Note: This update is longer than usual but I felt a comprehensive review was necessary.
The Federal Reserve panicked last week and spooked investors into the worst week for stocks since the onset of COVID in March 2020. The S&P 500 is now firmly in bear market territory but that is a fraction of the pain in stocks and other risky assets. Stocks are now down 10 of the last 11 weeks but the pain was concentrated in the last two weeks. 5 of the last 8 trading days have seen 90% of the stocks in the S&P 500 down on the day and there are only 11 stocks in the index up over the last month. Unprecedented is an overused word but not in this case. Last week was also the second week in a row that saw all the major asset classes down on the week. And energy stocks led the way down, getting the correction I talked about last week a lot sooner than even I expected. Crude oil and natural gas were both down hard last week (10.5% and 21.5% respectively) and some other economically sensitive commodities were also down last week (copper, palladium, platinum).
But back to the Fed panic. The Fed has, since the Bernanke years, practiced what it calls forward guidance. This basically consists of telling the market what they are going to do before they do it. They always add the caveat that it depends on incoming data but it takes a lot to change their course once it is set. The Fed had prepared the market for a 50 basis point hike at last week’s meeting with Powell explicitly saying that 75 basis points was off the table. And I think there were – and are – very good reasons for that. The end of the Fed/Treasury MMT/helicopter drop experiment pretty much ensures that inflation will moderate over the coming months regardless of what the Fed does. But the market reaction to the CPI report apparently spooked the Fed and they leaked a story to the WSJ early last week that put 75 basis points back on the table. Actually it more than did that since merely leaking the possibility was tantamount to signaling that course. And on Wednesday they did exactly that and I’m sure felt pretty good about themselves as stocks managed to finish the day higher.
Unfortunately, the celebration of the Fed’s “courage” lasted less than a day and the declines resumed. The Fed thought they could allay investors fears about inflation by raising 75 basis points but instead all they did was raise other fears, now of the Fed doing too much rather than too little. The 10 year Treasury was trading right around 3% but jumped to almost 3.5% by the time of the FOMC meeting. Rates did fall back the rest of the week and closed around 3.24% but the damage was already done. Mortgage rates jumped to nearly 6.25% at one point last week and the housing market is downshifting rapidly. As I said last week, a cooling of the housing market is necessary but slamming on the brakes of an economy is generally not a good idea, as I thought we learned during the COVID fiasco. If rates come back down – and with the economic data continuing to weaken that seems likely – we may avoid a collapse in the housing market but it will be a close call – we need to get some good news on inflation soon.
We seem to have reached the indiscriminate selling part of the bear market. We have maintained a defensive equity posture and a cash cushion (10-15%) dating back to last year and that continues to be the case. But, to take one example of babies and bath water, the Select Dividend ETF (DVY, we own) fell from a nearly 8% gain YTD on June 7th to a 6% loss by last Friday. I suppose it is somewhat interest rate sensitive with 26% in utilities but the fundamentals didn’t really change much, if any, over that two week period. The index now trades for 12.5 times earnings but it wasn’t expensive before the selloff. The S&P 500 value index (IVE, we own) had similar performance, falling from a 3% loss to a 14% loss over the same time frame. The largest holding in the index is Berkshire Hathaway which went from +5% to -10%. I suppose if you’re going to bail on Berkshire Hathaway, you can justify selling just about anything.
Our portfolios are still outperforming on the year but losses have now reached double digits (depending on timing, risk tolerance, etc.; the 60/40 stock/bond portfolio is down 19%) and I am reviewing all of our indicators to see if there is more we should do. It has been a challenging year to say the least but we have continued to follow our process. But losing less than everyone else, while admirable, it not our goal. We aim to make money every year – even knowing that is likely an unattainable ideal in the long run – and we still have half a year to go. I think it would be helpful to review where we are and how we got here.
Interest Rates/Fixed Income
We came into this year expecting the economy to slow. That wasn’t exactly a courageous bet since the growth rate last year was goosed by Biden’s American Recovery Act and an accommodative Fed; neither of those items seemed likely to repeat. Biden’s legislative agenda died in West Virginia. The Fed should have started their tightening last year and everyone knew that except perhaps the folks who run the Fed. Of course, we don’t give the Fed so much credit around here but everybody else does and that is what matters to markets, at least in the short term. So, slowing economy and tightening Fed was the outlook at the beginning of the year. But we faced a bit of a dilemma because it was also obvious (at least to me) that interest rates were going to rise. Our normal response to slowing growth would be to extend the duration of our bond portfolio and if it reached recession proportions, actually reduce risk assets and add more bonds. But if rates are rising that plan is off the table.
We entered the year anticipating higher rates with about 50% of our bond portfolio in short duration bonds (1-3 years) and 50% in intermediate (3-7 years). We shifted our portfolio to a longer duration profile when the 10 year Treasury hit 3%. I believe that was the right choice even though rates have moved modestly higher since but all bond durations are down on the year. We now have 75% intermediate, 12.5% short term and 12.5% long term (7-10 years). Have rates peaked? The fact that bond yields fell after the Fed hike gets me closer to a yes but I’m not there yet. I continue to think there will be a major opportunity to buy long duration bonds sometime this year. Note: We don’t own TLT but included it for reference in the below chart. Being wrong on duration this year has been painful and the wronger you were, the more it felt just like owning stocks. This is why it takes extraordinary conditions for us to buy the very long end.
