Market Outlook

September 30, 2022

In the third quarter of 2022, economic data once again sent conflicting signals about the US economy. On the positive side, the US labor market remained strong, with unemployment of 3.5% near all time lows, and initial jobless claims well below expectations. On the negative side, inflation softened only a bit during these months, from a high of 9.1% reported in June to 8.2% reported in September. These opposing signals led to continued volatility across a range of asset classes: equities, fixed income, commodities, and alternatives. The Federal Reserve (Fed) doubled down on its intention to stamp out inflation by tightening monetary policy via both higher short-term rates and so-called Quantitative Tightening, which accelerated in the month of September. In the US, the Inflation Reduction Act passed Congress, impacting the domestic fiscal outlook. Unexpected global geopolitical events – including the recent progression of the Russia-Ukraine war and the UK’s twin about-faces on tax and monetary policy – drove increased volatility and created additional uncertainty.

In this issue, we touch on the impact of rising interest rates on fixed income portfolio construction, equity volatility, preliminary observations on the Inflation Reduction Act, and how all of these inform our asset allocation stance. We also dissect how these forces are manifesting in various private markets, not merely via shifting valuations, but also examining which areas are exposed to tighter liquidity conditions or higher funding costs.

As we approach the final quarter of the year, we expect continued volatility, as evidence of these opposing economic forces drive investor opinions one way and then the other. Through it all, we remain opportunistic and disciplined.




Asset Allocation Overview

We started the third quarter with an overall defensive asset allocation posture. We were fully weighted in equities with a tilt toward US large companies and underweight toward international firms. Within the fixed income asset class, we were heavily underweighted as interest rates continued to rise, producing losses in bond portfolios throughout the first half of the year. We were overweighted toward alternative investments, which provided some ballast during the first half of the year from losses in fixed income and equities.

Investors witnessed a strong rally in both fixed income and equities in July as interest rates moderated and investors speculated that the Fed might become somewhat less hawkish. From an asset allocation perspective, our positioning benefited as the US economy chugged along at a solid pace and the US dollar sustained its rally against other currencies. We continued to be concerned with the international economic situation as developed economies exhibited increasing risks from energy shortages due to Russia’s war on Ukraine. In response, we reduced our exposure to international by eliminating our small company developed world allocation. Given the continued volatility in the overall equity and fixed income markets, we maintained the proceeds in cash. This action has modestly supported portfolios as international markets continued to underperform US markets during the third quarter.

The rally was crushed in the second half of the quarter as inflation numbers showed no signs of slowing. Interest rates rose, and credit spreads widened, which negatively impacted both bonds and stocks. After a sizable decline in August, markets again rallied and diversified asset allocation seemed to be rewarded. The September Fed meeting completely dampened the short-term improvement in sentiment, however. Revised forecasts for interest rates and economic growth by the Fed spooked investors, resulting in sharp declines in stocks and bonds, more than wiping out the gains that had occurred during the quarter. September ended up as one of the worst months in years for equities, and bonds lost more than 2.5%. Commodity prices also declined as investors began to fear that rate increases may lead to recession. Unfortunately, during the period there were few places to hide, and diversification provided limited downside protection.

We also eliminated exposure to gold near the end of the period, as gold has struggled with the rising US dollar despite elevated inflation. This action allowed us to add fixed income to portfolios, taking advantage of higher short-term Treasury yields. We remain underweighted in bonds with a high-quality focus and relatively short duration. The shifting of funds from gold to Treasurys provides higher yields and improves the credit quality of our fixed income position.

Alternative investments did not escape the downdraft of equities and fixed income during the quarter as real assets, real estate, and commodities all declined during the period. These investments have been beneficial to diversifying portfolios: real assets and real estate losses were modest for the period and provided better returns than fixed income, from where they were sourced. Commodities sustained greater drawdown during the period as overall commodity prices fell during the quarter.

