When Doves Cry
SUMMARY
For much of the decade leading up to COVID-19, a combination of excellent profitability and some of the least volatile economic conditions in history implied that the U.S. stock market would trade at substantially higher valuations than long-term averages. But now, with economic growth much more volatile and inflation farther from the market’s 2% happy place than we have seen in 40 years, things suddenly look far less comfortable for investors.
– Matt Kadnar, GMO , July 2022
The late, great artist formerly known as Prince released “When Doves Cry” in 1984, and it ultimately spent five weeks as the number-one hit song in the U.S. In the song, he writes, “How can you just leave me standing? Alone in a world that’s so cold? Maybe I’m just too demanding.” In what has been an incredibly challenging year for capital markets, Prince’s lyrics eerily echo the mood of many investors. After benefiting from a 40-year decline in interest rates, capped off by far-above-average gains of 17.8% per year for a traditional “60/40” portfolio (60% U.S. stocks/40% U.S. bonds) for the three years ending December 2021, investors are now faced with the harsh reality of inflation and the terrible toll it takes on the value of financial assets.
It’s not only that investors may have been too demanding, but the pivot by the Fed from one extreme to the other has exacerbated the situation, taking markets from “party like it’s 1999” to being “left in a world so cold.” By any standard, the first half of 2022 has been extremely difficult for markets. Both stocks and bonds suffered historic concurrent drawdowns. Today, stocks are in a bear market, and the economy is clearly slowing. In the most recent GDPNow projections released by the Atlanta Fed, second-quarter GDP growth is expected to come in at -1.2%. This comes on the heels of the first-quarter GDP growth of -1.6%. Real personal consumption expenditures have also slowed to 2.1% year-over-year amid signs that consumers are starting to overextend themselves. Revolving consumer credit increased at an annual rate of 19.6% to an all-time high at the end of April (the most recent data available). It appears that consumers, squeezed by higher prices, are stretching to fund even their reduced spending levels. Wage gains are not keeping pace with inflation; real wage growth dropped to a new low of -3.9% in May relative to the year prior.
The Fed has just begun the process of withdrawing its unusually accommodative monetary policy over the past 13 years. It is attempting to slow demand, cool the red-hot labor market, and hopefully reduce inflation. Recent economic developments suggest the odds of a “soft landing”—a scenario where the Fed is able to cool the market just enough to stop inflation without doing harm to the economy—are too low to bet capital on. As a result, we think investors should still err on the side of patience when it comes to deploying capital. Although stocks and bonds are meaningfully below their record highs, the policy goosed prices of the past few years may have anchored investors to unsustainable levels of economic activity and market prices. In order to get more comfortable deploying more risk in stocks, we would like to see more compelling valuations (lower prices) or enough evidence of a material improvement in the inflation backdrop that would suggest an imminent pivot in monetary policy.
Despite this far-from-optimistic backdrop, there is good news. Lower prices are creating opportunities. Investors can now earn a 2.8% yield on a two-Year Treasury that yielded just 0.1% early last year. Further, the average high yield bond, as proxied by the Bloomberg High Yield Bond Index, now yields approximately 8%, its highest since February 2012. The pain felt today via lower prices (and higher yields) increases the return potential of all financial assets. In the adapted words of the late great Prince, “Dearly beloved, we’re gathered here today to get through this thing called… the bear market.”
2Q, 2022 MARKET REVIEW
The second quarter was unusually challenging in that both U.S. large cap stocks (-16.1%) and bonds (-4.7%) declined together... again!
SUMMARY
LONG-TERM ASSET CLASS RETURNS
Key markets in bear market territory, while inflation continues to run well above “target” exposes the challenge policymakers face
GROWTH, INFLATION & POLICY
Recent oil price hikes and tighter financial conditions have dominated the news. We use approximations of the drivers behind these developments to quantify the twelve-month outlook for CPI inflation in the U.S. and the euro area. In both regions, inflation is projected to ease somewhat but will remain elevated by May 2023.