Commodities and Gold
Rising rates also affected our commodity and gold exposure. We expected real rates to rise and in the past that has not been a positive environment for commodities. 10 year TIPS rates are up from -1.04% at the beginning of the year to 0.67% Friday. That 171 basis point rise is about the same as the nominal 10 year (176 basis points) but is arguably much more important. Positive real rates are actually a positive sign for quality long term growth but it will have to rise more and stay that way for it to really impact the economy. And, in general, what is good for growth is bad for gold.
Our response to rising real rates was to keep our commodity and gold exposure at half our strategic weight. In 2013 the last time real rates rose from negative to positive, gold fell 25% and the GSCI index of general commodities fell 6%. We have positive returns from both this year and a full position would have been more beneficial but we couldn’t justify it based on past experience. We did allow the positions to gain within the context of the portfolio but have more recently been trimming them back to the target (half strategic weight). If real rates start to fall again we will revisit our allocation.
We also came to the conclusion last year that the S&P 500, and especially the growth part of that index, was essentially uninvestable. From meme stocks to SPACs to technology stocks to crypto, speculative fever gripped investors last year to a degree I hadn’t seen since the turn of the century dot com boom and bust. I knew there would be a comeuppance but when was a question I couldn’t answer. By the fourth quarter though we had eliminated our S&P 500 exposure in favor of more defensive positions in Dividend stocks and US and International value stocks. We had and have no exposure to the S&P 500 growth index or NASDAQ index. By the way, we have never recommended any crypto investments and despite the ongoing crash, are not likely to soon. I am treating this like every other speculative boom I’ve seen in my career which is to wait for the bust and sift through the survivors to see if I can find a pony (if you don’t know that joke send me an email). But I don’t think the crypto comeuppance is done yet.
Similar results were seen in small cap stocks where dividend and value indexes outperformed the growth index:
Our allocations to small cap are generally pretty small but we are currently smaller at 75% of our strategic allocation. Strong dollar environments tend to favor small caps over large but with a slowing domestic economy I didn’t want to make an oversized bet on that. In this case, small cap and large cap returns have been quite similar (-25.4% and -22.4% respectively).
Real estate (REITs) has performed in line with large cap stocks this year. For most of the year we have maintained an allocation that is 50% of our strategic allocation. We raised that to 75% when we extended the duration of our bond portfolio. REITs are rate sensitive and performance should improve if rates come back down. REITs also perform well in inflationary environments and that might argue for a full allocation. However, truly inflationary environments are marked by a weak dollar which isn’t true today. Interest rates are probably the more important driver of REIT returns going forward.
One of the strangest outcomes in this year of strange outcomes, is the outperformance of international equities over US. This is wholly unexpected in a strong dollar environment but even EM equities are outperforming the US this year. We own a small position in Japan and despite the plunge in the Yen (-14.7% YTD), the Japan ETF has managed to slightly outperform the S&P 500. With commodity prices on the upswing, Latin American stocks have led, still positive on the year. That, despite the continuing political swing to the left (Colombia joined the trend yesterday) that may continue in Brazil later this year. Two things come to mind here that investors should take to heart. First of all, the economy is not the market and the market is not the economy. Everyone knows about China’s ongoing economic difficulties and yet its stocks have done better than the US this year. Second, don’t let your politics dictate your investment choices. The leftward swing in LA politics is probably not a long term positive but it hasn’t stopped those markets from outperforming.
I have maintained for some time now that once the COVID distortions in the economy are gone, the US economy would settle back to its previous growth trend around 2%/year. That is based merely on the observation that GDP grew 2.1%/year for the decade prior to COVID and we did nothing during COVID to change that trajectory. Economic growth can be boiled down to just two things: productivity growth and workforce growth. Either workers become more productive and output grows or you add more labor and output grows. Did we do anything to enhance productivity during COVID? Well, there were changes due to COVID – work from home, etc. – but whether those things turn out to be positive for productivity is still an open question. As for workforce growth, the number of total employees has risen but is still below the pre-COVID high:
As a percentage of the population we are still a full 1% below the pre-COVID level:
Productivity rebounded out of the COVID economic low but fell sharply in Q1 ’22 as we added workers and GDP contracted.
With Q2 GDP also looking weak, those numbers probably won’t improve soon. If we are headed for a deep recession, you can count on companies to cut workers but that is hardly the best way to improve productivity. Productivity growth is really about investment in the real economy though and there we do have some potential positives. First is that real rates have turned positive and that is generally associated with higher investment and productivity growth. Second is that core capital goods orders have finally broken out of a 20 year stagnation and are still climbing:
But investments take time to pay off so any productivity gains from this investment will take some time to show up in the real economy. And that assumes it isn’t peaking now.
