April 2023 Market Update: Bank of Charts, pun intended

1. Despite the failure of two large U.S. banks, the equity market rose in March.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), KBE (SPDR S&P Bank ETF in purple), and KRE (SPDR S&P Regional Banking ETF) in orange.

In March, bank stocks experienced sharp declines as three well known banks failed, namely Silicon Valley Bank, Signature Bank, and Silvergate Bank. Silicon Valley Bank had over $200 billion in assets and Signature Bank had over $100 billion in assets as of December 31, 2022.

Over a two-year period ending in early 2022, many banks experienced rapid balance sheet growth and increased interest rate risk to earn a higher return. The spike in interest rates in 2022 led to unrealized losses on securities and loans and damaged the solvency of most banks.

That said, Silicon Valley Bank was an outlier and will serve as a case study on how not to do interest rate risk management.

To the extent the banks do not experience a rapid rise in credit losses, akin to what happened during the Global Financial Crisis of 2008, a banking crisis is highly unlikely. Most banks can access financing from the combination of the capital markets and the Federal Reserve as they deal with the unwind of rapid deposit growth.

Source: Bloomberg

The current decline in bank deposits and corresponding rise in money market fund assets looks like a replay of the late 1970s / early 1980s.

Source: @MaxfieldOnBanks, The San Francisco Examiner - December 27, 1981

2. Certainly, the events of March will lead to higher financing costs for banks. Combined with rising credit provisions, banks will continue to tighten lending standards, creating a headwind for economic growth.

Source: federalreserve.gov

According to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, banks have been tightening lending standards on Commerical & Industrial loans since July 2022. Even more severe has been the tightening the Commercial Real Estate loans.

Source: federalreserve.gov

After a period of decline from the pandemic peak, commercial mortgage loan delinquency rates have started to creep up. The special servicing rate (loans that have been modified due to default) has been rising since mid 2022.

This chart shows delinquency. special servicing, and grace rates for CMBS (commercial mortgage-backed securities).

The delinquent loan rate has started to rise before the outstanding balance of delinquent loans returned to pre-pandemic loans.

3. Despite some signs of stress in the loan market, the high yield debt market remains sanguine. Credit spreads remain below the the highs of 2022, and well below crisis peaks.

4. The yield curve has become more inverted since the beginning of the year, signaling increasing concerns about future economic growth.

Source: treasury.gov, Two Centuries Investments

5. U.S. manufacturing activity is already contracting. Manufacturing output is more volatile than service sector output and typically leads the services sector.

ISM Manufacturing PMI (Purchasing Manager Index)

Source: March 2023 Manufacturing ISM® Report On Business®

New orders remain weak.

ISM Manufacturing PMI: New Orders component

Source: March 2023 Manufacturing ISM® Report On Business®

6. China’s manufacturing activity is rolling over, a surprising outcome given China only fully reopened its economy late last year.

The weakness in both US and China manufacturing activity is concerning.

7. Inflation continues to decline and is currently running at a 6% annual rate after peaking at 9% in mid 2022.

The big unknown is whether the decline in the inflation rate will continue to be symmetric to its rise. We suspect it will be over the next few months, but are concerned the rate will plateau near 4%.

8. A continued moderation in inflation will benefit businesses who have faced declining profitability during the recent two year period of above historical average inflation.

March 2023 Market Update: Waiting Patiently

The title says it all. We are waiting patiently for more data, especially inflation data. Inflation has peaked, but its rate of decline has slowed, and where it settles is what matters most.

1. February was a weak though uneventful month for global equity markets.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

2. Corporate earnings season confirmed businesses are still dealing with cost pressures.

With 99% of S&P 500 companies having reported earnings, year over year revenue growth was solid 6.3%. However, earnings declined 4.6%. Profit margins declined in eight of the eleven sectors. The energy, industrials, and real estate sectors were the three exceptions.

3. The tightness in many segments of the labor market will continue to be a headwind for profit margins. Our bigger concern is the Federal Reserve’s reaction function if inflation remains sticky above a 4% level.

On March 1, Minneapolis Federal Reserve Bank President Neel Kashkari commented, "I think my colleagues agree with me that the risk of undertightening is greater than the risk of overtightening”.

If the Federal Reserve resumes more aggressive monetary tightening, the risk of a policy error will jump and a recession in the near term will be the likely economic outcome.

February 2023 Market Update: Stranger Things (in the U.S. Equity Market)

1. The composition of the U.S. equity market performance in January qualifies as one of the stranger things I have seen in my career.

In January, the U.S. equity market market rose 6.3% (as proxied by the S&P 500 Index). I wasn’t surprised risk assets started the year with a strong upward bounce as the U.S. equity market declined 18.1% in 2022. Nor was I surprised high beta stocks outperformed low volatility stocks after underperforming low volatility stocks by 15.7% in 2022, though the degree of outperformance, by 19.3%, was a bit surprising. Some mean reversion was likely for both the market overall and for underlying equity factors. Risk on.

What was “Upside Down”, given the aforementioned mean reversion in both the overall market and high beta vs. low volatility, was the lack of mean reversion in the performance of growth stocks vs. value stocks. Growth underperformed Value by 1.4% in January after underperforming by 24.2% in 2022. Pure Growth did even worse on a relative basis, underperforming Pure Value by 7.9%.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance in January 2023, using the S&P DJI factor methodology.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance for the calendar year 2022, using the S&P DJI factor methodology.

