“Of all the hardships a person had to face, none was more punishing than the simple act of waiting.” ─ Khaled Hosseini, A Thousand Splendid Suns
As eventful as 2022 was, you could call it a year of waiting. Investors eagerly awaited each month’s inflation numbers, the Fed’s next interest rate increase and comments to the press, as well as many other highly anticipated developments. But there was a much bigger waiting game going on. Simply put, many investors were – and still are – waiting for the economic and market environment to revert back to what many of us have experienced most of our adult lives (and for young people under 30, their entire lives): low inflation and low interest rates amid unconstrained and expanding globalization supported by easing fiscal and monetary policies. The market results in 2022, however, speak to the sea change that has likely started to take place, potentially moving us into a new market regime. The long-term implications for investors are not yet clear, but the forces driving the change in macroeconomic variables seem to be long-term. COVID-19 revealed fissures in “just-in-time” global supply chains; Russia’s invasion of Ukraine has transformed these fissures into national security risks (not to mention the increasing risk of China taking action to absorb Taiwan). This has likely ushered in an era during which the political and economic connections between nations become more polarized as the “peace dividend” fades.
- Because of geopolitical, demographic, and economic trends, we appear to be transitioning to a new market regime defined by regionalization, higher inflation and higher interest rates vs. what we have been used to during the past decade (although not high by historical standards).
- The implications for the markets are significant but not to be feared as much as the press would lead you to believe: Fixed income is regaining its role as a lower-risk income generator; Equities should continue to provide a hedge against inflation through growth in earnings and dividends.
- This environment is well-suited for long-term investors that do not need to sell into market weakness. Because market regime change often takes years to manifest amid great uncertainty, we will be evolving our portfolios to enhance diversification and take advantage of opportunities as they arise.
Dwindling Peace Dividends
Starting in the early 1990s, lower military spending due to the end of the Cold War was termed “the peace dividend.” And in fact, defense spending as a percentage of U.S. GDP has been almost halved since 1989 to 3.5%, with Europe’s allocation remaining much lower. We would argue that the “peace dividend” defined a world without the ominous threat of world war, allowing for a dramatic expansion in free trade and the globalization of supply chains, integrating the world economy and helping to drive down inflation. These trends appear to be reversing course, as countries have become aware of the national security implications of global interdependencies.
How this era plays out remains to be seen. Increased geopolitical tension is likely to affect where and how goods are produced – domestically (onshoring), closer to final distribution (near-shoring) or in allied countries (friend-shoring). Resulting shifts in production may keep inflation higher than it has been in the past decades. Additionally, the ramp-up in defense spending, especially by Western economies, could lead to more government borrowing, keeping interest rates higher than what we have become used to in recent decades.
On top of geopolitically induced changes, there are underlying factors that could keep inflation, and by extension interest rates, higher for longer (although not necessarily above historical standards): an aging/retiring workforce in developed economies; slowing growth in China; higher energy and other input costs in Europe as they decouple from energy dependence on Russia; the global energy transition to cleaner energy; and much less support from U.S. monetary and fiscal policy.
While all of this sounds ominous — and to some extent, the world has become a riskier place — we posit that the previous market regime could have been the aberration and that we are returning to a more normal time less distorted by the artificial stimulants of fiscal and monetary policies and probably more favorable, as a result, to skilled investors. What’s more, new market regimes (despite the turmoil and the pessimistic headlines) tend to bring with them innovation, new positive trends, and opportunities. If you open the aperture of time, it would be difficult to argue that society is worse off today than it was 100 years ago — with the exception being the state of natural resources and the planet. Transitions like these take time, and the new risks and opportunities they create can take a while to become evident. We expect evolution (not revolution) in our portfolios as we diligently explore ways to benefit from the change ahead.
What is Normal?
By the end of 2020, $18.4 trillion in global government debt had negative rates: the lenders were paying the borrowers! Is this normal? As of Jan. 5, 2023, negative yielding debt was down to $01, which makes more sense. In equities, five big tech companies comprised 23% of the S&P 500’s value on Dec. 2021, and U.S. equities represented ~60% of world equity market capitalization — likely not normal. From a geopolitical perspective, we could equally argue that the past 30 or so years were an anomaly. Prior to that, the 20th century was studded with regime-changing events: two world wars, the oil crisis in the early 1970s, and the dissolution of the Soviet Union in the late 80s and early 90s.
What Happened in 2022?