So, with low productivity growth and weak workforce growth, I just don’t think it is realistic to expect something other than what prevailed prior to COVID. If anything, since we added a lot of government debt during the pandemic, we might even assume growth will be somewhat less than the pre-COVID trend. On the other hand I think that is mitigated by the fact that a lot of the government debt added was merely a shift from household balance sheets to the government’s balance sheet. The savings rate has fallen this year but that doesn’t mean, contrary to a lot of commentary out there, that people are spending the huge pile of savings they accumulated during COVID (flow vs stock). I’m sure that is true for lower income Americans and, with prices rising, probably for some middle class as well. But in aggregate, the accumulated savings hasn’t been depleted and that may act as a cushion for any economic slowdown.
Last year’s 5.7% GDP growth rate was not sustainable, fed as it was from Biden’s spending plan and an accommodative Fed. Growth had to slow this year and it is. What is remarkable so far though is how little evidence we have of that. Real retail sales have been running well above trend and should come down but they remain elevated:
If retail sales are going to fall back to trend – and I think that makes sense – the question is how. Will it be a rapid drop or gradual? More importantly, how will this affect overall consumption? Will a rise in services spending offset some of the – potential – drop in goods spending? Will it be sufficient to keep overall real consumption growing on trend?
On the investment side of the economy, can non-residential investment rise enough to offset a drop in residential?
There are plenty of indicators that confirm the recent slowdown but slowdown isn’t recession. I’m sure the odds of recession have risen, especially with the spike in interest rates and the impact on housing but any forecast that goes past the next couple of months is speculative at best. We could be in recession by the end of the year but you sure can’t make that call right now. Futures markets still point to mid-2023 for the peak in rates although that has moved forward by a quarter.
Example: The ISM surveys have come off their highs but are still well above levels associated with recession. And neither of these is a primary input to our portfolio process because they produce too many false signals. Readings under 50 happen fairly frequently and don’t lead to recession. It takes a reading under 45 to confirm recession and it has usually started by then. A reading in the upper 50s isn’t anywhere close to recession. It could fall fast but we shouldn’t assume that.
The regional Fed manufacturing surveys also show the slowdown. Like the ISM, these surveys often turn negative without a recession. A negative reading just means things are slowing. We don’t use this as a primary indicator either because of the high number of false signals:
One indicator we are watching very closely is credit spreads which have recently widened. It is concerning but as you can see there have been numerous higher readings that weren’t associated with recession. Making a big portfolio change based on a spurious reading is exactly what gets investors in trouble. If you sell on a false signal, how do you get back in? This is the one indicator that worries me the most though because risk aversion can have a powerful impact on the economy. Recessions can become self-fulfilling prophecies and economic sentiment is very, very negative at present.
I don’t know how this slowdown will be resolved. There is very little data available right now that points to recession at all much less something catastrophic like 2008. Yes, credit spreads could keep getting wider, the ISM surveys could get worse, the regional Fed surveys could deteriorate and retail sales could fall off a cliff while consumers also pull back on travel and other services spending. But we don’t make big portfolio changes based on extrapolating a present trend to its worst case scenario. We came into this year with our portfolios defensively positioned and we still are. To get even more defensive would require evidence that the economy is doing something more than just slowing from an unsustainable growth rate.
Market sentiment is at extremes in almost all asset classes. It is profoundly negative about stocks and real estate and, despite a selloff last week, still profoundly positive for commodities. I suspect we are at or near turning points for both but that doesn’t mean either trend is over. The S&P 500 could easily rise by 15 to 20% from these levels and still be in a downtrend (below the 200 day moving average). Commodities could do the opposite and still be in an uptrend. That’s how far away from the long term trends we are right now.
One measure of sentiment I track is the percentage of stocks in an index that are trading above their 200 day moving average. A low reading would be 20 or less and an extreme reading would be 10 or less. Non-recession corrections tend to bottom above 10 and bear market recessions below. There are extreme situations like 2002 and 2008 when the percentage hit single digits and stayed low for months. In 2002 the % of stocks in the S&P 500 above their 200 day MA first hit single digits in July with the index at 775.68. It rallied and hit a high of 965 in August (24.5% rally), fell and made a new low in October (768.63), rallied again to 954.28 (24.2% rally) in December and retested the low a final time in March of 2003 (788.90). Point being that just because it hits that low doesn’t mean you are off to the races. The bottom can take a while. In 2008, the % fell into single digits in October and the market bottomed at 839.8, rallied to over 1007 (19.9% rally) in November but didn’t make its final low until March 2009 at a low 20% below the October low. The history with the same metric applied to NASDAQ is similar. Where are we today?
If this is not a recession or a very mild one, then I’d say we’re very close to making a bottom. If it is a recession, we probably have more time to spend near the lows although new lows are far from a guarantee – a lot of bad news has been priced in already.
I would also point out that the very long term trend of the S&P 500 is still up even after this large selloff. The only times we’ve been more oversold was in 2002 and 2008 and in both of those cases the index traded below its 50 month moving average (which it did briefly in 2020 but didn’t close a month down there). If this isn’t another 50% bear market – and those are rare despite us having had two in the last 20 years – then the bottom is probably here or very close.
