Risk markets rebounded off their lows last quarter enabling us to earn back some of the losses endured during the first 3 quarters of the year.  The highest price posted by the S&P 500 was on the first day of 2022 and it was downhill thereafter, declining by almost 20%.  The bulk of the losses landed on technology, but energy investors made money.  There will be lots of talk about this being the worst year since 2008. At the same time, equity levels landed where they began in 2021 and over the past 5 years, stocks have made 5% per year. Such dips happen from time to time – our long term expected returns include this expectation.

What’s surprising is the 10% decline in bonds.  Some would say this means bonds have lost their diversification value.  I would posit that bonds resumed their natural level of interest, or the rates they would have yielded had the Fed and Treasury not actively pushed rates to zero to bolster the economy through the Global Financial Crisis (GFC) of 2008 and the Covid-19 pandemic.  During that time, I concluded that the risk-free cost of capital (indexed by treasury bonds) should have been about 3-4% higher.  We lamented the fact that savers were left with few low-risk options forcing them to take more risk in stocks than the norm.  This affected all investable assets as all risk assets are priced relative to treasury bonds.  Therefore, negative interest rates propagated throughout global risk markets leading to asset bubbles and even the invention of new assets to capture this excess money.  Framing this situation against the proper rate of interest shows us that rather than failing to perform, bonds gave those with wealth a boost to their asset values that lasted 10 years. 

This has turned around, as rates rise the receding tide of money shows who—in Buffett’s parlance—is not wearing a swimsuit!  Bitcoin, NFTs, SPACs, and unprofitable companies suffered the most.  Technology stocks were hit with a double whammy of lower valuations and compressed profit margins from regulation and supply chain issues. 

Looking at our performance last quarter.  Most of our stock allocations beat the S&P 500 resulting in most portfolios “losing less” than their benchmarks for the year.  How did we do it? Our proprietary analytical framework led me to determine that which sectors would outperform, and this paid off.   Looking backward and forward at market returns affects how we feel about them, leading us to frame the narrative as half empty or half full. However, there's a reference point bias that causes us to anchor on the absolute highest value in history as the starting point for our accounting.

Advancing into the new year, I see three big themes for 2023:

1. China Reopening

We expect the Chinese economy to mimic that of North American and European economies’ reopening: a massive outbreak of Covid with consumers coming out of lockdown while facing lower interest rates that causes product demand to spike.  Remember that the prevalence of Covid means a lot of workers might get sick. Accordingly, you will likely see ports backlog and store shelves emptied of necessities as we saw in the US.  Both effects will increase aggregate demand and reduce supply leading to higher prices or inflation in the short run. 

Although China is back, we might never see the level of open globalization we had pre-pandemic.  A rise in nationalism means countries will value home production over imports.  In terms of capital, we see risks to cross border investments.  Normally investors in North American and European counties enjoy a rule of law that is blind to national origin.  For the first time in almost a century, that rule was suspended for certain nationalities based on their domestic politics.  As a response to the Ukraine invasion, G8 governments seized Russian assets such as superyachts, London properties, and investment accounts without any legal process.  Could this happen to Chinese investors as their government raises the idea of invading Taiwan?  We have seen capital inflows into real estate in places like Vancouver, San Francisco, New York, Sydney, and London based on the belief that capital was safe in these countries defined by their adherence to this rule of law and private property rights.  If Chinese investors begin to feel these assets are in peril, they might consider reducing investment in the US and Europe in favor of other parts of Asia or the Middle East.  Consequently, we could see the second largest buyer of US Treasuries recede from the market, pushing interest rates higher. 

2. The Fed’s Ability and Credibility to Respond to Inflation

Recall that a year ago the Fed justified inaction of budding inflation under the wrongheaded belief that it was “transitory” and self-correcting.  Last year Fed officials suddenly reversed this view and being behind, embarked upon the most rapid rate increase in their history.  This pattern of behavior damaged the Fed’s credibility leading many to believe that in response to an imminent recession the Fed will once again abandon their commitment to a 2% inflation target and lower interest rates.  The problem with this logic is that it’s based on the premise of a bursting bubble-led recession, similar to 2000 or 2010.  In contrast, our data foreshadows a modest slowdown which would enable the Fed to remain disciplined in their efforts to squelch inflation and therefore keep rates high.  It is important to remember that the Fed is not raising rates so much as taking their thumbs off the scale and letting rates rebound to their normal levels.  The old normal is the new normal. 

3. Last Year’s Market Rotation Might be Permanent

A narrative counterpart to the idea that interest rates will “normalize” is the idea that when they do, tech will reclaim its place as the market leader.  I would question this assumption.  Bear markets are painful, but also seen as a critical transfer of leadership from one sector to another. 

If we look historically at the US stock market decade by decade over the past 40 years, we come up with the following leaders: 70s: oil companies, 80s: Japanese banks, and 90s: telecom.  What do all of these have in common with today’s market leader?  Once they lose their dominance, they don’t regain it.  Who nowadays talks about Japan Inc., Japanese banks, or telecom?

So how should investors approach a high interest rate, high inflation world?  One thing is for sure, given a mild recession plus inflation, the 2000 and 2008 playbook directing investors to “get out of the market” and hold massive amounts of cash is not an option because inflation harms cash and benefits certain corporations.  Persistent inflation means it's reasonable to assume that sectors raising prices due to inflation are going to start gaining prominence—in economic parlance, they face inelastic demand curves.  Higher inflation could also trigger a decline in the US Dollar.  US Industrials mix their sales across the globe.  Consequently, they are positioned to benefit from dollar weakness as they translate foreign sales back into domestic financial reporting.  At Camelotta, we are “gaming out” the impact of even higher interest rates on all risky asset classes. Lastly, capital flows out of US Dollar based treasury bonds look to benefit your international holdings, especially in the emerging markets complex where we see China plus Andean and South Asian economies whose stock markets appear undervalued. 

As always, we continue our yeo-person’s work, focusing on applying advanced economic analysis to protect and grow our clients’ wealth.

Enter your text here...