TEN turns 10 years old – A Look Back & an Important Market Update
FIVE THINGS YOU SHOULD KNOW
- Equity Markets – were lower this week with U.S. stocks (S&P 500) down -5.75% while international stocks (EAFE) fell -3.36%.
- Fixed Income Markets – were mixed with investment grade bonds (AGG) up 0.05% while high yield bonds (JNK) fell -0.85%.
- Fed Talk Amplifies – Only a few weeks into 2022 the ever-increasing expectations for an accelerated rate of Fed tightening continues to dominate headlines. The 10-year Treasury yield now sits at its highest level since January 2020, with market makers now pricing in the possibility for as much as a 50-basis point rate hike at the Federal Reserve March meeting.
- Global Banks Differ – While domestically the conversation has centered around raising rates sooner rather than later, the same cannot be said around the rest of the world. Bank of Japan Governor Kuroda was quick to squash rumors of current stimulus policies ending anytime soon, stating that the idea of “raising rates is unthinkable”. European central bank officials were also adamant that increasing market expectations for a rate hike as early as September are overblown, with ECB President Lagarde noting they have “every reason not to react as quickly”.
- Key Insight – [VIDEO] In celebration of TEN turning 10 this week, Tim looks back on what drove him to start the firm, some of the team’s accomplishments he’s most proud of, and the group’s commitment to its clients for the decades still to come. [ARTICLE] Volatility is back. Tim shares his thoughts on what got us here, where we might be headed and what the team at TEN is doing as result.
INSIGHTS for INVESTORS
"A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty." - Winston Churchill
Markets Wake-Up
After a relatively “sleepy” year for virtually all markets in 2021, 2022 is off to more volatile start. Yields spiked Tuesday coming off the long-weekend with two-year Treasury notes rising 9 basis points to crest over 1% and the 10-year Treasury climbing to 1.85%. All signals point to the markets now fully pricing in a March rate hike from the Fed after prior signals from the Fed that such a move wasn’t likely until the back half of the year. The two-year note rising over 1% reflects as many as four hikes in 2022 – not a good sign … for now.
Perhaps more importantly, the 30-year Treasury fell 50 basis points, flattening the yield, and seemingly confirmed what the recent growth data points had begun to show, which is that the economy is now slowing. On top of December’s very disappointing retail sales numbers, came this week’s Empire Manufacturing number which plummeted from a reading of 30.7 to -0.70 (estimates were for a reading of 25).
As we’ve discussed before, the market doesn’t trade on absolutes nearly as much as it does rates of change (i.e., going from horrible to less bad is usually better than going from great to just good). Second quarter was always likely to be a problem, given the year over year comparisons to 2021’s second quarter. This is due to the strength of the rebound in 2021 as things reopened and vaccines allowed economic activity to spike.
Are You Calling for a Crash?
No, for one I don’t make calls. Furthermore, drawdowns that many would call a crash, are just normal market corrections in most cases, and many don’t have any true explanation at all (despite the media’s attempts to find one). However, we did engage in some trades early Tuesday within some strategies where we took the equity overweight’s we put on during the crash in March of 2020 back to neutral weightings and raised some cash.
Why? Recent strong equity markets had us now 10%+ above our neutral weighting for these strategies, and this reality coupled with a shifting risk/return set up suggested the time was right to act on our process to regularly rebalance portfolios, lock in gains, and develop our next moves while we see how the Fed’s next meeting plays out.
Is this the “end” of the economic cycle? Many investors work on calendars and clocks, while markets play a perpetual game. So, no, I don’t think this is the end, it’s simply what’s next. Our process is to always manage risk accordingly depending on strategy and client risk tolerance, while always be preparing for our next move.
It is noteworthy to consider even if the market were to fall 10% and have a long overdue correction, which is considered “normal” market behavior, it would also simply represent an equivalent loss of purchasing power. This, no more similar to the one experienced due to inflation for those perpetual worriers who’ve held excess cash over the last year or so.
Investing is not a practice where one should vacillate between being too aggressive or too fearful, but rather as we describe above, strive to maintain balance and discipline at all times.
The former mindset is poor for many reasons, but one of the biggest reasons is that it increases one’s chances of becoming overly emotional as they ping pong between the extreme fears of losing, or fears of missing out.
Why are we here?
Unprecedented monetary policy (i.e., easy money) coupled with disrupted supply chains have triggered widespread buying and demand for goods, and as a result, 40-year highs in current inflation readings. In an of itself this would be a concern, but its impact is heightened given 2022’s status as an election year and the related conflict around President Biden’s Build Back Better bill and concern that more government spending will only serve to stoke the flames of inflation.
