightening is rare; looking at trailing twelve-month periods where the Fed Funds rate rose, December 2022 ranked in the 97th percentile in terms of size. Given that higher interest rates in general tend to drive down the valuation of risk assets, the moves in rates we encountered over the past year likely help explain a good bit about the pervasive market decline.
Another explanatory factor may be the consequences of these aggressive actions by central banks around the world. Though inflation has shown some signs of ebbing in recent months, policymakers appear committed to maintaining tighter financial conditions, so as to avoid a premature declaration of victory like that seen in the fight against inflation in the 1970s. While this is understandable, it raises the risk that central banks may have to pursue a “tighter for longer” policy, engineering a recession in the process. Though some have referred to this as a policy “mistake”, others believe such a recession may be the only viable way for inflation to be solved by way of monetary policy. Whatever the case may be, it is clear to us that the clear risk of a recession has also weighed on asset prices.
Whether it is elevated inflation, tight monetary policy or the risk of a recession, we would again reiterate that the environment for investors over the past year has taken a decidedly more difficult turn. That said, client portfolios at Drum Hill were able to benefit from several mitigating factors, that in many cases helped blunt the impact of this backdrop. For example, our exposure to the commodity and energy complexes offered a rare bright spot in an otherwise difficult year. Though we are constructive on these spaces from a long-term perspective, the volatility encountered this year benefitted many commodity-related businesses, especially those with a good sense of capital allocation, and helped to offset general market drawdowns. While inflation and central bank policy shifts weighed on bond markets, our fixed income allocations were comprised mostly of low-duration assets complemented by hedges which actually benefitted from rising interest rates. Here too, this positioning was more an expression of our view on rising long-term capital costs, which happened to perform quite well amidst turbulent bond markets. Simply put, while client portfolio positioning helped to offset general market losses, this was not a function of our team picking “winning trades” for 2022, but rather our longer-term views enjoying unexpectedly outsized leverage to the year’s volatility flashpoints.
What’s more, client portfolios also benefitted from a generally defensive positioning throughout the year. While we found some opportunities to allocate capital, the fact remains that most portfolios continue to hold a higher-than-normal allocation to cash and short-term fixed income securities. As we have noted recently, this is certainly unsatisfying, but feel it important to once again note that if history is any indicator, equities, at least in the aggregate, are still not offering any massive bargain at the moment, even after last year’s decline:
Source: Bloomberg
With that said, we are more constructive about finding new opportunities now than we were this time last year. Increasingly, we are seeing businesses and assets that are not only interesting, but also carry valuations that look increasingly reasonable. While we do not wish to make any sweeping predictions about the market, we do believe there is a strong likelihood that volatility will persist in the coming year. This may mean certain industries or assets classes could “go on sale”, and there may be more idiosyncratic opportunities around specific businesses. Though we intend to allocate capital deliberately, we feel we may have a less difficult time finding quality assets at compelling valuations.
Should this be the case, we have set our sights primarily on areas we feel will benefit in the next cycle. Midway through last year, we discussed a number of possible “regime changes” we believe will be important in the coming years: fragmentation of global trade, moderating but persistent inflationary pressures, and a higher cost of capital. While it is difficult to say which, or how, any of these shifts come to fruition, we do believe they create opportunities for investors.