Even stranger was the growth vs. value performance when considering history. Value stocks typically underperform growth stocks in risk on markets. January 2023 was definitely an anomaly, especially for pure value vs. pure growth. A supernatural force at work?

Source: S&P Dow Jones Indices LLC.

2. January was a banner month for all major asset classes.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), GLD (SPDR Gold Trust ETF in dotted yellow), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in dashed light blue), TLT (iShares 20+ Year Treasury Bond ETF in dashed light blue) and IEF (iShares 7-10 Year Treasury Bond ETF in dashed red.)

3. Inflation as measured by CPI-U may be moderating, but businesses are still dealing with cost pressures that have resulted in earnings declines despite revenue growth.

With 50% of S&P 500 companies having reported earnings as of February 3, year over year revenue growth is estimated to be a modest 4.3%. However, earnings are estimated to decline 5.3%. Only the energy, industrials, and real estate sectors are showing both revenue growth and earnings growth.

4. The paths forward for the U.S. equity market and the U.S. economy remain encased in heavy fog, a view introduced in last month in our 2023 year ahend outlook commentary.

From my perspective, the two debt market charts below encapsulate the divergent messages being sent to investors.

The Treasury yield curve remains inverted, and is even more inverted than it was at year end. Interest rates, via the inverted yield curve, are signaling economic weakness and maybe even deflationary pressure is on the horizon.

Source: treasury.gov, Two Centuries Investments

On the other hand, the credit markets remain sanguine. High yield credit spreads fell 51 basis points in January, are 120 basis points below their most recent peak at the end of September, and are 169 basis points below their 2022 peak in early July.

Credit markets are signaling the U.S. economy is weathering the large and rapid tightening of monetary policy.

If credit markets are correct, the question will become at what level inflation settles. If the level is too high, the Federal Reserve will likely be forced to resume more aggressive monetary tightening. The risk of a policy error and an ensuing recession would become likely.

At this stage, we are monitoring for economic and financial market data for clues.

January 2023 Market Update & Year Ahead Outlook: Credit Risk Takes the Wheel

1. Inflation risk and interest rate risk drove financial market performance in 2022, not just for bonds, but also for stocks.

In its November 3, 2021 statement, the FOMC asserted “…Inflation is elevated, largely reflecting factors that are expected to be transitory.” Inflation, as measured by CPI-U, proved less transitory than the Fed thought, rising an additional 3.6% from 5.4% to a peak of 9% in June 2022.

In 2022, the FOMC raised the target range for the Federal Funds Rate by 425 basis points to 4.25% - 4.50% in an attempt to dampen inflation.

Source: Forbes Advisor

For the first four months of the year, the Treasury yield curve steepened, signaling continued Fed rate increases, higher inflation, and a shift in demand for Treasuries relative to the supply of Treasuries. In the back half of the year, the yield curve flattened and finished the year slightly inverted, signaling slower economic growth on the horizon.

Source: treasury.gov, Two Centuries Investments

Because of their higher interest rate sensitivity (higher duration), long maturity Treasury portfolios experienced large declines, in the neighborhood of 30% drawdowns.

This chart shows the price performance of IEF (iShares 7-10 Year Treasury Bond ETF in purple) and TLT (iShares 20+ Year Treasury Bond ETF in blue).

The long duration equivalent in the equity market, namely growth stocks, declined by a similar percentage, also near 30%, as measured by the performance of the Russell 1000 Growth Index. The growth stock headwind dragged down the performance of the U.S. equity market, with the S&P 500 Index barely avoiding a 20% drawdown for the year.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), and IWG (iShares Russell 1000 Growth Index ETF in blue).

2. As we enter 2023, inflationary pressures are moderating. Interest rates for longer maturity Treasuries are likely approaching a peak.

Global supply chain issues have lessened, especially in the global shipping network. The prices of many goods are falling as the pandemic induced demand bounce has ended. Shipping container rates have plummeted towards pre-pandemic levels.

Source: Flexport

Prices have fallen rapidly for used passenger vehicles and computer hardware as previously spiking during the pandemic. Housing rents are rolling over, though the impact has yet to appear in the shelter cost component of CPI-U. The housing market faces the headwind of higher mortgage loan interest rates. Food price increases have likely peaked and energy prices have fallen, though we would caution against expecting further energy price declines.

With inflation moderating and no large tailwind for real economic growth, we suspect interest rates are approaching a peak.

3. Service sector inflation and wage pressures, along with de-globalization trends, will likely put a higher floor under inflation in the near term.

The labor market remain tight, largely due to the supply side. In particular, many older workers left the labor force during the pandemic and are not expected to return. The number of unemployed persons per job opening is at a low level relative to both recent history and the entire post World War II period.

Geopolitical tensions, especially with China, mean supply chains will be adjusted, resulting in higher costs. In addition, the massive influx of low cost Chinese labor into the global economy is over. China’s population has likely peaked. Wages in China have risen significantly over the last decade.

4. While U.S. equity market valuation multiples have contracted, the market is facing profitability headwinds due to higher expenses.