Bonds are in a similar situation, very oversold and due for a rally. The trend is obviously down since the early 2020 peak:
For bonds to rally, we need rates to fall and that will only come with better inflation news and/or weaker economic data. A helpful market based indicator is the copper/gold ratio which correlates well with the 10 year Treasury yield. The 3,6,9 and 12 month rates of change on the copper/gold ratio are now negative and if this continues to weaken, the 10 year Treasury yield will likely follow:
A 6 to 8% rally in IEI and an 8 to 10% rally in IEF (we own both) seems quite reasonable. I’m looking for a little more confirmation but I expect to extend the duration of our bond portfolio again soon. Whether it is a short term or long term move I don’t know yet; that will be determined by the nature of the economic slowdown.
A rally in bonds – a fall in rates – should also be positive for REITS and the dividend stocks (26% utilities).
The bigger question is what a fall in rates would do to commodities, gold and the dollar. It will be important to see how real rates react relative to nominal rates and how inflation expectations change. Ideally, we’d see a fall in nominal bond yields and steady real rates resulting in a fall in inflation expectations. But ideal may be too much to ask and if real rates start to fall in the context of an economic slowdown, gold should outperform general commodities. As for the dollar, its course is more likely to be determined by what is going on outside the US but in general, a slowdown here relative to the rest of the world would be negative for the buck.
The course of the dollar will largely determine if and how we might change our equity allocations. Right now, we have some international value exposure but the rest is defensive US equity. If the economy cools but doesn’t fall apart, we may need to shift to more offense and valuations would point to increased mid or small cap exposure. The S&P 500 and its growth piece are still expensive, if a lot cheaper than they were, but I would be reluctant to make any long term commitments to those areas unless we believe earnings will accelerate sharply (which we don’t at present). International stocks are still cheaper than the US and it really doesn’t matter what part of the world you look at. EAFE is 12 times earnings, Asia ex-Japan is 14 times, Japan is 12 times and global stocks are 15 times. The value versions of those are even cheaper.
Shifting to more international exposure though would require that the dollar get in a downtrend and right now it is still sitting near its recent highs.
For now, we are not making any big moves because we don’t have sufficient evidence to do so. We remain defensive because the economy is slowing but we also think inflation is peaking (example: Philly Fed manufacturing prices paid component is down 20% over the last 3 months). We are likely to soon extend the duration of our bond portfolio again to take advantage of what we think could be a significant rally in bonds. I would expect too that better inflation data and softer economic data should put the Fed on a less aggressive path. But Powell seems uniquely clueless in the recent string of lousy Fed Chairmen so who knows? If the market starts to price out some of the currently expected rate hikes, I would also expect a positive response from stocks. Whether that is a temporary reprieve, the calm before the recession storm or a new bull market I can’t say yet.
The rising dollar, rising rate environment continues although the ascent of both slowed at the end of last week. Which means nothing of course; it was just a couple of days. The trend for both is still solidly up and both could pull back considerably and still be considered as such. A first downside target for the 10 year yield is about 2.94%, second down to the May low at 2.71% and a third at 2.25%. For the dollar, first downside target would be 102.6, second @ 98. Anything below that would end the intermediate uptrend.
Obviously, there was no place to hide last week but that isn’t even interesting. What is, is that growth stocks outperformed value for the week and since late May. It isn’t enough yet to change the trend but it is potentially a positive sign if the things that were hit hardest are starting to do relatively better. China was again an outperformer but still down on the week.
Energy stocks got clobbered last week, and are now down over 20% from their recent highs. Crude appears to have broken its short term uptrend last week. A return to the intermediate term trend line would take it down to about $88. If you get that drop in crude, XLE is going lower. A guesstimate would be another 15% down from here. Utilities were the second worst performer, on the back of higher rates I suppose. If bonds rally I’m pretty sure utilities and REITs will too.
It is a very uncertain time for markets and the economy. Of course, it always is; uncertainty is the norm because none of us can predict the future. We have acted defensively this year and that has been the right call but I think we need to be thinking about offense now. Stocks and bonds are both extraordinarily oversold and sentiment is as negative as I’ve ever seen it. In some ways it feels more negative than 2008 but the economic condition today is a lot healthier than then. Investors seem to want to price in the worst case scenario when we don’t even have evidence yet of anything other than an economic slowdown. It may turn into something worse but, if the past is any guide, there will be some monster rallies along the way even if that is true. If you don’t feel good about where you are now, use one of those rallies to lighten up. We didn’t go straight down in 2008 and I doubt we will now. Right in the heart of that mess, in November of 2008, the S&P rallied 20%. Yes, it was short term and we went on to make new lows but anyone who wanted to sell some got a chance to do so in a rally rather than selling on the lows.
I don’t know where or when this bear market will end. No one does. Will it be a down 50% like 2002 and 2008? Or are we almost at the bottom? There are certainly a lot of similarities between today and the 2000-2002 bear market with crypto taking the role of the dot com stocks. Is Tether the Enron of crypto? Maybe. Are NFTs the Beanie Babies of that earlier time? Could be. Is the crash in crypto affecting the stock market? With so many “hedge” funds out there chasing those returns, my guess is yes. But crypto is down to about $800 billion in total market cap so whatever impact there is should fade from here. But, yes, I can see some parallels between those two periods. On the other hand, comparisons to 2008 just seem a tad overwrought. I don’t see a banking crisis in our future.