Let us consider the archetypical “winner” of the previous cycle: it was likely a large-cap, U.S.-based technology company with a wide, but not necessarily deep global footprint of operations, that came to trade at a dramatic multiple to earnings (or, failing the ability to generate current profits, dramatic multiple to sales). In a world where globalization is not as strong of a force, one may prefer to be deeply integrated into certain markets and choose not to play in others. Similarly, should inflation moderate but remain elevated, we believe that those businesses which can solve the problem of “just in case” versus “just in time” may become more attractive: producers of tangible resources, or businesses that help conserve them may find themselves enjoying greater profits than in the past, likely at the expense of those reliant upon cheap energy or labor. In such a world, one input we think would certainly be more expensive is the cost of capital. As such, those businesses which are constantly reliant upon external funding, whose profits are uncertain and far off into the future, may not command the valuations they once did. By contrast, those businesses which generate present cash flows, especially if those cash flows can keep up with inflation, may be seen as more attractive. Though some larger businesses certainly fit the bill in this regard, their valuations frequently reflect this, meaning investors may wish to seek out lesser-known businesses with greater room to grow. With all this considered, the next cycle’s “winners” may be decidedly smaller but profitable businesses levered to higher costs of resources (or financing), whose earnings offer some degree of inflation protection.
To be clear, we are not trying to make any type of prognostication about which types of businesses may be “in vogue” among investors in the coming years. Rather, we simply believe that investors may wish to throw away the post-GFC “playbook” of investing, which so frequently focused on a narrow selection of the largest names in certain industries, regardless of their valuation, profitability, or balance sheet health. As fundamentals-oriented investors, we have always sought to purchase quality assets at reasonable prices and believe that others may choose to do the same. Finding such assets, regardless of where one is in a given cycle, is always difficult, but a willingness to go off the beaten path certainly helps.
To that end, we would like to again highlight an opportunity we have seen developing for quite some time now. It goes without saying that U.S. equities were the clear leader of the post-GFC era, benefiting from many of the factors we described above, in conjunction with massively stimulative policy from the Federal Reserve. As it seeks to fight inflation in the world’s largest economy, we believe tighter policy from the U.S. central bank may mean overseas assets begin to look more compelling. We have owned a number of larger U.S.-listed, European-domiciled businesses for quite some time now, mainly in the energy and telecommunications spaces. While these positions have generally served us well, we do believe there may be a further catalyst for foreign equities as investors look further afield for opportunities.
In addition, we see a particularly interesting opportunity in smaller and medium-sized businesses in Europe, where valuations have become particularly disconnected from those in the U.S. Historically speaking, when the discount between smaller-cap European equities and large-cap U.S. equities is this wide, the former tend to outperform in the subsequent years. Having spent several years now getting to know businesses, management teams and dynamics in this region, we believe we have identified a number of quite interesting opportunities which fit in well with our investment methodology. We believe that several of these may, in the not-too-distant future, be included in our existing client portfolios. In addition, we offer a Focused European Value Strategy for those seeking wider exposure to these businesses. It is our intention to send out an update letter on the strategy shortly, which not only will offer a deeper dive into some of the data we have collected on valuation and performance versus the U.S., but also more generally explore in greater depth how we are thinking about the opportunity in Europe. Should you have further questions, we encourage you to reach out.
While we certainly feel the opportunity set is beginning to widen, we would be remiss not to express our belief that this year may prove to be even more challenging than the last. With so many questions about inflation, global growth and the central bank policy reaction to these factors, we would be quite shocked if volatility did not continue to persist. It is worth noting that during these periods of volatility that long-term opportunities typically present themselves when investor expectations become disconnected from fundamental quality. That said, while “volatility” typically refers to movements to the downside in investor parlance, we would not discount the possibility of outsized moves in the opposite direction as well this year, especially if deteriorating economic conditions force the Federal Reserve to pause or even reverse their tightening of monetary policy. Despite the increasingly muddled outlook, however, we believe client portfolios are well positioned as we enter 2023, regardless of what may be in store.
Nevertheless, given the environment, we must yet again emphasize the importance of dialogue in the context of managing your portfolio. If you believe that there is a material change to your financial situation or your investment objectives, it is important that you let us know. Similarly, we also wish to reiterate that should you desire a more in-depth discussion of our views on markets and the opportunities we are seeing, do not hesitate to reach out- we truly welcome the opportunity to share our thinking with you.
We greatly appreciate the support and trust you put in our team and wish you all a happy, healthy and prosperous 2023.