– Jan Groen & Adam Noble, Liberty Street Economics, June 2022
CPI & PPI
For inflation to moderate in July, MoM CPI change needs to be lower than 0.5% and below 0.9% for PPI
While commodity prices rolling over will help contain inflation, house prices impact the shelter component of CPI with a 12–18-month lag
INFLATION SURPRISE
Inflation Surprise Index has rolled over, but from an extreme level; still surprising forecasts on a global scale, a first since 2008
TIPS-IMPLIED INFLATION
Market-based inflation expectations have eased after breaking out to multi-decade highs; 2-year TIPS-implieds currently at 3.2% vs 4.9% peak
2-YEAR TREASURY VS. FED FUNDS
Watch the Treasury market for policy changes: the 2-year Treasury tells you everything you need to know about pending Fed decisions
RATE HIKE EXPECTATIONS
Fed funds futures expecting peak rates as early as December 2022 and the Fed to start cutting rates again as early as May 2023
MORTGAGE RATES
Current pace of mortgage rate increase is unprecedented, but rates are still manageable in absolute terms
MORTGAGE RATES & HOUSING MARKET
With mortgage rates rising, housing is much less affordable; this will negatively impact pricing, but with a lag
REAL EARNINGS
Since early 2021 inflation has outpaced wage growth, eroding real household disposable income
PERSONAL INCOME
Real Income, excluding government transfers, is still grinding higher; total disposable income, however, has been treading water in recent months
PERSONAL SAVINGS
Savings edged slightly higher in May, largely due to consumer spending from January to April being revised lower
DEBT SERVICE & REVOLVING CREDIT
Consumer revolving credit increased at an annualized rate of 19.6% in April and 8.1% in May, now back at all-time highs
MANUFACTURING & INVENTORIES
ISM Manufacturing PMI has rolled over; retailers have seen a dramatic improvement in inventories; employment contracting in both sectors
ISM services has also rolled over but in much healthier shape as consumer spending shifts from goods to services; employment contracting in both sectors
GDP & INFLATION
Stocks and bonds declining together reflects markets adjusting to the growing likelihood of stagflation—slowing growth with elevated inflation
TRANSIT ACTIVITY
Travel, proxied by TSA throughput, is back to pre-COVID levels, while work-from-home dynamics appear to be here to stay
ENERGY PRICES & APPROVAL RATING
University of Michigan Consumer Sentiment now at an all-time low
MIDTERMS
Looking ahead to November, the race for Senate control will rely on a select few toss-up states
RUSSIA VS EUROPE
At the onset of the war, both Russia and Europe were “losing”, Russia now seems to have upper hand; Ruble has appreciated 45% vs Euro since start of the year
EQUITY
Regardless of what part of the cycle we are in, we remain fully in the camp that earnings are like gravity and prices eventually accrue to wherever the earnings are going. However, to us, there is no doubt that the prior cycle’s extraordinary monetary impulse helped to spur “confidence” and support for all things “disruptive” regardless of the durability of the earnings (or, in many cases, a hope of distant earnings to come).
– Rajiv Jain, CIO GQG Partners
MARKET RETURNS SUMMARY
Despite dropping into bear market territory, U.S. stocks have outperformed their international peers over the last year; emerging markets have outperformed YTD
SECTOR RETURNS
Tech, communication services and consumer discretionary have been hit hardest in the sell-off, but have bounced most since the start of Q3
EARNINGS
Analysts are expecting 2022 earnings growth of 9.9%
S&P 500 VALUATIONS
Forward equity valuations have come in substantially due to sell-off but are roughly average relative to history; focus now shifts to actual earnings
VALUATIONS VS FORWARD RETURNS
Forward P/Es have no predictive power for one-year forward equity returns, but have been reasonably predictive over longer time horizons
S&P 500 VALUATIONS
Trailing equity valuations are still above long-term averages, despite strong earnings growth and current bear market drawdown dramatically helping valuations
VALUATIONS
Valuations continue to contract so far this year
VALUE VS GROWTH
Growth equity prices still not supported by earnings
EXCESS RETURN CYCLES
Manager excess returns tend to go through cycles driven by investor sentiment
SALES & EARNINGS GROWTH
Sales and earnings growth expected to decelerate but remain healthy in 2022; impact of inflation and further Fed tightening huge wild cards
SPRINGTIDE EQUITY SENTIMENT COMPOSITE
US equity sentiment has rebounded to 33.1% from 12.8%, the lowest level since the GFC; extreme low readings have historically been good buying opportunities
SPRINGTIDE EQUITY SENTIMENT COMPOSITE
Average forward returns have been significantly higher when composite reading <30%; short-term range of returns however remains unpredictable
EARNINGS VS INFLAITON
Historically, inflation has been a significant issue for the stock market when it is above 4%, even more so when above 6%
CONSUMER SENTIMENT VS CONFIDENCE
Historically, when Consumer Sentiment is at extreme lows relative to Consumer Confidence, U.S. equity performance has been poor; currently at record lows
S&P 500 MOVING AVERAGE
The percentage of stocks trading above their 200-Day M.A. crossed above 15% (currently 16.4%); previously moves back above 15% have provided good buying opportunities
S&P 500 EQUITY RISK PREMIUM
A loose correlation exists between the S&P 500 equity risk premium and 1-year forward returns; S&P 500 equity risk premium currently at 3.0%
HIKING CYCLES & RETURNS
Can’t rely on averages when evaluating what the yield curve inversion means for markets; fast vs. slow hiking cycles remains the key
HIKING CYCLES & RETURNS
Fast hiking cycles correlate with poor returns following first rate hike; in order to be classified as a fast hiking cycle the Fed needs to hike more than 8 times
VENTURE CAPITAL
Venture valuations remain high while exits are on pace for lowest year since 2016
PRIVATE EQUITY SECONDARIES
Secondaries fundraising activity on pace for a 10-year low
FIXED INCOME & CREDIT
It would be silly to expect every bear market to turn into the Great Depression. It would be equally wrong to expect that a fall from overvalued, to more fairly valued, couldn’t badly overshoot on the downside.
