LEVATUS Perspective | THE GLOBAL ECONOMY AND MARKETS | Who’s on First?

In the classic Abbott and Costello skit ‘Who’s on First?’ confusion reigns, as meaning is misinterpreted, interrelationships are misunderstood, and impatience exacerbates an already confusing situation. In the current market environment, where the interrelationship between the economy and asset markets has rarely been more complex or more precariously balanced, many market commentators have become entangled in similarly jumbled reasoning. In the note that follows we will drill down to disentangle the elements that matter most in this delicate interplay and discuss which are likely to drive markets around the bases in the months to come.

July 2022

BACKDROP

The first part of 2022 sent global markets cascading lower, with the attack on Ukraine igniting the already smoldering embers of inflation and triggering an acceleration in interest rate increases by global central banks. Rapid fire U.S. Federal Reserve (Fed) interest rate increases sent thirty-year mortgage rates from 2.5%  in the fall, to over 6% as summer arrived. Real estate came under pressure as mortgage rates rose, stock market valuations pulled back sharply and even commodities succumbed to market pressures in the second quarter. 

The destabilizing effect of economic change that unfolds at that pace left almost no place to hide within asset markets. The S&P 500 Index ended the period down 21%, the growth-oriented NASDAQ ended down 30% and world equity markets outside the US declined 18%. The traditional safety of bonds did not provide cover, as ten-year U.S. Treasury bonds ended June down over 10% year-to-date, thirty-year bonds declined over 20%. Even short-term bonds posted a negative 4% return, as the U.S. Federal Reserve (Fed) went into aggressive tightening mode to fight inflation. While commodities offered a bright spot early in the year, they also rolled over as spring turned to summer and recession fears grew.

As is often the case in the early part of market drawdowns, high quality companies were thrown out with low quality companies, as investors sold what they had. While it has been painful to experience the mark down in prices, these quality businesses continue to post earnings and margins that are supportive of growth and have cash that leave them  well positioned to take advantage of the weakened competitive landscape. Markets are experiencing a ‘clearing out’ of the weak. This leaves meaningful room for companies who leverage their relative strength to accelerate into the next phase of growth.

UNPRECEDENTED ECONOMIC CROSS CURRENTS | Portfolio Construction

‘With no historical analogue more humility around your view of the potential outcomes in financial markets is required.’  Stan Drunkenmiller

Stan Drunkenmiller is an investment legend, predicting many of the major market turns in our lifetime. His humility around the current set of economic conditions is telling. Portfolio construction demands that an assessment of long-term outcomes be merged with a fair, data driven assessment of short- and medium-term range of outcomes as well, especially at the extremes. The reason Mr. Drunkemiller says we are without historic analogue is not because many of the elements of current conditions have not occurred in history, but because they have not all occurred at the same time.

While cash is not a typical player within equity portfolios, rare instances during which the range of outcomes is particularly wide, can leave cash and very short-term bonds uniquely equipped to address risk management goals.

What Is the Role of Cash?

Moving portfolio weight to cash or short-term securities is very seldom optimal within the data driven equation of portfolio construction. The math surrounding this is in large part driven by -  the negative outcomes associated with short term trading, the positive data on long term equity returns, and the negative return impact of taxes. Within our asset allocation framework these three factors combine to make significant allocations to cash rare within growth portfolios. Said differently, one never knows when the best days will come, and most frequently they come when conditions feel most dire. Cash faces the high bar reflected below, missing those best days has a very bad impact on outcomes.

Economic cycles come and go and in most instances, holding quality companies is the best course of action for long term investors. With that said, the humility described by Mr. Drunkenmiller points to a fairly unique set of economic and market circumstances that are significant enough to shift the balance somewhat.

Why Cash Now?

With the hurdle for building allocations to cash so high, what does the current higher than normal  allocation to that asset class mean? It means, that the range of potential outcomes remains quite high. It means that bonds have not provided their normal safe harbor in the storm and inflation leaves questions around their future ability to do so.  It means that the unwind of the unprecedented liquidity injected into the global economy over the past ten years is creating unprecedented economic cross currents, that are only now beginning to disentangle themselves.

