Welcome back readers. As we proceed through the 4th quarter of 2022, and into the busy holiday season, we wanted to give you an update on some important developments in the markets.
As we discussed in our last newsletter, higher interest rates and inflation will be one of the largest drags on the on the markets investors have seen for years, and maybe a decade. In 2022 globally, we have experienced negative returns in nearly every asset class, market, sector and industry. Outside of a few areas including oil, natural gas, grains, select minerals and some segments of the commercial North America Real Estate market nearly everything is down, and in the double-digit realm. The once darling North America technology sector is off -30% this year, with nearly half stocks in Nasdaq down -30%. For investors there has been nowhere to hide. The standard 60/40 portfolio, consisting of 60% stocks and 40% bonds is down -15% which is the worst return in decades.
Since the beginning of the year, we have all become extremely familiar with hearing the terms “inflation” and “interest rates” in our daily lives; two terms that had hardly a mention over the previous few year(s). Volumes of books, and entire academic studies, have been dedicated to these two subject matters, so we are in no way going to cover any substantial ground here. But that said, we are going to briefly discuss how interest rates and inflation have deeply impacted markets in 2022 and what we see for 2023 for investors.
Inflation and Interest Rates
Yes, we all see the price increase in our daily lives. From energy, rent, mortgages to a meal at our favorite restaurant. The reasons are debatable, and multiple factors are in play. The Labor Department reported last week that so-called core prices, which exclude volatile food and energy items, rose 0.3% from September, the smallest monthly gain in a year, and by 6.3% on a year-over-year basis, down from 6.6% in September. Investors and policy makers watch core readings closely as a reflection of broad price pressures and as a predictor of future inflation. While recent Federal Reserve data is showing an improvement and or a possible “leveling off” inflation is still way too high for the Federal Reserve. It is important to understand the Federal Reserve has 2 mandates. One is price stability, and the other is job stability. Despite the markets desire, and past misguided interpretations, investors should brace for more Fed hikes to tame inflation. The Fed raised rates in November by .075%, and most likely will raise .50% in December. In 2023, if inflation numbers do not come down substantially, they will increase again. Yes, at some point it will come to an end. Rates have a lag effect, and a pause will be needed to see the impact of raising nearly 500 basis points this year. But, having listened to nearly every word, and speech, by Chairman Powell for last year he has been as clear as anyone can be; he will not stop raising rates until inflation in well under control and in the 2% range. One month of improving numbers will not meet the Federal Reserve benchmark of 2% inflation rate. We still have a way to go.
The Federal Reserve’s tool kit of implementing monetary and fiscal policy is large, but it is blunt. To fight higher inflation the Fed has two hammers. One, tighten monetary conditions, restricting the amount of money it lends to the markets. Second, and primary to reduce inflation is raise short term interest rates. While raising rates cools everything, from lending, borrowing, housing to demand from consumers it has negative side effects of being difficult to measure its results in real time (lag effect). Bottom line investors and markets won’t know when, and if, the interest raise increases will have their desired effect. The Fed is in a race to tame inflation without tipping the consumer and economy into a recession. Federal Reserve does not know if they will achieve this tight balance and Copper River does not know as well. The longer that inflation stays in the higher 6,7 to 8% range the more risk of extreme rate increases and the probability of a soft landing for the economy and consumer diminishes greatly. Investors should remain excessively cautious until we see the recorded inflation numbers come down steadily over a few months, and an official Fed stance taken publicly that they have ceased in their rate hiking campaign. Fed governor Chris Waller said recently that is was too soon to conclude inflation had peaked, and the Fed could end its rate increases; he was quoted as stating “I will not be head- faked by one good inflation report”.
If inflation and higher interest rates have created a bear market, why do we have a rally in October and November?
Stock and bond markets do not move in straight lines. The markets hit an inflated high last December 2021 before the Federal Reserve started raising rates and the world realized we had a real inflation problem. Individual positions, and sectors that make up a portion of one’s “equity allocation” will never price in a straight line. Investors were however lulled into a bit of a false sense of higher and higher returns coming off of 2020 Covid recovery which inflated the market. We are in a Bear Market, without a doubt, but we will see relief rallies inside the market. We have seen 3 of these since beginning of 2022, but we are very wary of over-allocating on these relief “bear hug” rallies as the core problem of reducing inflation and interest rates being held steady has yet to occur.
When will the equity markets will recover?