The result is that the Fed is stuck between a rock and a hard place, as inflation numbers are objectively high, and Republicans are seizing on them to punish Democrats recent policies and thwart their “BBB” bill. Democrats are already facing bleak odds in the mid-terms and will howl if the Fed raises rates too quickly (something they’ve always been loath to do in election years), creating even more market volatility before the election, which is an environment that almost always punishes incumbents.
What’s next?
Mohamed El-Erian spoke about the risk of a Fed induced recession this week saying, “We haven’t had a situation in the past in which the Fed has been really late [with rate hikes] and the Fed hasn’t ended up tipping the economy into a recession — that’s why we want to avoid that outcome.”
While markets seem to be bracing for the worst (four hikes in 2022 and related volatility), the fact that equity markets haven’t really fallen yet seems to reflect the equal possibility that inflation will likely remain well above the sub-2% rate of recent years, and should abate as soon as supply chains become unstuck and panicked consumer demand tempers (see December’s retail sales numbers).
If that does come to fruition, the Fed will have political cover to slow the pace of future hikes. The most probable result in our opinion then, is that the Fed does hike once (maybe twice) creating a risk-off event, only to walk back or pause future hikes giving the market reason to have a decent back half of the year (e.g. Q4 of 2018 and Q1 of 2019). Then again, if market action such as this week continues over the next month or two, we may not even get one hike.
History would suggest the most likely path is a “dead cat bounce” for markets followed by a retest of recent lows, after which Fed commentary and supply chain issues will determine whether the market and economy can regain its footing and move higher.
For more on this, see the great Brian Wesbury article at the end of the commentary.
What to do?
Commentators and investors tend to misuse averages as they look ahead, and we think in 2022 this likely applies to the stock indices themselves which reflect the “averaged” performance of many sectors.
Historically, equity markets in general struggle with conditions such as we have today. Namely, things such as:
a) mid-term election years (in the post-WWII era average, half the historic average at 5.03% vs. 10.26%),
b) during Fed tightening/rate hikes,
c) slowing economic growth,
d) technical trend reversals/breakdowns, and
e) geopolitical turmoil (see Russia tension on the Ukraine border).
But that isn’t to say there aren’t opportunities and better ways to approach such markets, which is why we have engaged in the following activities.
- Rebalance portfolios to book gains and restore overall balance, and
- Reconsider sector/asset class weightings to adjust for such current market conditions.
We discussed point #1 above, which of course is highly dependent on the client, portfolio strategy and entry points and thus not in any way actionable advice without such context – feel free to give us a call.
Regarding point #2, while overall markets may post moderate returns, certain sectors should outperform others and not surprisingly the result of such bifurcated performance is that yesterday’s “losers” are likely tomorrow’s “winners” and vice versa. See the chart below.
Goldman Sachs had this to say, “US 10-Year Treasury yields have returned to pre-pandemic levels which we believe can remain supportive of risk assets. While the rate transition may drive near-term volatility, select equity sectors may also stand to benefit. Cyclicals and value sectors such as financials have historically been positively correlated with 10-year yields while rates have had a negative relationship with defensive growth sectors.”
If we do see a correction or “crash” it is likely to be one based on valuations (e.g., 2001) and not the risk of systemic failure (e.g., 2008) and thus, there should be asset classes that actually do well both on a relative and even absolute basis).
Our rebalancing and reallocation will be based on the above historic correlations and focus on adding to asset classes we’ve long identified as trading at safer valuations. We will do this while also maintaining our core equity income positions, many of which already have strong exposure to such areas. We believe positions such as our (intentionally unnamed) international blue-chip strategy should help buoy overall performance both in terms of its 7.2% dividend yield, as well as from a continuation of its recent relative outperformance (over 7% YTD as compared to the S&P 500). Such strategies provide exposure outside the Fed’s mess here in the U.S. and instead give exposure to a fundamental backdrop in Europe with sequentially improving economic data, still accommodative Central Banks, and attractive valuations.
While two-year treasury bonds trading over 1% suggests four or more hikes this year from the Federal Reserve, which in our view would be a mistake and hard on risk markets, we still think that is unlikely and that their tone will change this spring. Should the Fed come in at two or less hikes in 2022, this current headwind would likely become a strong tailwind for equity and other risk markets.