With that said, the above chart makes it clear that one is not well served by having all their eggs in the cash basket. As discussed in the scenarios outlined below, the range of outcomes has a positive side as well and over time good companies survive economic dislocation and in many cases thrive as they come out the other side. This drives the current balance between quality growth companies and sectors, and our cash/short-term bond allocations.

How Long?

With the strong case for staying invested across the span of economic cycles, the question of when to redeploy the current cash positions and move equity allocations back to target is critical. We expect this transition to begin when the threat of the stagflation scenario diminishes, even if the pressure of a normal economic slowdown still persists. Some coincident indicators will likely be, the U.S. Federal Reserve moving away from interest rate increases, and a reversal in the upward trajectory of consumer inflation expectations.

History tells us that when the buildup of excesses happens over a long period of time, time is required to unwind these excesses. There has never, in history, been a decade-long asset bubble that has deflated in only six months. Even if the market does not go substantially lower from here, it will take more time to heal.  Historically, equity market bottoms occur about six months prior to the trough in economic activity. With that, one of the central questions that arises is, ‘What to do you do with time on your hands?’.

What Do You Do with Time on Your Hands?

Patience is often the most difficult part of successful investing. Over the next six to eighteen months, we expect markets to remain volatile, as data around the probability of the economic scenarios outlined below become more defined. What strategies do we have at our disposal at moments when time must pass for markets to heal?

·         Covered Call Writing Strategy - Use market volatility to your advantage by selling calls against existing positions; earn the premium and maintain positions in quality companies as the time required for market healing elapses.

·         Cash Strategy – Deploy cash and rebalance equity allocations up to target once inflation expectations have hit an inflection point. Market conditions such as these produce exceptional buying opportunities.

·         Rip Van Winkle Strategy – A bit tongue in cheek, but the main point here is that 3% yields are now available on one-, two- and three-year U.S. Treasury bills. With safe assets finally moving off the zero bound, some allocation to short term bills gets you almost halfway to the 7% annual hurdle rate for equities we have discussed. This is not a bad outcome for holding a very safe asset and addressing the ‘time element’ we think is required for the market to fully heal.

·         Tax strategy – Create a tax buffer for future realized gains with tax loss harvesting. Market corrections often push prices down across the board. Within the IRS rules, stocks and bonds sold to realize a loss can be repurchased in the portfolio thirty-one days later, while still maintaining the ability to use the loss for tax purposes. The loss can be used to offset current or future gains with no expiration on when it can be used.

Each of these strategies benefits from a gradual approach that allows for re-assessment of key fundamentals over time. Each has been employed across client portfolios in the past months and we anticipate each will be useful in the months to come.

CURRENT PORTFOLIO SPECIFICS

The selloff in equity markets during the first half of the year pushed prices on even the best companies and most compelling secular growth industries lower. While cash flow, margins and financial flexibility have in most cases remained quite solid, a revaluation of stock multiples has taken prices down. Based on the data, we believe that the companies that play the most critical role in making the economy more productive will re-emerge as market leaders as earnings growth accumulates to raise valuations.

Quality Growth Holdings

The growth heavy NASDAQ ended the first half of 2022 down 30%, a full ten percentage points more than the S&P 500. As interest rates rose, reflecting the uptick in inflation and Fed policy, many growth sectors and industry groups were particularly hard hit.

Portfolio holdings Microsoft and Nvidia provide illustrations of market dynamics in the first part of the year. Microsoft ended the first six months of the year down over 23%, while Artificial Intelligence and computing leader Nvidia declined close to 50%. From a portfolio perspective, we had trimmed back position sizes in both companies earlier in the year. With that said, core positions are maintained because of the extraordinary cash flow, balance sheet and long-term business prospects of these companies. We will look for prices that are low enough to offset the tax impact of sales when re-building positions.

Business strategies that focus on making other companies, industries, and individuals more productive by applying technology and innovation are setting up to lead the next wave of economic activity. This is where we want client accounts positioned. We expect that when an inflection point in inflation is reached, the return to the slower growth economic backdrop will provide additional tailwinds to this group, and that they will thrive in both absolute and relative terms.