Much higher labor, materials, and equipment costs have reversed the trend of increasing operating profit margins. Higher interest expense and higher taxes will be additional headwinds to net income margins and earnings per share growth.

Source: spglobal.com, Two Centuries Investments

Non-US developed markets equities and emerging markets equities appear more attractive. Europe is facing energy related cost pressure due to the Russia-Ukraine conflict and China is facing a real estate crisis as it emerges from its zero-Covid economic activity restrictions, but valuation multiples outside the U.S. embed a lot of bad news already.

Source: Yardeni Research

5. The path forward for the U.S. equity market is encased in heavy fog. We suspect the path will be inseparable from the path of credit risk.

The heavy fog is due to several factors.

• The new floor for inflation is impossible to predict.

• The lagged effect of a sizable and rapid tightening of monetary policy on economic activity is difficult to predict.

• The Fed’s reaction function is difficult to predict as the Fed balances inflation risk vs. recession risk.

• China’s new trend line of economic growth is difficult to predict.

• The damage done to the European economy from the Russia-Ukraine conflict and the accompanying energy crisis is difficult to predict.

If the Fed leans too hard in the direction of crushing inflation, an economic downturn is a near certainty and will manifest itself in rapidly rising credit risk.

On the consumer front, we are monitoring credit card delinquencies. We do know consumers are running down the savings they built up during the pandemic.

Note: Data from July 1, 2012 to July 1, 2022

Credit card balances increased by over 10% annualized in the second and third quarters of 2022.

Source: New York Fed Consumer Credit Panel/Equifax

On the business front, we are monitoring corporate credit spreads, especially for below investment grade debt.

Leveraged loans (floating rate loans for lower quality issuers) experienced over 300 basis points in rate increases (higher interest expense) in 2022.

Source: Eaton Vance, data through September 30, 2022

Higher operating expenses and interest expense are starting to take a toll on some companies as the percentage of distressed loans has increased. However, the percentage is well below crisis levels.

Source: Eaton Vance, data through September 30, 2022

High yield debt spreads have risen 175 basis points from post pandemic lows, but still remain well below crisis levels.

6. Increased credit risk will translate to higher U.S. equity market volatility, even if a recession is not a near term outcome. We suspect the odds favor non-US equities, Treasuries, and gold relative to U.S. equities in 2023. Within U.S. equities, robust business models are the likely winners, with strong and sustained free cash flow growth, strong intangible assets, and / or revenues tied to commodities with structural supply issues.

December 2022 Market Update: Markets Rally, Cryptonite Captivates

1. In November, almost every class exhibited a reversal of trend. Global equities rallied, led by non-US equity markets. Long maturity U.S. Treasuries rose in price and the U.S. dollar declined modestly.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

Year-to-date, equities and long maturity Treasury portfolios remain significantly underwater.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

2. In October, U.S. inflation rate (as measured by CPI-U) fell to 7.7% from September 8.2% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

The moderation in inflation was likely a contributor to the reversal of the trend of asset class performance. If inflation continues to moderate at the pace experienced in October, it will facilitate an earlier end to the tightening of monetary policy.

3. While equity risk, interest rate risk, and inflation risk have hammered asset class performance this year, credit risk remains muted. We anticipate the trend in credit risk will drive financial market performance over the course of the next year.

While high yield credit spreads have risen almost 150 basis points year-to-date as of November 30, the level of credit spreads remains quite low compared to the last 25 years. From our perspective, the big question going forward is whether the combination of inflationary pressures, tighter monetary policy, and economic imbalances precipitate a credit crisis.

4. Is the lack of container ship backlog at the Ports of Los Angeles and Long Beach the proverbial canary in the coal mine?

Source: Freightwaves.com

As we noted late last year and earlier this year, strong demand for goods, supply chain issues, and global shipping network challenges led to an unprecedented container ship backlog at the Ports of Los Angeles and Long Beach. The backlog has evaporated. On November 22 and 23, there were no container ships waiting offshore at the ports.

Certainly, the global supply chain has adjusted as pandemic related economic restrictions have been removed. Certainly, there was a pull forward in demand for goods, so there will be a period of below trend demand. However, the labor, equipment, and warehouse issues at the ports have not been resolved. Thus, our concern is the lack of a backlog may be signaling economic weakness.

5. Credit risk has emerged in a few pockets of the economy. most notably in the cryptocurrency industry. The FTX bankruptcy filing was the latest and biggest outbreak of credit risk in the industry. As with almost every credit crisis these days, the cryptonite was financial engineering.

In last month’s monthly update, I noted “Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.”

Part of the financial engineering revolved around the concept of yield farming, whereby cryptocurrency owners could lend their cryptocurrency and receive a high interest rate, much higher than rate in a commercial bank savings account or the yield on a money market fund.

This concept befuddled me, as cryptocurrencies do not generate cash flows, so it seemed much riskier than traditional securities lending (applied to stocks and bonds).

Many cryptocurrency companies engaged in yield farming also held low amounts of equity capital, i.e., they were highly levered. Commercial banks are required to hold higher equity capital and the banks even have the benefit of access to the Federal Reserve’s discount window.

In addition, the so-called cryptocurrency exchanges did not operate like traditional stock, commodity, and derivative exchanges, by managing counter-party (credit) risk tightly via daily, and often high, margin requirements.

