March 31, 2022
In our last newsletter, we outlined a macro forecast that focused on several key economic factors transitioning in 2022 that would have major impacts on equity and fixed income markets. They included fiscal and monetary policy, inflationary trends, global growth, and equity market leadership. Three months into 2022, these issues are creating a multitude of cross currents that will play out for several months. Both equity and fixed income markets declined in the quarter as they grappled with higher interest rates and questions relating to corporate earnings. Russia’s invasion of Ukraine and its potential impact on the global economy also unnerved investors in March. Read on for updates to our outlook for capital markets as well as our tactical asset allocations, which reflect the likely implications of this eventful quarter.
- Macroeconomic Outlook
- Tactical Asset Allocation Positioning: At a Glance
- Equity Markets: Inflation Expectations
- Fixed Income Markets Outlook [Fixed Income Focus: The Yield Curve]
- Sustainability Spotlight: Russian Energy – There is no going back
- Private Markets and Alternative Investments
- Market Diary: Recap of market activity in the first quarter of 2022
The economy continues to recover from COVID-related shutdowns and employment growth has been strong, with more than 400,000 jobs per month being created for almost a year. The unemployment rate currently stands at 3.6% at the end of March, near the lows prior to the start of the pandemic. Consumers are spending freely and remain in solid financial shape. While we expect economic growth to slow from 2021 levels, we still expect the economy to grow by 3-4% in 2022, well above levels we have seen over the last several years.
Inflation and energy prices have increased to worrisome levels however, which has put the Federal Reserve (Fed) in a challenging position of raising rates and tightening monetary policy to reign in price increases. This process began in March as the Fed initiated a 0.25% increase in the Federal Funds Rate and is expected to continue raising rates throughout 2022 and into 2023. In addition, they will also move from quantitative easing to quantitative tightening, which will further dampen economic growth. These actions are focused on lowering inflation levels, but also increase recession risk if the moves choke off economic growth. We do not foresee a recession within the next year, but caution is warranted and requires close monitoring of the impacts of higher rates as they become more pronounced.
The war in Ukraine is also impacting global economic growth, especially in Europe, which is highly dependent on Russian oil. The invasion has pushed up global oil prices, dragging on global economies and compounding supply chain disruptions that have existed for the last two years. The length of the invasion and impact of continued sanctions on Russia need to be watched closely to assess their impact on long-term energy prices, broader inflation trends, and economic growth.
We remain fully invested in equities for clients with a tilt toward large US companies over international and smaller firms. All equity markets were adversely affected in the first quarter and large US stocks declined 4.6%. This was about in line with mid and smaller US companies, and slightly better than companies outside the US, which fell by 5.26%. Stocks rebounded in late March after declining nearly 10% on a year-to-date basis, but we expect volatility to persist in coming weeks and months based on the factors noted above. Longer term, we expect healthy economic growth will result in strong earnings and stocks will still look attractive if the Fed can tame inflation over time.
Fixed income continues to struggle, and we remain underweight in the asset class. The yield curve has already adjusted to reflect the Fed’s expected rate increases, and bonds experienced losses of 4.51% in the first quarter. [See Fixed Income Focus below.] Corporate bonds suffered more than Treasurys as yield spreads widened with concern over risks to the economy from inflation and energy prices and the likely Fed response. We maintain our focus in the corporate area and recognize that yields going forward are significantly higher than we have seen recently.
Real assets and real estate supported portfolios in the first quarter providing positive returns while both equities and fixed income sustained losses. These asset classes provide a solid diversification benefit to portfolios and perform better in inflationary periods.
Overall, the first quarter was a difficult one for investors. Increased volatility resulted from rising economic risks, along with geopolitical issues. We are watching how the Fed addresses inflationary pressures and the economy’s response to Fed actions. We expect growth to be positive during the year and profits to remain strong, allowing stock prices to benefit. Bonds reflect the likely rate increases, but changes to Fed direction need to be watched closely and fixed income seems likely to remain under pressure. Alternative investments such as real assets will likely provide diversification benefits throughout the year. Ultimately, we expect the cross currents that buffeted markets in the quarter to continue and result in an environment that resembles a tug of war between the competing market forces throughout 2022.