2022 was a year for the record books. All told, approximately $35 trillion of wealth was wiped out (at least on paper), with equities accounting for about $25 trillion and the global bond market nearly $10 trillion — equivalent to about one-third of world GDP.2 The Dow, filled with lower-valuation equities, was the “winner,” dropping only 9%, while the tech heavy Nasdaq sank 33%. The S&P 500 lost over 19%, its worst year since 2008, with only one stock managing to end at a record high (Howmet Aerospace). Most of the damage (61%) was done by just seven mega-tech stocks (Apple, Amazon, Microsoft, Tesla, Meta, Nvidia and Google), the same group that accounted for 45% of the S&P 500’s returns from the beginning of 2020 to the end 2021. Foreign equity markets weren’t much better as elevated inflation was a global phenomenon, the U.S. dollar rallied strongly on swiftly rising U.S. rates, and persistent COVID-19 and the war in Eastern Europe weighed on markets. High-quality U.S. bonds (as tracked by the Bloomberg Aggregate US Bond Index) were down nearly 15%, their worst year since the index was started 35 years ago. At its lowest, the 30-Year U.S. Treasury bond was down 36%(!), on par with the Nasdaq. This led to traditionally stable balanced portfolios (60% stocks/40% bonds) experiencing one of their worst years in history. Hedge fund strategies were one of the few bright spots, as they outperformed broadly, and in some cases, even contributed positive returns. Real assets also held up, with oil the greatest beneficiary of the tumult in Ukraine and poor weather (+9%), while REITs faced the dual headwinds of rising interest rates and a weaker economy. We would be remiss if we didn’t also point out the turmoil experienced by the cryptocurrency markets. Fortunately, we have not recommended direct exposures to specific cryptocurrencies, while any indirect exposures through blockchain-focused strategies or venture funds were de minimis.
Asset Class Performance 2022 & 4th Quarter
(As of Dec. 31, 2022)
Where Are We Now
Inflation and the Fed’s response remain the most important topic for investors. During 2022, the annualized rate of inflation as measured by the Consumer Price Index peaked at 9.1% in June, was down to 7.1% in November and at 6.5% in December. Inflation does not seem to be spiraling out of control and could surprise on the downside.
In the near to intermediate term, the biggest risks are:
- A policy mistake by the Fed — raising interest rates too far, triggering credit stress and/or liquidity issues here and abroad, or lowering them too quickly, re-igniting inflation
- U.S. recession that is not mild
- Escalation of the Russian invasion of Ukraine
- A dysfunctional U.S. Congress creating turmoil in the markets with showdowns regarding the debt ceiling and federal budget
Index of Leading Economic Indicators
(Nov. 2017 – Nov. 2022)
It appears evident that rising interest rates are cooling economic activity. Future-looking economic indicators continue to weaken, including various consumer and corporate confidence readings, plans for future hiring, and corporate pricing power and revenue projections. Residential real estate, a critical economic driver, saw existing home sales down nearly 40% in November (on an annualized basis), the worst decline since the 2008 financial crisis. A dramatic decline in real estate-related activity can have significant negative impacts on the economy since it not only affects the housing sector, which accounts for about 2.4 million jobs. Other sectors dependent on the real estate market make up approximately 9x that amount in employment, or approximately 21.6 million jobs.3
U.S. Existing Home Sales: Down Dramatically*
Could the markets drop significantly from here? Absolutely. If the most-anticipated recession in recent history is upon us, or imminent, and it becomes protracted and/or deep, a combination of earnings’ declines, corporate margin pressure and compression in valuations could drive markets down, by some estimates another 15-25% from current levels based on historical precedent.
Unfortunately, attempting to step aside due to the risk is highly unlikely to pay off, especially for investors with a long-term perspective. Consider that since Laird Norton Wealth Management opened its doors in 1967 through 2022, there have been eight bull markets and eight bear markets – a nice symmetry. However, that’s where the symmetry ends. The average cumulative gain on the S&P 500 during those eight bull markets was 270% (or about 3.7x your money), while the average decline during bear markets was 36%. Additionally, the average bull market lasted 4.5x longer.4
S&P 500 Performance
(1967 – 2022)
What This Means for Portfolios
We have updated our view of risks and opportunities, adding more opportunities than when we rolled this out in 2022. After an era when seemingly anyone could put money in virtually any index and see it gain in value, skill (while always important) should become even more so for both corporate executives and asset managers. Our focus will continue to be on sharpening our skills to build portfolios that have a blend of indexed exposures to minimize decision risk while owning active strategies in areas we believe are best suited to navigate a different and more challenging economic and market environment.