Lastly, there seems to have been an incestuous relationship between several cryptocurrencies and cryptocurrency companies, meaning the cryptocurrencies and businesses were highly correlated.

Note 1: I am ignoring the allegations of fraud and focusing only on the structural problem of financial engineering, since it relates to my concern about credit risk lurking below the surface of the economy. While frauds can be large, they will be contained. Credit risk in systematic form is the big danger; it is hard to contain.

Note 2: Not all cryptocurrency industry players engaged in financial engineering, as some act as true custodians of customer assets, supported by compliance, risk management, and audit systems.

November 2022 Market Update: WhatsUpp with Financial Markets, META, and Crypto

1. In October, global equity markets rebounded, with the big exception being China, which weighed on emerging markets performance. Year-to-date, equities remain significantly underwater.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

The Chinese stock market was the big outlier, reacting poorly to the outcome of the Communist Party Congress. Chinese Premier Xi Jinping will remain as leader for an historic third five-year term and be surrounded by loyalists in the Politburo. This concentration of power raised the concern China will be less focused on economic growth and more focused on domestic wealth inequality and national security issues. Zero-Covid policy, with associated activity restrictions, will also remain intact.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

Has the sell-off in stocks finally ended? We doubt it for two reasons.

First, we haven’t witnessed the widespread investor despair that typically accompanies equity market bottoms. Second, the Federal Reserve will need to continue to tighten monetary policy to lower inflation to a more acceptable level.

That said, to the extent a credit crisis does not develop, we don’t anticipate anything like the equity market carnage we witnessed in the 2008 Global Financial Crisis.

2. In September, U.S. inflation rate (as measured by CPI-U) barely fell to a 8.2% from August’s 8.3% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

We anticipate inflation in the U.S. to moderate as the demand for goods continues to ease post pandemic. However, labor market challenges, structurally higher energy prices, and supply chain challenges emanating from China will put a floor on the intermediate term range for inflation.

3. US interest rates continued their rise, wreaking havoc on all major asset classes, as the Federal Reserve raised the Federal Funds Rate target by 0.75% in October. The Fed has raised the rate by 3.50% so far in 2022.

Source: treasury.gov, Two Centuries Investments

4. Corporate earnings season highlighted the impact of rising expenses on earnings growth for many companies. Ex-energy, earnings growth will be negative for the S&P 500 for the second consecutive quarter.

As of November 4, 85% of the companies in the S&P 500 had reported quarterly earnings results for the third quarter of 2022. No surprise, the energy sector continues to be the star performer. Notably, the industrial sector also has shown strong revenue and earnings growth. The communication services, financials, and materials sectors have experienced double digit earnings declines, year over year.

While revenues grew 10.5% year-over-year, earnings growth only grew 2.2% as higher expenses lowered profit margins.

Labor cost growth is the primary culprit and is currently running about 200 basis points higher than its pre-pandemic trend.

5. Many companies with seemingly robust business models have performed poorly this year. Below, I briefly discuss the issues facing META, a company which scores highly in the “brand” category of our Focused Quality equity model. I use a discounted cash flow model framework.

META, which owns Facebook, Instagram, and WhatsApp, reported earnings on October 26 after the stock market close. On October 27, META's stock price declined 24%. Year-to-date through the end of October, the stock price had declined 72%. What happened to META, a company which is one the big three, along with GOOGL and AMZN, in the growing and oligopolistic digital advertising industry?

Certainly, higher interest rates have contributed to a higher equity discount rate (all else equal, namely the equity risk premium). This factor has impacted higher growth stocks, which have longer "durations", as more of the cash flows to equity shareholders are further out in the future. GOOGL was impacted similarly. Think of it as a contributor to valuation multiple compression.

The boost in digital advertising during the pandemic has ended. The economy is also slowing and advertisers are reducing all forms of spending. META faced the additional headwind of AAPL allowing iPhone owners to change their privacy settings to limit tracking by advertisers. In other words, revenue growth has slowed.

Higher operating expenses, including higher labor costs, reduced profitability as profit margins declined. Lastly, META committed to maintaining much higher capital expenditures (over $32 billion in 2022) to develop the "metaverse" and expand their artificial intelligence capabilities. There is no guarantee these expenditures will produce anywhere near the high Return on Invested Capital (ROIC) produced by META’s core advertising business.

Comparing 3q2022 to 3q2021...

Revenues declined from $29.0 billion to $27.7 billion.

Net Income declined from $9.2 billion to $4.4 billion.

Cash Flow from Operations declined from $14.1 billion to $9.7 billion.

Capital Expenditures increased from $4.3 billion to $9.4 billion.

“Free Cash Flow” declined from $9.8 billion to $0.3 billion.

In summary, lower revenues, higher operating expenses, and valuation multiple compression hit the stock, like they have hit other growth stocks this year. But two other META specific issues have led to additional underperformance, namely AAPL’s business decision and META’s decision to spend aggressively to build a new business at as time when most companies are spending cautiously due to emerging economic growth headwinds.

6. As I was writing this monthly update, news broke about the failure of FTX, one of the largest cryptocurrency exchanges. While we await more details, I will highlight a few principles, likely applicable to the FTX situation and which we articulate to our clients who are considering investing in crypto.