This new landscape will be a bit different than the one that existed when we entered 2020, with software companies playing a part but not necessarily the leading role. We expect companies leveraging technology in industry specific ways to shine during the next cycle in markets, and that this stage could last a decade.

In our view, a strategy that tilts toward long-term growth opportunities, even in periods where relative headwinds prevail, is a far superior long-term investment strategy than positioning in lower quality cyclical investments that tend to fall in and out of favor depending on where we are in the economic cycle.

Cyclical and Commodity Sectors

As with cash, cyclical sectors need a particularly high pay off outcome to overcome the negatives associated with the group. The negatives include large ups and downs over the course of an economic cycle, but relatively limited upward progress over time. Short lived rallies and high sensitivity to the economic cycle, make this sector less attractive from a wealth building perspective.

Many commodities are, by definition, the epitome of a cyclical asset. They tend to spike at the end of an economic cycle, just as the economy begins rolling over. Meaning they go up when the economy is hot and then slide lower when the economy weakens. These swings can be quite dramatic, and quite short lived.

The current set of economic conditions is important because these historic patterns (especially regarding commodities) remain true so long as inflation expectations do not become imbedded.  If we are at the beginning of an economic recession, then one would expect commodity prices to roll over and go lower. We have in fact recently seen a rapid decline in the price of copper, wheat, and lumber. However, if inflation remains persistent from this point forward then commodities could play a more prominent role in portfolios.

Funding and Bond Holdings

At three percent U.S. Treasury rates for one-year, two-year and three-year instruments, we are now moving toward a place where bonds can once again begin to fulfill their traditional role in the portfolio; a counterbalance to risk assets that produces some cash flow and frequently go up in price when risky assets are going down. This was not possible when interest rates were at zero. At zero percent, cash became one of the only portfolio hedges that played reliable defense. Inflation is a headwind to bonds fully taking on their traditional roles, but higher absolute rates are a good place to start.

While the speed with which interest rates have risen has been unsettling to markets, rates in absolute terms still have room to go to return to ‘normal’. The transition to a longer-term laddered portfolio in funding accounts has therefore been incremental. With a change in inflation expectations the lengthening of the ladder will become more rapid.

As current portfolio positioning reflects the potential for a range of possible economic outcomes, we remain vigilant in assessing the changing probabilities around each scenario.

RANGE OF POTENTIAL ECONOMIC OUTCOMES

Assigning probabilities to potential macroeconomic outcomes is one approach that is effective in uncertain and unusual economic times. The probabilities themselves are difficult to determine because available models are not equipped to handle the irregularity of the current economic and policy environment. For example, the probabilities of an economic recession in the next year according to widely used models vary from 20 percent to 80 percent. These probabilities change by the week as new data becomes available.  

Rather than begin with a percentage estimate of the likelihood of recession, we present three scenarios that are most often discussed by analysts and market participants. From this starting point, we examine key factors that will influence the likelihood of each outcome. This approach gives us a better lens through which to assess the potential impact to financial markets in the next several years.   

ECONOMIC SCENARIOS

Although there are numerous economic outcomes that could emerge over the course of the next year, we have chosen three that hinge on whether there is a recession in store for the United States and what type of price environment is likely to be associated with economic growth conditions. In terms of defining a recession, a mild recession could see real GDP growth decline 2 percent during a one-year period before recovery. A severe recession could stretch to two years with real GDP declining by as much as five percent.    

MAJOR FACTORS INFLUENCING ECONOMIC SCENARIOS

Given the complexity of a modern economy, there are any number of factors that could push the U.S. economy in one direction or another. We are focused on two factors that we believe are central, and  have been at the center of attention for investors and policy makers, inflation, and macro policy (government policy aimed at impacting macro-economic conditions).

While inflation is generally associated with stresses on one’s pocketbook, the dynamics of it are not easily understood and therefore make its impact on the overall economy and financial markets difficult to predict. This makes policy setting difficult in the best of times. Macro policies are tied closely to the behavior of inflation and their interaction is closely scrutinized by investors especially when inflation falls outside the target range of central banks.   

INFLATION

Inflation has returned to prominence after hovering in the background of economic and financial decision making  for the better part of three decades. The main concern at the moment is when will inflation reach an inflection point and head downward, settling in a new target range acceptable to central banks. There are three forces driving inflation at the present time.