I’ve said recently that investors ought to be at least thinking about doing some buying and I stand by that. There are definitely bargains out there and everyone else is scared to death. Last week I quoted Warren Buffett’s maxim to be greedy when others are fearful. Well, they got more fearful last week based on nothing more than a useless interest rate moving up by 0.25% more than previously thought necessary. Is an interest rate a quarter point higher really going to push us into something as bad as 2008? I have my doubts. Maybe it’s time to get braver.
Joe Calhounbonds pandemic sp 500 nasdaq equities stocks crypto reit mortgage rates real estate housing market etf small cap stocks crypto small caps commodities gold oil
Off Campus Texas A&M Housing With “Resort Style” Rooftop Pool Defaults On Debt Payment
Off Campus Texas A&M Housing With "Resort Style" Rooftop Pool Defaults On Debt Payment
Who could have possibly thought, amidst all this…
Who could have possibly thought, amidst all this euphoria, that luxury college housing complexes for students might not be the best idea in the world?
It's looking like for one complex - with, of course, a "resort style" rooftop pool (which everybody knows is integral to ones studies) - near the Texas A&M University campus is starting to find out this harsh reality.
The 3,400-bed student housing complex, called Park West, is going to default on its July debt payment according to Moody’s Investors Service, who downgraded the company's bonds deeper into junk territory this week.
The property, which provides off-campus housing for students, is located in College Station, Texas, Bloomberg reported in a mid-week wrap up. It has reportedly been struggling since even before the pandemic, thanks to the building's higher rents.
Moody's commented: “The project’s financial distress is directly linked to prolonged weakness within its College Station, Texas student housing submarket which has been an ongoing problem since Park West opened for fall 2017.”
$15.3 million is due in principal and interest, but the complex will only pay $8.5 million. The company that sold the bonds, NCCD-College Station Properties LLC, still has about $342 million in bonds outstanding, Bloomberg reported.
The vice president and director of operations for the company confirmed that the company would default but offered up no other color.
For a look at the complex's posh amenities, you can review its website here.
“Worst Start Since 1788”: A Closer Look At The Catastrophic First Half Performance
"Worst Start Since 1788": A Closer Look At The Catastrophic First Half Performance
As discussed yesterday…
Worst first half for stocks…
As discussed yesterday...
Worst first half for stocks in 52 years. pic.twitter.com/mOYvbJ6pvo— zerohedge (@zerohedge) June 30, 2022
... and again this morning, when Rabobank's Michael Every said that "if you bought stocks in H1, you lost; if bonds, you lost; if commodities, you were doing great until recently; if crypto you lost; if the US dollar, you were fine" but lost purchasing power to inflation, the first six months of the year were terrible.
Just how terrible? To quantify the destruction, we go to the latest chart of the day from DB's Jim Reid who writes that "the good news is that H1 is now over. The bad news is that the outlook for H2 is not looking good."
To demonstrate just how bad H1 was, Reid shares three charts. They show that:
1) Deutsche Bank's US 10yr Treasury proxy index did indeed see the worst H1 since 1788 in spite of a sizeable late June rally, and...
2) the S&P 500 saw the worst H1 total return since 1962 after a rally last week just pulled it back from being the worst since 1932.
Here, BofA has outdone DB, and notes that in real timers, the S&P500's performance was the worst since 1872!
As Reid further notes, "I’ve found through my career that these type of charts are always the most demanded as investors want to put their performance in context." Which is why he also added a the third chart which is an abridged version of one published by DB's Henry Allen in a report fully reviewing H1, June and Q2 (more below, and also available to professional subs in the usual place).
As Reid concludes, "if you like horror stories its an alternative to Stranger Things which returns to our global screens today. Obviously if you run a commodity fund you may think differently!"
Stepping back from this narrow take, we look at the full performance review for June and Q2 conducted by Reid's colleague, Henry Allen, which finds that "it's hard to overstate just how bad markets have performed over recent months, with the returns in Q2 very much following in Q1’s footsteps... a range of asset classes saw significant losses, including equities, credit and sovereign bonds, whilst the US dollar and some commodities like oil were among the few exceptions. In fact, in total return terms we’ve just seen the biggest H1 decline for the S&P 500 in 60 years, and in June alone just 2 of the 38 non-currency assets in our sample were in positive territory, which is the same as what we saw during the initial market chaos from the pandemic in March 2020."
On a YTD basis as well, just 4 of 38 tracked assets are in positive territory, which as it stands is even lower than the 7 assets that managed to score a positive return in 2008.