1) Know the protections available, or not available, with the safekeeping of your assets.

2) Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.

3) Be wary of a financial market exchange that has not subjected itself to the rules and best practices governing public financial market exchanges. In the FTX situation, FTX engaged in a related party transaction with the hedge fund Alameda Research.

4) Research the legal framework and creditor status that will be applicable if an insolvency occurs.

June 2022 Market Update: Waiting for the Fog to Go

Where is the inflation rate ultimately headed? Financial market action during May reflected the lack of clarity on inflation’s future path. Corporate earnings season highlighted the consequences of the government policies that have facilitated higher inflation. Our optimism inflation will moderate is tempered by our concern about a potential energy crisis.

1. The US stock market eked out a small gain in May. Stocks have returned -12.8% year-to-date as proxied by the S&P 500 Index. Higher expenses due to labor and supply chain issues, tighter financial conditions driven by Federal Reserve actions to squash inflation, and burgeoning concerns about decelerating revenues remain headwinds to stock prices.

Before a bounce during the last week of May, US equity prices had declined over 18% from the start of the year.

This chart shows the price performance of SPY (the SPDR S&P 500 Index ETF in blue).

While nine of the eleven equity sectors have negative returns year-to-date, most of the damage has occurred in the consumer discretionary, communication services, and information technology sectors, which have returned -24.3%, -22.3%, and -19.1% respectively. Combined these sectors constituted 51.9% of the S&P 500 Index at the beginning of the year.

This chart shows the price performance of SPY (the SPDR S&P 500 Index ETF in blue), XLK (the Technology Select Sector SPDR Fund in yellow), XLC (the Communications Services Select Sector SPDR Fund in orange) and XLY (the Consumer Discretionary Select Sector SPDR Fund in purple).

2. First quarter 2022 earnings were solid but revealed two big challenges facing most businesses. First, higher expenses are eating into profitability. Second, uncertainty about the composition of demand has made planning and inventory management more difficult. Consumer spending preferences have shifted post pandemic and inflation has constrained budgets for non-discretionary items.

With 97% of companies having reported earnings, S&P 500 revenues increased 13.6% year-over-year. Nine sectors saw revenue growth above 7.5%, an outstanding but likely unsustainable result.

Unfortunately, expenses increased faster than revenues for many companies, so S&P 500 earnings only increased 9.2%, a 440 basis points haircut to revenue growth. In other words, profit margins declined, a result investors are worried will become a trend.

Year-over-year, net profit margins decreased for 50% of the S&P 500 companies. The financial and consumer discretionary sectors experienced the largest declines in profit margins.

Three of the best managed consumer companies, namely Amazon, Walmart, and Target, acknowledged inventory issues, in addition to rising costs. The excess inventory will have to be marked down in price. The composition of consumer spending has shifted rapidly, particularly away from big ticket goods to services, like travel and entertainment. In addition, the rising prices of certain non-discretionary items, especially gasoline and foods, and rising home mortgage rates have put the squeeze to consumer budgets.

This chart shows the price performance of AMZN (Amazon.com, Inc. in green), WMT (Walmart Inc in purple), and TGT (Target Corporation in blue).

3. In May, the ups and downs of the bond market (interest rates and credit spreads) reflected the uncertainty about inflation’s path, the Fed’s potential reaction function, and the implications (recession?) if the Fed backs up its tough talk with substantial interest rate hikes.

The ten-year Treasury yield spiked 23 basis points in the first week of May to 3.12%, representing an 160 basis point increase from the beginning of the year. That pace of increase was unprecedented, was not sustainable, and began to raise fears of monetary tightening induced recession. By month end, the ten-year Treasury yield had settled at 2.85%, just below where it ended April.

Source: treasury.gov

Credit spreads acted similarly to US equities and interest rates, moving rapidly in one direction at the beginning of the month before reversing direction. High yield spreads spiked 100 basis points from the beginning of the month through May 24, before giving back 70 basis points of the rise during the last week of the month.

The combination of rapidly rising interest rates and rising credit spreads has translated to one of the worst historical periods for bond market returns. Even US Treasuries, which outperform during recessions and crises, have generated negative returns. The worst performing segment has been long-maturity Treasuries, often considered the flight to quality asset. Depending on the benchmark, long-maturity Treasuries have generated returns in the neighborhood of negative 20% year-to-date.

A rebound in long maturity Treasury yields was not surprising given the easing of pandemic related economic restrictions, the spike in inflation, and the Federal Reserve’s stated monetary tightening plan, i.e., Fed Funds rate increases and the ending of the asset purchase program. As long as inflation moderates, we suspect most of the increase in long maturity Treasury yields is in the rear view mirror.

This chart shows the performance of AGG (iShares Core U.S. Aggregate Bond ETF in purple), JNK (SPDR Bloomberg Barclays High Yield ETF in orange), and TLT (iShares 20+ Year Treasury Bond ETF in blue).

4. Our big concern for financial markets is energy prices, driven by the current energy supply crisis. In particular, if crude oil prices continue to climb, it may not be possible for the Federal Reserve to put the inflation genie back in the bottle without a severe recession. Even in a non-recessionary outcome, higher energy prices will weigh on corporate revenues, corporate profitability, and company valuations, outside of a small number of energy companies.