·         Demand both from consumers and businesses plays an important role in determining inflation. During the pandemic and its immediate aftermath high demand for goods helped to rekindle inflation. This has been followed by outsized demand for services as people normalize their lives by returning to travel and entertainment and satisfying other postponed needs. Demand has been facilitated by the ability of people to obtain higher wages and salaries in a tight labor market. This condition is likely to persist even in case of a mild recession, because of unfavorable demographics and a slow rebound in labor force participation. The contractionary side of the demand impulse is often impacted via policy, which is discussed in the next section.

·         Supply has become a crucial factor when determining the outlook for inflation. The shutdown of many parts of commerce during the pandemic did much to disrupt domestic as well as international supply chains, thus placing upward pressure on prices. Logistical problems in the transportation sector had a ripple effect throughout the entire global economy creating nightmares for manufacturing. A whole cottage industry has developed trying to measure the status of supply chains. This situation is showing noticeable improvement. Further progress will likely be tied to progress on staffing and regulatory issues.

·         Commodity and food prices make up a large share of the consumer price index (CPI) in most countries. In the United States food and energy prices represent nearly 45 percent of the consumer price index. While these two components of the CPI are generally viewed as cyclical and subject to volatility, they have also become susceptible to geopolitical risk in the face of the war between Ukraine and Russia. This has added uncertainty to the behavior of inflation going forward and by extension the effectiveness of macro policies. The Ukraine-Russia war is likely to remain a stalemate for the foreseeable future as both sides seem deeply committed to a costly war of attrition. With that said, we have seen wheat prices return to prewar levels as supply from other sources and drawing from reserves has filled the supply gap for now.

MACRO POLICIES

Macro policies have been the subject of inordinate attention since the global financial crisis in 2007-2008. Financial market participants became enamored with the ride-to-the rescue actions of central banks, particularly the Federal Reserve, when any hiccups in markets took place. Such actions in market lexicon became known as the Bernanke, Yellen and Powell ‘Puts’. This approach has become a victim of circumstances in the form of inflation, sending the Federal Reserve on a new course of monetary tightening, unnerving equity as well as bond market participants.

Fiscal policy remained in the background until the pandemic when many traditional elements of demand were sharply curtailed. Fiscal expenditures skyrocketed on par with those during periods of World War II, culminating in direct transfer payments to citizens to increase household consumption. With no new major programs enacted since the dark days of the pandemic, fiscal stimulus from the federal government has been sharply curtailing. It will be important to follow whether the recent uptick in government revenues will cause this fiscal restraint to fade.

·         Monetary policy – in its new tightening phase, the U.S. Federal Reserve has everyone wondering how high interest rates will go. With a less than stellar record in terms of policy timing, there is concern that Fed policy makers could push the economy into steep recession. For its part, the Federal Reserve is extremely concerned that inflation expectations of consumers remain well anchored so that a feedback loop where higher prices begets higher wages does not develop. In addition to raising policy interest rates, the Federal Reserve has discontinued the use of quantitative easing tools which provided liquidity to markets through the direct purchase of fixed income instruments by the central bank. With the Federal Reserve now selling these instruments from its balance sheet, the central bank does not want to withdraw liquidity too quickly as it serves as the life blood of well-functioning financial markets. 

·         Fiscal policy – the pandemic showcased the ability of fiscal policy to stimulate the economy quickly, complimenting and in some cases supercharging the efforts of monetary authorities. However, with the Federal Reserve now working strenuously to rein in inflation by slowing demand in the economy, politicians at the federal and state government levels face difficult decisions on how to administer funding to those most in need while not derailing the intended effects of monetary policy. Closer cooperation between the Federal Reserve and the administration would help in the process of reducing inflation and keeping federal government debt service manageable through low real interest rates.

In our view, the best possible long-term outcome for the economy and financial markets is if the Federal Reserve does not abruptly give up on dedicated monetary policy tightening because of misguided pressure from politicians and market participants believing that inflation will be tamed quickly. History teaches that outsized excesses of the past will take time to heal. In addition, success in avoiding a steep recession will depend on the Fed learning from its own past mistakes in policy timing. On the fiscal side, the best thing that politicians can do in the short legislative window available before the mid-term elections is avoid the passage of half-baked spending programs and tax measures in the name of benefitting the voters.  