Equity Markets: Inflation Expectations
The first quarter of 2022 was historic in many ways. Inflation as measured by the Consumer Price Index (CPI) continued its rapid ascent and reached 7.9%, which is the highest level in more than 40 years. Existing inflation trends caused by the post-pandemic supply/demand imbalance were tragically compounded by the invasion of Ukraine, and US monetary policy began to reverse course in earnest in response. The result has been an abrupt end to a period of stimulus-fueled steady appreciation in equity markets, and our outlook for equity markets has shifted as a result. We remain cautiously optimistic that economic momentum will drive some modest earnings growth and stock market appreciation this year, but we expect that markets will remain volatile given the headwinds that gathered strength this quarter.
We were concerned at the beginning of the year that valuations of US “growth” stocks that had been leading the market were unsustainable after the S&P 500 doubled over the prior three years. These growth stocks did prove to be vulnerable as the stock market fell into a correction (defined as a decline of at least 10% from a peak). Prior to the rebound in equities that began on March 15, the S&P 500 Growth Index declined by 18.4% in just the first 2½ months of the year, while the S&P 500 Value Index had dropped by only 5.3%. The damage to many former market leaders has been substantial. Some growth index heavyweights that are currently profitable like Facebook parent Meta and Netflix lost nearly half of their value in that 2½ month stretch, while more speculative companies fared far worse. Interestingly, growth stocks rebounded more than the rest of the S&P 500 in the last few weeks of the quarter. Valuations are now more reasonable and the ability of growth companies to expand profits regardless of the economic outlook is gaining appeal. We continue to seek a balance between growth and value with an emphasis on high-quality companies that can thrive in a highly uncertain economic environment.
One of the reasons to expect ongoing volatility is that estimates for 2022 earnings for S&P 500 companies in aggregate actually rose marginally over the course of the quarter despite increasing economic uncertainty. Aggregate earnings growth estimates for the coming year now stand at 17%, which would be the highest of the past decade with the exception of 2021’s 28% post-pandemic earnings rebound. While some companies can benefit from rising inflation and interest rates, most do not and many now seem poised to disappoint elevated expectations.
As noted in our recent webinar on market volatility, stocks falling into a correction is not new or problematic – it happens quite routinely when the market absorbs a negative surprise or valuations get too lofty. More severe downturns are typically linked to a recession, which seems unlikely in 2022. The stability of earnings estimates and of American balance sheets reinforces that increased volatility is part of business as usual, but there is one notable exception. The inflation outlook has shifted meaningfully as the global economy has absorbed shock after shock: trade disputes in 2019, pandemic-disrupted supply chains in 2020, pandemic-fueled pent-up demand in 2021, and now geopolitical disruption to an important commodity supplier in 2022. Even after the current inflationary shocks dissipate, our expectation is that inflation may remain elevated for some time as corporations rebuild their supply chains for greater resiliency at higher cost. From a longer-term perspective, humans are incredibly adept at making more with less and there are new technologies on the horizon that will eventually renew downward pressure on inflation such as automation of transport and manufacturing. In the meantime, we expect inflation to remain a significant hurdle for investors to clear.
The Federal Reserve came to terms with the scale of the inflation problem at hand in the quarter, which is driving an unusual dynamic in stock and bond markets. Stocks and bonds typically have a negative correlation, meaning that good news for stocks is usually bad news for bonds and vice versa. While bonds are typically an excellent diversifier for stocks, both declined precipitously this quarter. This was the first episode of positive daily correlation between the S&P 500 and the Barclays Intermediate Government / Credit Bond Index since the summer of 2007.
It appears the Fed is now firmly in the driver’s seat as the monetary policy implications of inflation trends have become the most important driver of both stock and bond returns. This creates the potential that we could enter a perverse environment where good news for the economy is bad news for the stock market as it emboldens the Fed to fight inflation more aggressively.