The price of crude oil continued its march higher in May.

This chart shows the price of WTI crude oil futures.

The price of US natural gas has doubled since the beginning of the year.

This chart shows the price of US natural gas futures in mmbtu (1 Million British Thermal Units) on the New York Mercantile Exchange.

Higher energy prices (a) feed into food prices, especially via higher fertilizer costs, (b) increase expenses for most businesses, (c) reduce non-discretionary spending for most consumers, (d) raise the cost of global trade, (e) make long term planning more difficult for businesses, thus reducing management’s proclivity for longer-term, productivity investments in R&D, plant, property, and equipment, and (f) arguably raise the cost of capital via higher risk premiums, thus reducing valuations.

Given some time, the US economy and most well-capitalized companies, especially those with valuable intangible assets, can adapt to shocks, including tightening monetary policy. There may be no such thing as successfully adapting to an energy crisis.

Beyond Diversification: An Insightful New Book on Dynamic Asset Allocation

I have just completed reading the 2021 book Beyond Diversification by Sebastien Page (Chief Investment Officer of T. Rowe Price who manages over $200 billion in multi-asset portfolios). It has been a pleasure to read as it blends academic richness with practical application on topics that are important to Two Centuries Investments.

The author did really well balancing rigor, utility, humor and personal meaning - for example by using well placed quotes from his father, while at the same time providing insights from two perspectives, given his background with both quantitative and fundamental investing.

The book is an inside view of how some of the largest asset managers think about total portfolios, often in contrast to the more traditional advisor or individual approaches.

I believe our readers and clients will find many of the concepts either familiar or clarifying, so I highly recommend that you buy the book as well as read the summary below. I have organized and cited various concepts that clarify many of the most important ideas in investing.

I also link to our content where the Two Centuries philosophy aligns with Page’s thinking. For example, the concept of moderate risk portfolio crashes being beyond typical investor’s risk tolerance has really resonated with me. Let’s dig in.

CHALLENGES FACING PORTFOLIOS & INVESTORS

• Risk: Many successful investors create their own definition of risk in order to fine-tune their overall understanding of the primary challenge that can prevent long-term compounding. Our own thoughts on Volatility vs Risk in many ways align to the author’s:

  • “Volatility is not always a good proxy for risk, especially if we define risk as exposure to loss” (pg. 89)

  • “we should put risk at the center of the asset allocation decision” (pg. 212)

• Crash Risk: Two Centuries often talks about failure of traditional portfolios like a 60/40 due to their outsized drawdowns. We agree, as the book title suggests, that traditional diversification does not work because it exposes investors to a loss that “is higher in crisis than what typical investor’s risk tolerance can withstand”:

  • “In financial markets, fear is more contagious than optimism” (pg. 132)

  • “Diversification fails across styles, sizes, geographies, and alternative assets. Essentially, all the return-seeking building blocks that asset allocators typically use for portfolio construction are affected” (pg. 127)

  • “fixed weight asset allocation does not deliver a constant risk exposure. To a certain extent, it invalidates most financial planning advice. Is a 60/40 portfolio appropriate for a relatively risk-averse investor? The answer depends on the volatility regime.

    In some relatively calm environments, a 60/40 portfolio may deliver 5% volatility, which seems appropriate for a conservative investor. However, in turbulent markets, the same portfolio maybe deliver as much as 20% volatility, which seems more appropriate for an aggressive investor, with a thick skin and high risk tolerance” (pg. 95)

• Correlations: One of the main reasons why diversification fails is correlations are not stable over time. Instead, they cluster together and even increase during crash periods, such as during March 2020, which we highlighted in our One Factor World post.

  • “real-world correlations differ substantially from their normally distributed counterparts” (pg. 125)

  • For example, a “25-sigma event (observed in quant factors during August of 2007), corresponds to an expected occurrence … that is 10 times larger than the estimated range for the number of particles in the universe” (pg. 152)

  • It appears that correlations belong to either a low-risk or a high-risk regime. “The idea is that the fat tails (crashes) belong to another probability distribution altogether - the risk-off regime, which is characterized by investor panics, liquidity events, and flights to safety”

  • Using author’s extreme events correlation table on page 126, we estimate that during market sell-offs, the average correlation between 10 most prevailing asset classes (corporate bonds net of duration, real estate, hedge funds, high-yield bonds, MBS, EM bonds, EM stocks, EAFE Stocks, small vs large stocks, value vs growth stocks), rises to 76% from the 7% correlation experienced during market rallies. That’s a huge move!

  • “if we ignore fat tails (crashes), we underestimate exposure to loss and take too much risk relative to investor’s risk tolerance” (pg. 149)

Solutions:

• Dynamic Investing: Our core belief that moderate risk investing is only achievable if advisors and investors accept that risk itself is dynamic and time-varying. This is a core principle of our Dynamic Balanced strategy that explicitly targets 8-9% volatility during rebalances. Page, himself, gives plenty of praise to volatility-managed strategies.