The main reason for these broad-based declines is the fact that recession and stagflation risks have ramped up significantly over Q2. This has been for several reasons, but first among them is the fact that inflation has proven far more persistent than the consensus expected once again, requiring a more aggressive pace of rate hikes from central banks than investors were expecting at the start of the quarter. For instance, the rate priced in by Fed funds futures for the December 2022 meeting has risen from 2.40% at the end of Q1 to 3.38% at the end of Q2. A similar pattern has been seen from other central banks, and the effects are beginning to show up in the real economy too, with US mortgage rates reaching a post-2008 high. The good news is that as of today, the market is now pricing in not just rate hikes to peak in Q4, but about 14bps of rate cuts in Q1.
in any case, the big worry from investors’ point of view is that the cumulative effect of these rate hikes will be enough to knock the economy into recession, and on that front we’ve seen multiple signs pointing to slower growth recently in both the US and Europe. For instance, the flash Euro Area composite PMI for June came in at a 16-month low of 51.9, whilst its US counterpart fell to a 5-month low of 51.2. Other recessionary indicators like the yield curve are also showing concerning signs, with the 2s10s Treasury curve still hovering just outside inversion territory at the end of the quarter, at just +5.1bps. The energy shock is adding to these growth concerns, and that’s persisted over Q2 as the war in Ukraine has continued. Brent crude oil prices built on their sizeable gains from Q1, with a further +6.4% rise in Q2 that left them at $115/bbl. Meanwhile, European natural gas is up by +14.8% to €145 per megawatt-hour. However, fears of a global recession have knocked industrial metals prices significantly, and the London Metal Exchange Index has just seen its first quarterly fall since the initial wave of the pandemic in Q1 2020, and its -25.0% decline is the largest since the turmoil of the GFC in Q4 2008.
That decline in risk appetite has knocked a range of other assets too:
- The S&P 500 slumped -16.1% over Q2, meaning its quarterly performance was the second worst since the GFC turmoil of Q4 2008.
- Sovereign bonds built on their losses from Q1,
- Euro sovereigns (-7.4%) saw their worst quarterly performance of the 21st century so far as the ECB announced their plan to start hiking rates from July to deal with high inflation.
- Cryptocurrencies shared in the losses too, with Bitcoin’s (59.0%) decline over Q2 marking its worst quarterly performance in over a decade
Which assets saw the biggest gains in Q2?
- Energy Commodities: The continued war in Ukraine put further upward pressure on energy prices, with Brent crude (+6.4%) and WTI (+5.5%) oil both advancing over the quarter. The rise was particularly noticeable for European natural gas, with futures up by +14.8% as the continent faces up to the risk of a potential gas cut-off from Russia.
- US Dollar: The dollar was the best-performing of the G10 currencies in Q2 as it dawned on investors that the Fed would hike more aggressively than they expected, and the YTD gains for the dollar index now stand at +9.4%.
Which assets saw the biggest losses in Q2?
- Equities: Growing fears about a recession led to significant equity losses in Q2, with the S&P 500 (-16.1%) seeing its second-worst quarterly performance since the GFC turmoil of Q4 2008. That pattern was seen across the world, with Europe’s STOXX 600 down -9.1%, Japan’s Nikkei down -5.0%, and the MSCI EM index down -11.4%.
- Credit: For a second consecutive quarter, every credit index we follow across USD, EUR and GBP moved lower. EUR and USD HY saw some of the worst losses, with declines of -10.7% and -9.9% respectively.
- Sovereign Bonds: As with credit, sovereign bonds lost ground on both sides of the Atlantic, and the decline in European sovereigns (-7.4%) was the worst so far in the 21st century. Treasuries also lost further ground, and their -4.1% decline over Q2 brings their YTD losses to -9.4%.
- Non-energy commodities: Whilst energy saw further gains over Q2, other commodities saw some major declines. Industrial metals were a significant underperformer, with the London Metal Exchange Index (-25.0%) seeing its largest quarterly decline since the GFC turmoil of 2008. Precious metals lost ground too, with declines for both gold (-6.7%) and silver (-18.2%). And a number of agricultural commodities also fell back, including wheat (-13.6%).
- Japanese Yen: The Japanese Yen weakened against the US Dollar by -10.3% over Q2, which also marked its 6th consecutive quarterly decline against the dollar. By the close at the end of the quarter, that left the Yen trading at 136 per dollar, which is around its weakest level since 1998. That came as the Bank of Japan has become the outlier among the major advanced economy central banks in not hiking rates with even the Swiss National Bank hiking in June for the first time in 15 years.
- Cryptocurrencies: The broader risk-off tone has been bad news for cryptocurrencies, and Bitcoin’s -59.0% decline over Q2 is its worst quarterly performance in over a decade. Other cryptocurrencies have lost significant ground as well, including Litecoin (-59.2%) and XRP (-61.2%).
Looking specifically at June rather than Q2 as a whole, the picture looks even worse in some ways since just 2 of the 38 non-currency assets are in positive territory for the month, which is the same number as in March 2020 when global markets reacted to the initial wave of the pandemic. The two positive assets are the Shanghai Comp (+7.5%) and the Hang Seng (+3.0%), which have been supported by improving economic data as Covid restrictions have been eased. Otherwise however, it’s been negative across the board, and even commodities have struggled after their strong start to the year, with Brent crude (-6.5%) and WTI (7.8%) posting their first monthly declines so far this year as concerns about a recession have mounted. The main catalyst for this was the much stronger-than-expected US CPI print for June, which triggered another selloff as it dawned on investors that the Fed would be forced to hike rates even more aggressively to rein in inflation, which they followed through on at their meeting when they hiked by 75bps for the first time since 1994.