Equity markets are adapting to an environment where inflation expectations are the fulcrum shifting all asset classes. As the Fed addresses inflation more decisively, short-term volatility seems likely, as do longer-term investment opportunities for thoughtful asset allocators and security selectors given economic momentum and increasing productivity of US businesses. We will be watching carefully for new risks and opportunities as they emerge in equity markets in 2022 – it looks as though both will be plentiful this year.
Fixed Income Markets: Year-end Summary and Outlook
In the first quarter of 2022, the bond market rapidly recalibrated its outlook due to a newly aggressive Federal Reserve, unrelenting inflation, and burgeoning geo-political risk. Without a doubt, these variables are interrelated. Fractured supply chains, worker shortages, and excess consumer demand have stoked inflation, which the Russia war on Ukraine has exacerbated. Fed chairman Jerome Powell and the Federal Open Market Committee (FOMC) were late to react and now must aggressively hike interest rates. At the start of the year, the bond market was forecasting only three interest rate hikes in 2022 to 0.75%. Three months later, inflation is embedded in the US economy and Powell has guided the market’s current expectation to an additional 2.25% worth of hikes in the next 12 months. Bond markets no longer doubt the Fed’s conviction and interest rates moved dramatically upward in the quarter. The Ten-Year Treasury yield rose by 0.83%, and the Two-Year Treasury yield moved higher by a considerable 1.6%. These new circumstances leave investors wondering if an aggressive Fed and inflation will derail the consumer-led US economy, in addition to weighing consequences of the war in Ukraine. The US economic outlook is more uncertain and corporate credit spreads have reflected this. After starting the year at 278 basis points (2.78%), the credit spread on the Bloomberg US Corporate High Yield Index has widened to 325 basis points, reflecting an increase in credit risk. Investment-grade corporate bonds, preferred securities, and municipal bonds are other fixed income sectors with incremental risk over US Treasurys and they have also exhibited weakness relative to Treasurys.
It has been a challenging first quarter for most fixed income sectors (see chart at top), but much of the risk is conceivably in the rear-view mirror. A rapid repricing of interest rate expectations has caused a dramatic rise in yields and left two-year through ten-year maturities with essentially the same yield. At a 2.35% current nominal yield, the Ten-Year Treasury is approaching the FOMC’s median terminal rate of 2.75%, which is the rate at which they expect to stop hiking interest rates. Admittedly, the future path of interest rates is highly dependent on the trajectory of inflation, but the relative value proposition of fixed income is vastly improved. To put the first quarter in perspective, it was the worst quarterly return for the Bloomberg US Aggregate Bond Index since 1980. On the positive side, bonds reprice at market yields and this index now yields 2.96%, up from 1.73% at the start of the year. High-yield corporate spreads have widened, interest rates have increased, and now the Bloomberg US Corporate High Yield Index boasts a healthy 6% yield. Even high-quality, longer-maturity municipal bonds offer tax-exempt yields that approach 3.5% (5.38% Tax-Equivalent Yield*). When looking for near-term recession signs, we are encouraged by the overall financial health of corporations and municipalities and the smooth functioning of their respective markets.
With Federal Reserve interest rate hikes mostly priced into the current market, we are looking for investment opportunities that accompany the recent rapid increase in yields. Our outlook for stubborn inflation keeps us overweight Treasury Inflation Protected Securities (TIPS) and investing in companies with strong balance sheets and pricing power. Given the flat Treasury curve, there is a reduced incentive to increase portfolio duration. We default to building intermediate-duration portfolios (3-6 years), and currently favor the lower end of that range. The US economy is resilient, and we do not see a meaningful risk of recession in the near term, which keeps us constructive on the High Yield and Investment Grade credit sectors.
*Tax-Equivalent Yield calculation at a 35% marginal tax rate.