RANGE OF POTENTIAL FINANCIAL MARKET OUTCOMES

The stakes for global central banks are clear. Get inflation expectations down with contained economic damage and financial markets can rally. Conversely, if inflation and rates stay high, earnings estimates, price to earnings multiples (PE), and the market will need to move lower. Our strategy framework in the context of this backdrop includes several key guideposts:

·         Lack of historical analogue means we must remain open minded about the range of potential outcomes

·         Additional clarity on the factors highlighted within our economic scenarios above will help determine which path is likely to emerge and steer the direction of financial markets

·         Financial markets will not stabilize until the U.S. Federal Reserve stops tightening and the U.S. Federal Reserve will not stop tightening until inflation turns decisively lower

·         Historically equity markets have done well once inflation trends below 5%

·         With sustained lower inflation, below target equity/growth positions and above target cash/short-term bonds will no longer be appropriate

To put some context to market history, downturns which overlap with recessions have an average decline of approximately 35%  lasting an average of 15 months. This history would indicate we still have further downside to current equity markets.

With that said, the above economic scenarios lead us to a working framework that includes three scenarios for how equity markets are likely to behave. The two economic scenarios that include a recession suggest 10 to 20% further downside in equity market prices. This is derived both from a top-down macroeconomic perspective and a bottom-up stock specific perspective derived from the fair value range of each individual holding. A soft economic landing that is supported by a continuation of the current jobs market, would imply that we are likely within 2 – 10% of a market bottom possibly in the next several months.

History of Bear Markets (1900 – Present)

The Ned Davis chart below, depicting the history of bear markets, provides a framework for thinking about the range of potential outcomes and puts this downturn into perspective. As the chart reflects, the duration of this downturn (black dot) has thus far been relatively short in comparison to others, while the percentage decline is within the low to mid range of history.

Source: Ned Davis Research

Armed with this perspective, market drawdowns such as the one we are experiencing can create exceptional buying opportunities for investors who are properly positioned to take advantage of them. They also create excellent opportunities for the companies in your portfolio to buy innovative new technologies with which to capture the next wave of innovation. Even some industries that seemingly had been left behind can change the trajectory with the right purchase. This requires some cash, financial flexibility, and management with a vision.

Within your portfolio we look to maintain exposure to both those companies that may be the acquirers and those companies that are innovators that can succeed either on their own or as part of a larger company. The common thread is quality management, good cash flow and financial flexibility, capital discipline, and a vision of the future. These companies will come out of this market stronger and well positioned for the coming decade.

THE FUTURE WILL LOOK DIFFERENT

For the moment, there remain many open questions about where the global economy is headed and what impact this will have on financial markets going forward. However, there is clarity on a viable investment framework that depends on the core tenets of our data-driven process for decision making in a shifting policy environment pressured by abrupt changes in economic conditions.

Just as technology cycles are being shortened by rapid innovation, we expect future economic cycles and development to be shortened by the increasing presence of disruptors. These disruptors will be both positive and negative, and infused with urgency by society. The adoption of green energy as the world’s primary source of power will address the negative externalities from climate change, while providing good paying jobs and sound investment opportunities. The reorientation of supply chains will give rise to increased health security and more reliable networks, but at the expense of higher costs of goods and services.

The past sins of unnecessarily low policy interest rates have left us with the disruptor of over indebtedness and the unproductive remnants of misallocated resources. The process of zombie companies being weeded out has already begun. This clears the way for strong and innovative companies to thrive as the world economy grows and changes. The transition to a more realistic interest rate and stable macro policy environment will ultimately provide a firm foundation for investors to invest more confidently in a forever entrepreneurial United States. This reawakening will spread elsewhere in the world offering exciting opportunities to invest in the shared vision of others in the global economy.   

The answer to the original question ‘Who’s on First? ’ is inflation is on first. Once the threat of an embedded inflationary impulse recedes, a return to the more normal rules of the game will return.