Finally, without further ado, here are the charts showing total returns for the month of June...
... for Q2...
... and for YTD.
Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back?
As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices…
As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices have fallen, and crypto has imploded, even true believers are questioning what the bottom for markets might be, and when we will get there. While it is easy to call the market movement in 2022 a correction and to argue that it is overdue, it is facile, and it fails to address the question of why it is happening now, and whether the correction is overdone or has more to go. In this post, I will argue that almost everything that we are observing in markets, across asset classes, can be explained by a pull back on risk capital, and that understanding the magnitude of the pull back, and putting in historical perspective, is key to gauging what is coming next.
Risk Capital: What is it?
To put risk capital in perspective, it is best to start with a definition of risk that is comprehensive and all-inclusive, and that is to think of risk as a combination of danger (downside) and opportunity (upside) and to consider how investments vary in terms of exposure to both. In every asset class, there is a range of investment choices, with some being safer (or even guaranteed) and others being riskier.
Risk capital is the portion of capital that is invested in the riskiest segments of each market and safety capital is that portion that finds its way to the safest segments in each market.
While risk and safety capital approach the market from opposite ends in the risk spectrum, one (safety capital) being driven by fear and the other (risk capital), by greed, they need to not only co-exist, but be in balance, for the market to be healthy. When to two are not in balance, these imbalances can have profound and often unhealthy effects not just of markets, but also on the overall economy. At the extremes, when risk capital is absent and everyone seeks safety, the economy and markets will atrophy, as businesses and investors will stay away from risky ventures, and when risk capital is too easy and accessible, risky asset prices will soar, and the economy will see too much growth in its riskiest segments, often at the expense of more stable (and still necessary) businesses.
Risk Capital's Ebbs and Flows
It is a common misconception that the risk-takers supply risk capital (risk takers) and that the investors who invest for safety draw from different investor pools, and that these pools remain unchanged over time. While investor risk aversion clearly does play a role in whether investors are drawn to invest in risk or safety capital, it obscures two realities:
- Variation within an investor's portfolio: Many investors, including even the most risk averse, may and often do set aside a portion of their portfolios for riskier investments, drawn by the higher expected returns on those investments. For some investors, this set aside will be the portion that they can afford to lose, without affecting their life styles in any material way. For others, it can be the portion of their capital with the longest time horizon (pension fund savings or 401Ks, if you are a young investor, for example), where they believe that any losses on risk capital can be made up over time. For still others, it is that segment of their portfolios that they treat las long shot gambles, hoping for a disproportionately large payoff, if they are lucky. The amount that is put into the risk capital portion will vary with investor risk aversion, with more risk averse investors putting less or even nothing into the riskiest assets, and less risk averse investors putting in more.
- Variation across time: The amount that investors are willing to put into risk capital, or conversely redirect to safety capital, will change over time, with several factors playing a role in determining whether risk capital will be plentiful or scarce. The first is market momentum, since more money will be put into the riskiest asset classes, when markets are rising, because investors who benefit from these rising markets will have more capital that they are willing to risk. The second is the the health and stability of the economy, since investors with secure jobs and rising paychecks are more willing to take risks.
There are two macro factors that will come into play, and both are in play in markets today. The first is the return that can be earned on guaranteed investments, i.e., US treasury bills and bonds, for instance, if you are a investor in US dollar, since it is a measure of what someone who takes no or very low risk can expect to earn. When treasury rates are low or close to zero, refusing to take risk will result in returns that are very low or close to zero as well, thus inducing investors to expose themselves to more risk than they would have taken in higher interest rate regimes. The second is inflation, which reduces the nominal return you make on all your investments, and the effects of rising inflation on risk capital are complex. As expected inflation rises, you are likely to see higher interest rates, and as we noted above, that may induce investors to cut back on risk taking and focus on earning enough to cover the ravages of inflation. As uncertainty about inflation rises, you will see reallocation of investment across asset classes, with real assets gaining when unexpected inflation is positive (actual inflation is higher than expected), and financial assets benefiting when unexpected inflation is negative (actual inflation is less than expected).
If you are wondering why you should care about risk capital's ebbs and flows, it is because you will feel its effects in almost everything you do in investing and business.
- Risk Premiums: The risk premiums that you observe in every risky asset market are a function of how much risk capital there is in play, with risk premiums going up when risk capital becomes scarcer and down, when risk capital is more plentiful. In the bond and loan market, access to risk capital will determine default spreads on bonds, with lower rated bonds feeling the pain more intensely when risk capital is withdrawn or moves to the side lines. Not only will default spreads widen more for lower-rated bonds, but there will be less bond issuances by riskier companies. In the equity market, the equity risk premium is the price of risk, and its movements will track shifts in risk capital, increasing as risk capital becomes scarcer.