Fixed Income Focus: The Yield Curve
Recently, there has been a great deal of speculation about what it means when the yield curve “inverts,” the infrequent occurrence when short-maturity Treasury yields are actually higher than longer-term yields. Many believe in its ability to predict recessions, the common refrain being that 10 out of the last 13 recessions have been preceded by a yield curve inversion. Yield curve inversions are rarely good news, but we do not subscribe to the predictive nature of this indicator or a predetermined recession as a result. Rather, an inversion is simply one mile marker along an economic path that deserves scrutiny. Complicating the situation further, there are multiple ways to measure whether the yield curve has indeed inverted. The news media tends to focus on the yield spread between the 2-Year and 10-Year US Treasury, which is currently negative (inverted). We assign more significance to the yield spread between the 3-month Treasury Bill and the 10-Year Treasury. Furthermore, Chairman Powell and the FOMC focus on the slope at the very front end of the yield curve. Importantly, the latter two measures are firmly upward- sloping. It is also worth noting that the Fed still owns $5.7 trillion in US Treasury securities, which is undoubtedly distorting the supply/demand dynamic and the corresponding shape of the yield curve. Ultimately, a mosaic of information informs any investment decision, and yield curve measures are worth paying attention to. However, we place as much emphasis on other indicators such as employment data, consumer spending (including housing data and car sales), durable goods orders, financial conditions, and the index of Leading Economic Indicators (LEI).
Sustainability Spotlight: Russian Energy – There is no going back
It is becoming abundantly clear that in many ways the world is changing. Russia’s war with Ukraine is bringing what recently seemed like fraying alliances firmly back together and is potentially creating clearer separation between spheres of economic power centered around democratic and authoritarian leadership. Within global markets, the shifting world order has been most obvious in energy markets as major developed countries reassess the fundamentals of energy security and attempt to accelerate the shift to energy independence, both centered on a transition away from Russian oil and gas. This dynamic is most pressing in Europe, a region structurally short of primary energy sources and highly dependent on Russian oil and gas.
Some background data from the annual BP statistical review of world energy is helpful to set the stage. Europe, as most broadly defined including all countries in the region, holds just 1% of global oil reserves and 2% of global natural gas reserves, though the region was responsible for 4% of global oil production and 6% of global natural gas production in 2020. Europe is working with mature resources that are in decline, with regional production over the last ten years down 3% annually for oil and down 2.5% annually for natural gas. On the demand side of the equation, Europe is responsible for 14% of global primary energy consumption, a level that has declined 0.2% annually over ten years as energy efficiency gains have offset economic growth. In 2020, about 60% of Europe’s primary energy needs were met by oil and natural gas. About 80% of Europe’s oil consumption and 60% of natural gas consumption were met by imports, with 40% of oil and 60% of gas imports from Russia.
To be clear, Europe’s import-dependent energy position is not new news and pressure to accelerate change predates the Russia/Ukraine war. As the chart below shows, benchmark European natural gas prices began to accelerate to the upside as the region started to emerge from COVID-related restrictions a year ago. Forty percent higher residential energy bills in Spain led to protests in the streets last September. European leaders have enacted a host of measures designed to push toward an energy-independent net-zero future, including a decarbonization strategy in 2019 called EU Green Deal; a financing framework for environmentally sustainable activities in 2020 called the EU Taxonomy on Sustainable Finance; and in 2021, the Fit for 55 package covering legislative reforms needed to hit green deal targets.
The Russian war against Ukraine has put Europe in a very precarious position. European leaders have enacted increasingly impactful rounds of sanctions, though have hesitated to completely cut off Russian energy. Olaf Scholz, the German Chancellor, warned that an embargo would wreak havoc on the economy and risk social unrest. Despite short-term tensions, the European Commission (EC) recently announced an energy-independence proposal called REPowerEU, covering increased non-Russian liquified natural gas (LNG) imports and green hydrogen production, as well as an accelerated shift away from fossil fuels by increasing renewables and electrification, and boosting energy efficiency efforts. The EC outlined the potential to reduce Russian imports by 2/3 within a year. The EU Green Deal and other frameworks set a pathway that will now be expanded and accelerated.