– Seth Klarman, Investor and CEO & President, Baupost Group
MARKET RETURNS SUMMARY
All U.S. fixed income and credit asset classes were down over the quarter; international developed bonds faired the worst, are now down over the last decade
U.S. BOND RETURNS
2021 was 3rd worst year for U.S. bonds since 1989; 2022 is off to a dramatically worse start
TREASURY YIELDS & CREDIT SPREADS
U.S. Treasury yield curve has flattened with parts of the curve inverting; credit spreads have risen sharply over the quarter, but not to crisis levels
SPREADS BY SECTOR
Credit spreads remain at or slightly above median across sectors as a large portion of price declines has been due to the duration component
HIGH YIELD SPREADS
Historically, high yield spreads above 6% have resulted in above average forward returns; high yield spread currently trading at 4.8%
Historically, high yield spreads above 6% have resulted in above average forward returns; high yield spread currently trading at 4.8%
COMMODITIES & THE YIELD CURVE
Collapse in copper/gold ratio—a proxy for the real economy vis-à-vis financial assets—suggests Treasury yields may head lower
TREASURY SPREADS
Yield curve inversion signaling slowing growth; risky assets can generate strong short-term returns post inversion, but playing with fire
GLOBAL RATES
The U.S. bond market remains relatively higher yield, which could help keep U.S. rates somewhat contained
TREASURIES VS JGB’S
The yen has weakened to a 20-year low against the dollar as the BOJ continues its infinite QE; US Treasuries looking attractive vs JGB’s
TREASURY MARKET
The treasury market has been an enabler of increasing deficit spending and debt levels...is it now “fed up”?
REAL INTEREST RATES
The Fed has fallen so far behind the curve that unless inflation rolls over, they will be forced to continue to hike into an economic slowdown, likely recession
TREASURY ISSUANCE
Nearly $700bn in treasury issuance in Q1 reversed to -$23bn in Q2 due to strong revenue receipts; expected issuance of $252bn in Q3
REAL ASSETS
The real energy crisis isn’t even here yet. The U.S. Energy Information Administration forecasts U.S. oil production to average 12.5 million barrels per day for the next 30 years. This is all but impossible. Shale will likely tip into terminal decline in about five years as the main shale plays run out of locations. Unfortunately, by then, most of the individuals with incumbent knowledge about offshore and international development will have retired. The brain drain in the industry will create a real and much larger crisis in the mid-to-late 2020s.
– Dallas Fed Oil & Gas Survey, June 2022
MARKET RETURNS SUMMARY
Commodities and gold outperformed in the second quarter; U.S. REITs have struggled along with stocks and bonds given rate increases
OIL PRODUCTION/CONSUMPTION
Global oil production outpaced consumption in Q2 for the first time since Q2 2020
U.S. OIL PRODUCTION
U.S. oil production continues to deal with major supply chain disruptions
OIL & NATURAL GAS
Oil and natural gas producers have been cautious to bring rigs back online despite rising prices
National average gasoline prices are down 11% since peaking at over $5/gal in June, with more room to fall as crack spreads come down; crack spreads are down >40% from peak
YIELDS
Midstream distribution yields trending lower but remain relatively attractive, free cash flow yields of energy sector remain attractive
REITS
REIT yields may be currently attractive on a relative basis, but in keeping perspective they are at the lowest absolute levels in history
GOLD MINER FUNDAMENTALS
Gold miner performance starting to catch up to fundamentals, the industry has seen broad deleveraging and improved cash flow
GOLD FUTURES POSITIONING
Spec positioning in gold futures suggests markets are nearing capitulation, which has generally resulted in above-average forward returns
OPPORTUNISTIC
It’s good to have a view but it’s also good to be aware that you might be wrong. There might be things going on that we won’t know about for many years to come.