Advisors, analysts and market pundits have a way of over-analyzing nearly every piece of economic data released. We have been very clear to our investors, and it’s reflected inside our portfolios. This is that a higher than usual allocation to Cash, Private Equity and individual high-quality Bonds has been necessary in 2022. These higher-than-normal percentages should remain until the Federal Reserve pauses its rate hikes. Guessing “when” this will happen, and weighting equities prior to it happening in an attempt to” time” the market is not recommended. Investors make money slowly and or risk to lose it quickly, and large speculations on timing is one way to add excessive risk to a portfolio and suffer large setbacks. With so many indices, stocks and equity sectors down in deep double-digit territory we have lots of places with upside opportunity to start to redeploy cash once we see inflation numbers come down, and the subsequent Federal Reserve follow up of freezing rate increases. Investors need to be patient, but the time will come sometime in next 1-3 quarters.
Understanding returns inside a portfolio
Investors have been lulled into a bit of false security with the strong returns in 2020 and 2021 followed by this year’s correction. Markets coming out of Covid experienced little volatility spurred on by low rates, and governments of the world pumping unlimited funds into their economies. Historically, the S&P 500 average total return annually is at around +7% since 1934. Bonds have been around +3%. Investors need be careful looking at 2022 YTD returns and think something is terribly wrong with the markets. The returns of 2020 and 2021 were nearly double historical averages and the peak of the exuberance came at the end of 2021. Unfortunately, markets hardly ever move in s a straight line. With the current headwinds of inflation and higher rates investors need to show caution. On a bright note, these headwinds will pass at some point and we can begin rebuilding positions to take advantage of a better macro environment.
What areas& sectors are working inside portfolios?
2022 is really a screen of red across nearly all asset classes, indices, sectors, regions and countries. Only a few bright spots exist. These being commodities including; Oil, Natural Gas and Grains. The U.S Dollar is up YTD, and we have allocated a small amount into an ETF tracking the currency. Shorting “U.S Treasuries” has been effective hedge as rates and prices move in opposite direction. Certain parts of the credit market that capture the rising rates inside mortgages and credit have done well. We are starting to see really strong yields in Bonds again which we will cover below. Private Equity (PE) and specifically BREIT from Blackstone has been a real positive standout for our investors with a +9% YTD. Real Estate is holding up for time being. Here is a link if investors want to view those details a bit more. Cash has been a great spot to be in for 2022, and we have cash at a higher % of portfolios than almost at any time before. Globally only commodity producing nations like Brazil and Canada have fared well, but outside few small areas and sectors that can only be weighted in small percentage investors globally are seeing double digit negative returns for the year.
What about bonds? Yes, finally some good news
The equity market(s) have been on a roller coaster over the past 11 months, with a possible rocky landing soon to be determined in 2023. While at the same time the bond market is once again in the green. With the Feds historic rate increases this year comes higher yields, and finally relief for fixed income investors. Given our background and our client’s needs we are a firm that is heavily fixed income focused. With interest rates finally pushing bond yields to an attractive level, we are seeing strong applicability and interest in our individual corporate bond ladders for clients. The bond market has come a long way in past few years in terms of being accessible to the individual investor and transparent pricing. Our buy and hold strategy with laddered high-grade individual bonds are an efficient way to build a resilient asset class inside a portfolio and achieve steady and reliable stream of interest income. We are seeing yields at or near 5% annually on high grade bonds. We will be allocating a larger percentage to this asset class as we come into 2023.
At CRA each investors portfolio is customized based on age, risk tolerance and other individual factors. Being an independent firm, we have the luxury to quickly, efficiently and inexpensively shape a client portfolio to handle difficult macroeconomic events. This has been the case in 2022. It all starts with having designated a proper asset allocation, rebalancing when conditions change, and sector rotation of positions to the account level. Our goal is to aim for Institutional quality portfolio management, and very much what you would see at a leading pension fund, foundation, endowment. Using the best products such as ETF’s and partner managers like Blackstone and Ares for Private Equity we can achieve balance in even the most uncertain conditions.
While 2022 has been difficult, we understand and have managed assets in these types of markets in 2001, 2008, 2009, 2010 and 2020 (covid drop). While the positives have been few and far between this year, investors need realize that with so many great stocks and sectors down their will be tremendous opportunity ahead. We plan to position for these opportunities when we see inflation come into a reasonable place and when we see a Federal Reserve that stops raising interest rates. This situation will come, and we are certainly closer to the end than the beginning. We thank you if you continued reading up to this point and please call or email us at any time. Happy Thanksgiving.
-Team Copper River