We’ve preached proper planning and solid income production to avoid “sequence of return” risk for investors for a while now – this is why. Investors who listened should not only be prepared, but ready to seize the opportunities that result … just as the quote above highlighting Churchill’s mindset would encourage.
Bottom Line
Rebalancing is a prudent part of disciplined investing, especially when one is running above weight to their baseline allocation and when risk/reward probabilities are shifting for the worse. However, it is only a benefit to investors that were disciplined enough to be diversified in the first place.
Process not prediction is the key, the latter only reflects extreme sentiment/behavior that, even if one is right for a time, creates habits and false beliefs that will almost inevitably hurt one in the long run.
Any of our trades or views are not a reflection of trying to time markets, but rather our belief that the right process will put you in the right position most of the time without the need for prediction.
Have a wonderful weekend,
Tim and the team at TEN Capital
______________________________________________________________________________
Who Gets the Blame for Inflation
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Date: 1/18/2022
Consumer prices rose 7.0% in 2021, the largest increase for any calendar year since 1981. As a result, politicians across the political spectrum are working overtime to find someone to blame and attack.
Some politicians on the left are blaming "greedy" businesses for inflation. But we find this explanation completely ridiculous. Of course, businesses are greedy, in the sense that they're run by people who are free to maximize their earnings!
But businesses are no greedier today than they were before COVID. In the ten years before COVID, the consumer price index increased at a 1.8% annual rate; in the twenty years before COVID, the CPI rose at a 2.1% annual rate. Both figures are a far cry from 7.0%.
Those blaming greedy businesses for higher inflation have no rational explanation for why businesses somehow missed all the opportunities to raise prices faster in previous decades but suddenly had a "eureka moment" and decided to do so in 2021. Under this economically illiterate theory, think of all the profits they've voluntary foregone for decades.
Meanwhile, think about the rapid increase in workers' pay in 2021, when average hourly earnings rose 4.7%. Did workers suddenly become greedier, too? Is all this greed contagious? Can we stop it by wearing masks? What does the CDC have to say?
But the political left is not alone in misunderstanding higher inflation. Some politicians on the right are saying the inflation is due to the huge surge in COVID-related government spending and budget deficits. Part of this is likely tactical: by blaming government spending and deficits, they can reduce the odds of passing the Biden Administration's Build Back Better proposal, which they'd like to see defeated.
What they're missing is that there is no consistent historical relationship between higher spending, larger deficits, and more inflation. Yes, inflation grew in the late 1960s after the introduction of the Great Society programs. But government spending also soared in the 1930s under Roosevelt's New Deal, without a surge in inflation. Budget deficits soared in the early 1980s and inflation fell. The Panic of 2008 led to a surge in government spending and deficits and inflation remained tame.
So, if it's not greed or government spending, by itself, then what is causing higher inflation? We think it's loose monetary policy. The M2 measure of the money supply has soared since COVID started. That is the (not-so-secret) policy ingredient that has converted extra government spending and deficits into more inflation rather than higher interest rates.
That, in turn, makes it important to follow the path of monetary policy this year and beyond. In recent weeks, a number of Fed policymakers have hinted at rate hikes starting in March, including Mary Daly, the president of the San Francisco Fed and considered a dove. Rule of thumb: when the doves get hawkish and start hinting at rate hikes, it's time to believe the hints.
The futures market in federal funds is pricing in four rate hikes this year. For now, we think the most likely policy path is three hikes – 25 basis points each: in March, June, and December, with a hiatus for the mid-term election season.
In addition, we think the Fed finishes up Quantitative Easing (QE) in March and starts Quantitative Tightening (QT) around mid-year. The easiest and most straightforward way for the Fed to do QT would be by selling Treasury and mortgage-backed securities to the banks and having the banks buying them send their reserves back to the Fed. The Fed can then erase those reserves from its balance sheet. That would result in the Fed holding fewer bonds as assets while being liable for fewer reserves, reducing its overall balance sheet. Instead, the Fed will probably take a more complicated path of not rolling over some assets when they mature, which means the Fed will have to coordinate its operations with the Treasury Department.
The key to remember, though, is that a few rate hikes and some modest QT will still leave monetary policy too loose. "Real" (inflation-adjusted) short-term rates will still be negative while actual short rates remain well below the trend in nominal GDP growth (real GDP growth plus inflation).
The Fed has its work cut out for it. Its goal is to execute a reduction in inflation while sticking a soft-landing for the economy. A year from now, we'll have a much better idea whether it can meet both these goals.