– David Harding, Founder & CEO, Winton Capital
MARKET RETURNS SUMMARY
Closed-end funds continued down a further 12.3% during the second quarter while global macro returned 2.4% for the quarter
MONETARY POLICY & GLOBAL STOCKS
Global quantitative easing efforts supported the recent gains in global stocks; Fed, ECB and BoJ combined 12M change in assets declined for the first time since 2019 in June
CEF DISCOUNTS
CEF discounts narrowed slightly from -7.2% in May to -6.8% in June
HIGH BETA 6040 VS GLOBAL 6040
“High beta 60/40” (Tech/junk bonds) sold off more than traditional 60/40, will bounce now bouncing more off the lows
ASSET ALLOCATION
Despite this far-from-optimistic backdrop, there is good news. Lower prices are creating opportunities. The pain felt today via lower prices (and higher yields) increases the return potential of all financial assets. In the adapted words of the late great Prince, “Dearly beloved, we’re gathered here today to get through this thing called… the bear market.”
– SpringTide Market Commentary, June 2022
STOCKS & BONDS
2021 was an unusual year for global stocks and bonds, 2022 even more so; again, highlighting the unusual predicament the Fed is in
CMEs (AS OF 6/30/2022)
Expected 10-year returns for equity and credit assets rose substantially as riskier assets sold of while yields rose modestly
CMEs
Sizable improvement in 10-year returns with a smaller improvement in longer-term as the mean reversion of higher valuations is distributed over a longer time frame
APPENDIX 1 : ASSET CLASS DEFINITIONS
ASSET CLASS BENCHMARKS
Asset class performance was measured using the following benchmarks:
U.S. Large Cap Stocks: S&P 500 TR Index
U.S. Small & Micro Cap Stocks: Russell 2000 TR Index
Intl Dev Large Cap Stocks: MSCI EAFE GR Index
Intl Dev Small & Mirco Stocks: MSCI EAFE GR Index
Emerging & Frontier Market Stocks: MSCI Emerging Markets GR Index
Global Stocks: MSCI ACWI GR Index
Private Equity: Cambridge Associates U.S. Private Equity
Venture Capital: Cambridge Associates U.S. Venture Capital
U.S. Interm-Term Muni Bonds: Bloomberg Barclays 1-10 (1-12 Yr) Muni Bond TR Index
U.S. High Yield Muni Bonds: Bloomberg Barclays High Yield Muni TR Index
U.S. Interm-Term Bonds: Bloomberg Barclays U.S. Aggregate Bond TR Index
U.S. High Yield Bonds: Bloomberg Barclays U.S. Corporate High Yield TR Index
U.S. Bank Loans: S&P/LSTA U.S. Leveraged Loan Index
Intl Developed Bonds: Bloomberg Barclays Global Aggregate ex-U.S. Index
Emerging & Frontier Market Bonds: JPMorgan EMBI Global Diversified TR Index
Public BDCs: S&P BDC Index
U.S. REITs: MSCI U.S. REIT GR Index
Ex U.S. Real Estate Securities: S&P Global Ex-U.S. Property TR Index
Private Real Estate: Cambridge Associates Real Estate
Commodity Futures: Bloomberg Commodity TR Index
Midstream Energy: Alerian MLP TR Index
Gold: LBMA Gold Price
Long-Short Equity: HFRI Equity Hedge Index
Global Macro: HFRI Macro-CTA Index
Relative Value: HFRI Relative Value Index
Closed-End Funds: S-Network Composite Closed-End TR Index
Insurance-Linked Securities: SwissRe Global Cat Bond TR Index
Digital Assets: MVIS CryptoCompare Digital Assets 25 Index
Cash & Cash Equivalents: Bloomberg Barclays U.S. T-Bill 1-3 Month TR Index
U.S. Short-Term Muni Bonds: Bloomberg Barclays Municipal 1-3 Yr TR Index
U.S. Short-Term Bonds: Bloomberg Barclays U.S. Agg 1-3 Yr TR Index
U.S. 60/40: 60% S&P 500 TR Index 40% Bloomberg Barclays U.S. Aggregate Bond TR Index
Global 60/40: 60% MSCI ACWI GR Index 40% Bloomberg Barclays Global Aggregate Bond TR Index