A notable seismic shift in the opportunity set is the role cash and bonds can now play in portfolios. Bonds are once again playing their traditional role as income generators after years of almost exclusively playing a stabilizing role in portfolios (with the exception of 2022). In the reset toward normalcy, cash in savings and/or money market accounts has once again become attractive. The lure is obvious: low risk, low volatility, and moderate return (although less than inflation for the time being).
Growth of S&P 500 Dividends vs. Consumer Price Index (CPI)
(1960 – 2022)
Taking a step further, both investment-grade and lower-quality credit appear reasonably attractive versus recent history. Since 2017, except for the height of COVID-19 uncertainty, the additional compensation investors received for taking corporate credit risk was well below long-term historical averages.
Today, with “spreads” over Treasuries of 1.3% for investment grade and 4.8% for high-yield credit, these bonds now yield roughly 5.4% and 9.0% respectively, highlighting how the income has returned to the asset class. Additionally, private credit is looking more attractive. Experienced managers in this asset class are well-positioned to define attractive terms with businesses that have strong operating models and in many cases are in defensive sectors.
We have also highlighted public global equities as an exposure that mitigates risk if inflation settles in at a level higher than the 2% Fed target (but not high by historical standards). There are two reasons for this: (1) Owning dividend-paying equities via the broad indices can mitigate the impact of inflation since dividend growth has historically outpaced inflation by a sizable multiple; (2) An environment with higher inflation means nominal GDP can stay elevated, thereby providing a tailwind for nominal corporate earnings and asset valuations.
Supply Chain Restructuring. Given the disruption of the past few years, corporate executives have been compelled to understand their supply chain at a granular level – not just locations and sourcing, but also energy use and how to attract and retain workers. We think this is a big positive. In fact, despite all the headlines bashing ESG and impact investing, we think well-managed companies will, out of necessity, become more resilient, more able to identify and manage their risks, and more efficient at utilizing resources. All of this should be accretive to shareholder value.
New Technologies. Billions in new investment is going into up-and-coming technologies, including clean energy generation and storage, quantum computing, robotics, artificial intelligence (AI) and bioengineering. Related to this, the semiconductor industry is one poised for strong growth over the next decade due to its importance across a broad range of industries as well as the need to ensure supply is protected as part of national security, evidenced by the recent passage of the CHIPS Act to encourage U.S. production.
Sustainability. Whether or not you are a proponent of ESG investing, the investment opportunity set related to the net-zero carbon transition across sectors (such as industrials, building construction/renovation, transportation, waste and agriculture) has considerable appeal. According to McKinsey, the size of the addressable market related to this transition is estimated to generate revenue of more than $12 trillion per year by 2030.5
Infrastructure. Investing in infrastructure looks to be yet another area of opportunity as countries tackle issues associated with restructuring the global supply chain, reducing dependence on fossil fuels, and transitioning to sustainable agriculture. The current rate of investment is expected to continue increasing sizably into the next decade, and yet there is a rising gap between the projected investment and the need for investment, as illustrated by a joint study between Blackrock and the World Bank. Infrastructure also brings diversifying elements to portfolios by being somewhat inoculated from the economic cycle, an inflationary hedging component, and oftentimes an income producer.
Annual Global Infrastructure Funding: Needs vs. Current Trend
(2007 – 2040)
We leave prognostications regarding recession and the duration of the current bear market to the talking heads in the financial media. Instead, we will continue to focus on the ramifications created by the pandemic and increased geopolitical tensions and conflict. While the pervasive narrative now is predominantly negative, history tells a more optimistic story of society successfully innovating, adapting, and ultimately overcoming obstacles in the face of adversity. While everyone is focused on the risks, that’s when we need to be leaning into the opportunities.
Risks and Opportunities by Asset Class
I will end with this: Imagine we could jump into a DeLorean today with Doc Brown of “Back to the Future” and crash land into January 2033. Don’t you think it more likely than not that we would be looking back at the preceding ten years feeling rewarded for having continued to put capital to work during this period of turbulence and uncertainty?
1 Source: “Last bonds with negative yields vanish in latest major market milestone.” MarketWatch.com. January 5, 2023.
2 Source: “Breakfast with Dave.” Rosenberg Research. January 3, 2023.
3 Source: “Updated Employment Multipliers for the U.S. Economy.” Economic Policy Institute (epi.org). January 23, 2019.
4 Source: Laird Norton Wealth Management; Bloomberg.
5 Source: McKinsey Global Institute. December 2022.