- Price and Value Gaps: As those of you who read this blog know well, I draw a contrast between value and price, with the former driven by fundamentals (cash flows, growth and risk) and the latter by mood, momentum and liquidity. The value and price processes can yield different numbers for the same company, and the two numbers can diverge for long periods, with convergence not guaranteed but likely over long periods.I argue that investors play the value game, buying investments when the price is less than the value and hoping for convergence, and that traders play the pricing game, buying and selling on market momentum, rather than fundamentals. At the risk of generalizing, safety capital, with its focus on earnings and cash flows now, is more likely to focus on fundamentals, and play the investor game, whereas risk capital, drawn by the need to make high returns quickly, is more likely to play the trading game. Thus, when risk capital is plentiful, you are more likely to see the pricing game overwhelm the value game, with prices often rising well above value, and more so for the riskiest segments of every asset class. A pull back in risk capital is often the catalyst for corrections, where price not only converges back on value, but often overshoots in the other direction (creating under valuations). It behooves both investors and traders to therefore track movements in risk capital, since it is will determine when long term bets on value will pay off for the former, and the timing of entry into and exit from markets for the latter.
- Corporate Life Cycle: The ebbs and flows of risk capital have consequences for all businesses, but the effects will vary widely across companies, depending on where they are in the life cycle. Using another one of my favorite structures, the corporate life cycle, you can see the consequences of expanding and shrinking risk capital, through the lens of free cash flows (and how they vary across the life cycle).Early in the corporate life cycle, young companies have negative free cash flows, driven by losses on operations and investments for future growth, making them dependent on risk capital for survival and growth. As companies mature, their cash flows first become self sustaining first, as operating cash flows cover investments, and then turn large and positive, making them not only less dependent on risk capital for survival but also more valued in an environment where safety capital is dominant. Put simply, as risk capital becomes scarcer, young companies, especially those that are money-losing and with negative cash flows, will see bigger pricing markdowns and more failures than more mature companies.
Risk Capital: Historical Perspective
How do you track the availability and access to risk capital over time? There are three proxies that I will use, and while each has its limitations, read together, they can provide a fuller measure of the ebbs and flows of risk capital. The first is funds invested by venture capitalists, with a breakdown further into types, from pre-seed and seed financing to very young companies to capital provided to more young companies with more established business models, as a prelude to exit (acquisition or IPO). The second is the trend line in initial public offerings (number and value raised), since companies are more likely to go public and be able to raise more capital in issue proceeds, when risk capital is plentiful. The third is original bond issuances by the riskiest companies (below investment grade and high yield), since these issuances are more likely to have a friendly reception when risk capital is easily available than when it is not.
Let’s start with venture capital, the typical source of capital for start ups and young companies for decades in the United States, and more recently, in the rest of the world. In the graph below, I trace out total venture capital raised, by year, between 1995 and 2021, in the US:
|Source: NVCA Yearbooks|
|Source: Jay Ritter|
In the final graph, I look at corporate bond offerings, broken down into investment grade and high yield, by year, from 1996 to 2021:
Here again, you see a familiar pattern, with the percentage of high-yield bond issuances tracking the availability of risk capital. As with IPOs, you see big dips in 2000-01and 2008-09, reflecting market corrections and crises, and a period of easy access to risk capital in the last decade. Again, the percentage of corporate bond issuances hit an all-time high in 2021, representing more than a quarter of all bond issuances. In sum, all three proxies for risk capital show the same patterns over time, pulling back and surging during the same time periods, and with all three proxies, it is clear that 2021 was a boom year.
The last two and a half years may not represent much time on a historical scale, but the period has packed in enough surprises to make it feel like we have aged a decade. We started 2020 with a pandemic that altered our personal, work and financial lives, and in 2022, at least in North America and Europe, we have seen inflation reach levels that we have not seen for decades. Looking at the 30 months through the lens of risk capital can help us understand not only the journey that markets have gone through to get where they are today, but also perhaps decipher where they may go next. In the graph below, I look at venture capital, IPOs and high yield bond issuances over the last two and a half years:
|Spreadsheet for implied ERP|
|Source for raw data: S&P Cap IQ|
The big question that we all face, as we look towards the second half of the year, is whether the pullback in risk capital is temporary, as it was in 2020, or whether it is more long term, as it was after the dot-com bust in 2000 and the market crisis in 2008. If it is the former, there is hope of not just a recovery, but a strong rebound in risky asset prices, and if it is the latter, stocks may stabilize, but the riskiest assets will see depressed prices for much longer. I don't have a crystal ball or any special macro forecasting abilities, but if I had to guess, it would be that it is the latter. Unlike a virus, where a vaccine may provide at least the semblance of a quick cure (real or imagined), inflation, once unleashed, has no quick fix. Moreover, now that inflation has reared its head, neither central banks nor governments can provide the boosts that they were able to in 2020 and may even have to take actions that make things worse, rather than better, for risk capital. Finally, at the risk of sounding callous, I do think that a return of fear and a longer term pullback in risk capital is healthy for markets and the economy, since risk capital providers, spoiled by a decade or more of easy returns, have become lazy and sloppy in their pricing and trading decisions, and have, in the process, skewed capital allocation in the economy. If a long-term slowdown is in the cards, it is almost certain that the investment strategies that delivered high returns in the last decade will no longer work in this new environment, and that old lessons, dismissed as outdated just a few years go, may need to be relearned.
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