With Europe actively working to shift away from Russian energy as rapidly as physical infrastructure will allow, gas, oil, and other commodity prices are likely to remain elevated for some time. As European leaders attempt to balance availability, affordability, and the path to net zero, there will be winners and losers in Europe and in other markets. High natural gas prices should drive investment in US LNG export capacity and regassification infrastructure in Europe, benefitting energy producers and other companies in the energy and industrial sectors. Higher energy prices will lead to rising input costs for manufacturers in Europe and elsewhere, potentially weighing on margins. Higher traditional power prices make alternatives, which are already economically competitive, increasingly profitable. Even higher-cost fuels like green hydrogen are currently competitive, something that was not expected before 2030. Elevated oil and product prices should accelerate the shift from internal combustion to battery electric consumer vehicles and hydrogen fuel-cell-heavy transportation.
In the near-term, the developed world will pay more for traditional energy sources, potentially exacerbating inflation and leading to higher levels of oil and gas development to bridge the gap and keep the heat and lights on. The long-term consequences of this structural energy shift are profound. Higher prices send a powerful signal that will lead to an acceleration of growth in renewable energy, battery storage, energy efficiency, electrification, and other pathways to decarbonization. These trends and many others inform our security-level and broader asset allocation research and actions, with energy and commodity markets a central focus currently.
Private Markets and Alternative Investments
Performance in the first quarter highlighted the benefit of adding alternatives to a traditional investment portfolio. For the quarter, private assets across most venture, growth, and private equity categories continued to perform well. As noted in the equity outlook above, earnings for S&P 500 companies in aggregate rose for the quarter. The companies within the private equity universe should follow the broad economic path of the economy (which continues to grow) while also benefiting from entry valuation discounts and operational and financial initiatives undertaken by the underlying managers. Within the venture universe, performance continued to be strong as well, except for more capital-markets-sensitive crossover investments. Crossover rounds are later-stage venture deals where investors finance businesses with the expectation of an IPO over the following 2-3 years. As valuations were exorbitant for publicly traded growth businesses in 2020 and the first half of 2021, the valuations placed on crossover rounds in 2020 and 2021 utilized market assumptions that have since come back to earth. While we don’t anticipate any material markdowns to occur in the first quarter, the change in public market assumptions will weigh on the internal rate of return (IRR) potential of the 2020 and 2021 vintage crossover rounds. Early-stage venture capital remains largely unimpacted, because the investments are far from exit, significantly less sensitive to capital markets conditions, and benefit from massive amounts of dry powder within mid- and late-stage venture capital funds. For context, in excess of $100 billion was raised by US venture capital firms in 2021, a record amount.
In building out FLPutnam’s alternative platform, we have focused on three core private equity strategies to balance cash flow, IRR, and multiple profiles.
- Secondaries funds are an attractive tool to accelerate the deployment of capital across multiple vintages and deals and to mitigate the j-curve dynamic of any private investment program. Secondaries also tend to be more value-oriented, as the managers are viewed as providing a service to the market (liquidity), for which they are compensated by a discounted purchase price relative to NAV. Over the last decade, the proportion of allocator portfolios dedicated to illiquids has increased dramatically across funds and single assets. In the next cycle, we expect secondary volumes will increase materially and the discounts from non-economically driven sales should be substantial.
- Operationally oriented middle-market private equity funds tend to generate higher deal-specific outperformance through lower entry multiples (<10x EV to EBITDA) and leverage levels (<5x Debt to EBITDA). Through operational execution, managers can isolate performance that is within their control and reduce sensitivity to interest rates or other macro factors. In the last decade, rollup strategies haven’t necessarily required exceptional operational execution to be effective because financing rates were so cheap. To increase the probability of outperformance over the next cycle, we evaluated managers by the strength and depth of the resources used to execute their operational initiatives.
- Early-stage venture capital remains attractive as the least-sensitive venture category to volatility in broad equity markets and the dry powder previously noted. As such, early-stage managers who have demonstrated a clear ability to execute their strategies and identify businesses gaining traction should find their businesses well supported. Despite a decline in public growth valuations, businesses in the personalized healthcare/telemedicine, future of work, next generation of software, and Web3.0 verticals are structurally supported by long-term technological and business trends.