  • “What’s the solution? Managed volatility strategy is designed for that purpose. The asset mix becomes dynamic, but portfolio volatility is stabilized” (pg. 95)

  • “The strategy of managed volatility can be a particularly effective and low cost approach to overcome the failure of diversification (pg. 135)

• Simplicity: Like the author, we believe that simple models are often as good or better than complicated ones that seem to draw more attention:

  • “when I assume that next month’s volatility would be the same as this month’s…this model is perhaps the easiest to implement and…it’s very hard to beat” (pg. 91)

  • “many economists and financial analysts focus on risk models to satisfy their ‘physics envy’ (pg. 89)

• Government bonds: We are often asked why we use long-term treasuries in strategic asset selection and whether this allocation is a concern in a rising rate environment? The author explains the reason powerfully and concisely:

  • “When market sentiment suddenly turns negative and fear grips markets, government bonds almost always rally because of the flight-to-safety effect” (pg. 132)

  • “In a sense, duration risk (i/e treasuries) may be the only true source of diversification in a multi-asset portfolio” (pg. 132)

  • “Don’t blindly assume that rising rates are bad for risk assets such as stocks and credit bonds” (pg. 87)

• Momentum: Our dynamic expected returns for Dynamic Balanced are heavily influenced by recent asset class momentum, which also aligns with the author’s experience:

  • “studies and my own experience suggest that momentum is a useful building block for return forecasting in an asset allocation context, especially when combined with valuation and other signals” (pg. 69)

  • It was a pleasant surprise for me to discover the relatively extensive coverage of our Two Centuries of Price Momentum research in the chapter on momentum. I was especially pleased that Page mentions that, as early as 2013, we ‘warn of increased strategy risk overcrowding’, which we have observed since then in many equity factor strategies (pg. 71)

  • However, in asset allocation, momentum provides a critical and reliable risk protection role because “momentum strategies that sell risk assets in down markets provide left-tail diversification, almost by definition” (pg. 130)

• Yields: In our Dynamic Balanced model, we use bond yields as estimates of expected returns for the fixed income asset class. This aligns with the author’s strong support of this methodology.

  • “For fixed income asset classes, if your time horizon is long enough (3-10 year), current yield to maturity is a reasonable accurate predictor of future return” (pg. 39)

• Gold: Surprisingly, Page does not explicitly discuss gold in the book. However, one of the reasons we allow Dynamic Balanced to tactically invest in gold is because it tends to diversify the bond risk during the“rare scenarios”of unexpected positive changes in inflation and negative changes in growth. In addition, there is the unlikely but possible risk that treasuries will become less safe from credit risk perspective. In sum, gold acts as hedge to the hedge.

  • “Bonds diversify stocks when stocks sell off, but stocks do not diversify bonds when bonds sell off” (pg. 124)

  • “there might be a breaking point in the future. Treasuries could become a risk asset. Beyond their inflation risk, default risk could begin to drive part of their volatility” (pg. 161)

• Optimization: In our model, we utilize a constrained mean variance optimization process, which has been the subject of debate with some calling optimizers ‘error maximizers’. I was delighted to read the author’s support of optimization:

  • “Optimizers are helpful tools if used correctly” (pg. 211)

  • error maximization - a popular critique of optimizers - “only occurs when assets are highly correlated” (pg. 212)

  • “investors endowed with modest forecasting ability benefit substantially from mean-variance approach” (pg. 212)

• Calibration Alpha: Throughout my quant career, I often found untapped alpha in model calibration as well as via model invention. Page validates my experience, stating that calibrating volatility and correlation models can have a larger impact on the outcome:

  • “it’s not always clear how to calibrate the models, let alone questions on the lookback widow and data frequency, irrespective of the volatility-forecasting model” (pg. 112)

  • “perhaps answers to these mundane questions don’t bestow academic merit because they are deemed too basic and self-evident. Or maybe the hard truth is that the answers to these questions matter more than the choice of risk model itself” (pg. 145)

• Conviction: Beliefs are an integral part of any investing strategy. They build conviction and, without conviction, investors will not be able to hold on through market turbulence. Many of the concepts in this blog post represent our beliefs and our conviction that holding on to a dynamic strategy is much easier than staying invested in a static one:

  • “One of the greatest misconceptions on portfolio theory is that it precludes the use of judgement and experience. It doesn’t. It’s right there in Markowitz’s 1952 seminal paper:

  • ‘The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of a portfolio’” (pg. 84)

• The Unexpected: A commonly understood, and as commonly forgotten, insight is that only forecasts that are not already priced-in move the markets. Page often mentions that he compares views to what is priced in:

  • “Survey data may be useful, but they rarely reveal what markets are truly pricing in” (pg. 67)

OTHER USEFUL CONCEPTS:

• Macro: Page agrees that economic factors are better for explaining than forecasting. We also dedicate effort to monitoring and communicating the main macro trends in our monthly market insights blog to help our clients understand the investment context:

  • “with our macro dashboards, we don’t claim to identify causation, which is almost impossible to do given the complex and dynamic nature of how factors drive asset returns. Rather, we merely identify correlations that appear meaningful and leave it to investor to assess causation. Investors shouldn’t build systematic tactical asset allocation strategies based solely on these macro data” (pg. 67)

• CAPE: Although the author is more positive about applying the CAPE ratio to investing decisions than we are, we both agree that practical use of valuation ratios like CAPE is hard:

  • “if we put it all together, CAPE gives us a back-of-the-envelope signal that we shouldn’t ignore, and it’s on the pessimistic side. Despite good track record, the CAPE doesn’t tell the whole story” (pg. 28)

• Factor Investing: Over the past decade we have often predicted and observed that traditional Risk Premia are fading and many factors are only good for risk estimates versus establishing expected returns:

  • “The argument in favor of risk factor diversification is more about the removal of the long-only constraint and the expansion of the investment universe than anything else” (pg. 130)

  • “Unfortunately, there’s a lot of hype around risk factors. Major firms have developed commercial applications and products based on factors. Often their goal is to define factors as “asset classes” to raise assets” (pg. 174)

  • many factors '“help measure risk but they’re not expected to deliver a risk premium” (pg. 179)

• Risk Parity: We both concur that many elements of risk parity construction are very useful, but they are  not the “end all” solutions, especially when tested over the long-run

  • “Though most quantitative investors understand and manage tail risk, it’s not always obvious how risk parity portfolios, most of which are constructed based on volatility, account for non-normal distributions” (pg. 215)

• Active vs Passive: We also concur that blending active and passive investing, rather than being a devotee of one or the other, makes sense:

  • “my view is that there’s a place for both passive and active management in financial markets. Passive investors and stock pickers can happily coexist” (pg. 243)

• Private Equity and Real Estate: In our upcoming paper on comparing long-run asset allocation portfolios, we analyze private asset classes and adjust them for autocorrelation. Page also warns about potentially misleading returns from the private equity industry:

  • “Beware of diversification free lunches in privately held assets.”

  • “Private asset diversification advantage is almost entirely illusionary…reported quarterly returns represent a moving average of the true unobserved marked-to-market returns” (pg. 129)

  • “while quarterly correlation between real estate and US stocks was 29%, it jumped to 67% on a rolling annual basis. For private equity, quarterly correlation was 13%, compared to 85% on a rolling annual basis” (pg. 130)

Interesting Papers that are relevant to us today:

Bond Investing in Rising Rate Environment (2014) by Helen Guo and Niels Pedersen

• Addressing the concern that fixed income is a autonomically a poor investing in rising rates, the authors observe that ‘if rates risk gradually, or if the increase occurs later in the investment horizon, then it takes longer for the reinvestment risk…bottom line is that the impact of rising rates on bonds is both bad in the short run and good in the long run

Long-Term Bond Returns under Duration Targeting (2014) by Marty Leibowitz, Anthony Bova, and Stanley Kogeman

• Providing evidence that it is relatively straightforward to estimate expected returns for fixed income, the authors observe that fixed income “returns have consistently converged toward the initial yield to maturity on the index…historically, the simplest rule of thumb seems to have prevailed: returns have converged to the initial yield to maturity at a time horizon that matches duration…If the time horizon is long enough, it doesn’t matter whether rates go up, down or sideways”.

Practical Issues in Forecasting Volatility (2005) by Ser-Huang Poon and Clive Granger

• Although the complexity of statistical tools has increased, often simple tools work just as well, for example, in this mega study of various risk forecasting techniques, the authors find that “across 93 academic studies, there’s no clear winner of the great risk forecasting horse race”.

Volatility Managed Portfolios (2017) by Alan Moriera and Tyler Muir

• To answer the question about the apparent contradiction between volatility managed portfolios which end up selling equities as their risk goes up and value investing which advocates buying equities when they drop, the authors observe “that expected returns adjust more slowly than volatility. Therefore, managed volatility strategies may re-risk the portfolio when market turbulence has subsided and still capture the upside from attractive valuations”.

Tail Risk Mitigation with Managed Volatility Strategies (2019) by Anna Dreyer and Stefan Hubrich

• Managed volatility strategies are a “fundamentally different strategic, very long-term asset allocation - rather than an active strategy benchmarked to the underlying that can be evaluated quarterly”.

• “Managed volatility portfolios reduce risk taking during these bad times - times when the common advice is to increase or hold risk taking constant…(which) turned out to work well throughout several crisis episodes, including the Great Depression, the Great Recession, and the 1987 stock market crash”

• And one of my favorite quotes: “Warren Buffet once said that if the internet had been invented first, we wouldn’t have newspapers. I tend to believe that if managed volatility had been invented first, we might not have as many traditional balanced funds”

When Diversification Fails (2018) by Sébastien Page and Robert Panariello

• “Full-sample correlations are misleading. Prudent investors should not use them in risk models, at least not without adding other tools, such as downside risk measures and scenario analyses. To enhance risk management beyond naive diversification, investors should re-optimize portfolios with a focus on downside risk, consider dynamic strategies”

• “Many investors do not fully appreciate the impact of correlation asymmetries on portfolio efficiency - in particular on exposure to loss. During left-tail events, diversified portfolios may have greater exposure to loss than more concentrated portfolios”

The stock–bond correlation (2014) by Nic Johnson, Vasant Naik, Sebastien Page, Niels Pedersen, Steve Sapra

• Similar to today’s environment, the authors conclude that “when inflation and interest rates drive market volatility, the stock-bond correlation often turns positive.”

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At Two Centuries, we follow the principle of “Deliberately Different” investing by providing our clients access to dynamic portfolios constructed around these concepts.