Early indications of performance suggest low to mid-single digits performance for core real estate strategies. While real estate isn’t a panacea given anticipated rising interest rates and a slowing economy, these assets are well positioned to not only weather the environment but generate positive returns going forward. The greatest dispersion in real estate is between legacy office in Tier 1 cities that is likely to continue to underperform, while creative office in growth markets and specialized offices continue to do well.
The real estate investments considered for approval on our platform all share a handful of characteristics: 1. Diversification across real estate sectors (single family rental, multi-family rental, commercial, retail, mixed use, and industrial), 2. Scale to optimize long-term cheap financing, and 3. Operational platforms to push rental increases (1-5 years depending on asset type). Given the strength of employment and consumer balance sheets (supporting single and multi-family housing) and e-commerce trends (supporting industrial, particularly warehouses), these portfolios are well positioned to generate yield and modest appreciation. Also worth highlighting is that distributions are tax-advantaged due to offsetting depreciation and amortization from the underlying properties.
Private credit performed well for the quarter, with early indications of performance in the low to mid-single digits. Unlike public credit markets, private credits are typically held at cost unless the manager perceives an impairment event to be likely. With economic conditions remaining strong despite the war in Ukraine and inflationary pressures, the probability of mass near-term markdowns is low. While US businesses are likely to experience some margin pressures going forward, private credit managers are overwhelmingly exposed to first-lien senior secured loans at sub-50% LTV ratios, which provides ample margin of safety if economic conditions were to deteriorate. The underlying loans also are floating rate, so portfolio losses are isolated to credit events rather than interest rate moves. The managers with the most scale used 2021 to secure some fixed cost financing, setting up a positive yield spread dynamic if interest rates should continue to move higher.
Market Diary: Recap of market activity in the first quarter of 2022
|Global Market Returns – December 31, 2021||Last 3 Months||Last 12 Months*||20-Year Annual Return**|
|US Equities||S&P 500 (Large US Companies)||-4.60%||15.65%||9.24%|
|S&P 400 (Mid-size US Companies)||-4.89%||4.56%||9.91%|
|S&P 600 (Small US Companies)||-5.64%||1.15%||10.01%|
|Russell 3000 (All US Companies)||-5.28%||11.91%||9.36%|
|Dow Jones US Real Estate Index||-6.50%||20.66%||9.59%|
|International Equities||MSCI World Index ex-US (Developed Markets)||-4.68%||3.56%||6.68%|
|MSCI Emerging Markets (Emerging Markets)||-6.92%||-11.08%||8.96%|
|MSCI World ex US Small Cap (Developed Markets Small Companies)||-7.13%||-1.32%||9.36%|
|Fixed Income||Bloomberg Intermediate US Govt/Credit TR||-4.51%||-4.10%||3.55%|
|Bloomberg US Corporate High Yield Total Return||-4.84%||-0.66%||7.47%|
|Bloomberg Intermediate Corporate Total Return||-5.25%||-4.10%||4.55%|
|Bloomberg US Intermediate Treasury TR||-4.21%||-4.17%||3.05%|
|Bloomberg US Treasury Inflation Notes TR||-3.02%||4.29%||5.07%|
|Bloomberg US MBS Index Total Return Value Unhedged||-4.97%||-4.92%||3.65%|
|Bloomberg Global Aggregate ex USD 10% Issuer Capped (Hedged)||-6.07%||-7.53%||4.70%|
|J.P. Morgan Emerging Market Bond Index Global Core||-0.22%||-2.05%||8.14%|
|Bloomberg Capital 5-Year Municipal Bond||-5.10%||-4.48%||3.32%|
|Inflation||US CPI Urban Consumers Less Food and Energy NSA***||1.88%||6.41%||2.12%|
|Treasury Bill||US 3-Month Treasury Bill Index||-0.03%||-0.01%||1.30%|