We end the third quarter of 2022 with a diversified approach toward asset allocation, an underweight toward equities and within equities, and a tilt toward US companies over international firms. Within the US, we favor large and mid-capitalization companies over small firms. We remain underweighted in fixed income but recognize more opportunity within the asset class and added to bonds near the end of the quarter. We remain focused on high quality and shorter duration and expect more opportunities for fixed income to play its traditional role of buffering portfolios during significant equity drawdown periods.

Finally, alternatives continue to contribute to broader diversification and low correlation to both stocks and bonds and we remain positioned with exposure to broad-based commodities, real assets, and real estate.


Tactical Asset Allocation Positioning


Fixed Income Market Outlook

A resilient economy and a tough-talking Fed kept interest rates on an upward trajectory in the third quarter. At the annual Jackson Hole symposium in August, Chairman Jerome Powell reinforced the Fed’s intentions to tackle inflation aggressively even at the expense of economic growth. To make his point, he referenced necessary “pain” to be inflicted on households and businesses and even quoted former Fed Chairman and famous inflation fighter, Paul Volcker. Talk is cheap, but the Fed clearly plans on backing it up, as indicated by their three successive 0.75% interest rate hikes in June, July, and September. The rapid increase in the Federal Funds Rate, designed to slow the economy and reduce inflation, has left investors wondering how high interest rates will need to go and what the economic impact will be. Specifically, the market has been focused on the “terminal” Fed Funds Rate, the projected peak level of short-term interest rates. At the start of the quarter, 3.5% was the market’s projection for this number, but it has repriced to around 4.5% due to persistent inflation stemming from a resilient, consumer-driven US economy. Monetary policy works with notorious lags, but for now, a durable economy and an aggressive Fed mean higher interest rates. During the third quarter, the 10-Year Treasury increased from 2.88% to 3.82%, and the 2-Year Treasury increased from 2.95% to 4.27%. Powell and the Federal Open Market Committee (FOMC) inflicted a little more “pain” on bond investors too this quarter, with additional unrealized losses coming from increasing interest rates. A silver lining is that high-quality, intermediate-duration bond portfolios now yield over 5% on a go-forward basis, which bodes well for future returns.

Bond markets can provide important signals about the economic outlook. When we look at indicators such as credit spreads, the Treasury Inflation-Protected Securities (TIPS) market, the inverted yield curve, and new issuance markets, we see signals that are mixed. Credit spreads are an important indicator of funding stress, and while they have moved sharply wider in the first three quarters of the year, they have not yet reached concerning levels. Currently, the option-adjusted-spread of the Bloomberg US Corporate High Yield Index is +561 basis points (or 5.61%), but in recessions this measure can easily reach +800 basis points (8%). The TIPS market is a proxy for future inflation expectations and is forecasting that inflation will return close to a 2% trend. While we view this as another positive sign, it could be overly optimistic or reflective of lower inflation caused by a recession. Either way, it does reflect confidence in the Fed’s ability to reduce inflationary pressures through monetary policy. We continue to see concerning signs in the shape of the yield curve and in corporate new issuance markets. Most parts of the yield curve are now inverted, meaning short-term yields are higher than long-term yields. The spread between the 2-Year Treasury and the 10-Year Treasury has been inverted for the entirety of the third quarter and is the most inverted it has been since the year 2000, clearly a worrisome sign.  Finally, when we assess corporate bond issuance, we see a quarter of muted issuance that was marred by pulled deals, tepid demand, and issuers needing to offer more yield to attract buyers. Taken in sum, these factors render us increasingly cautious going forward.

With caution as a mindset, we have been continually reducing credit and interest rate risk in portfolios. We are maintaining a portfolio duration that is shorter than the benchmark and have been opportunistically swapping corporate exposure into government securities to increase average quality and liquidity. Within the corporate bond universe, financial leverage and coverage ratios have likely peaked but are still at robust levels. We see value in many high-quality corporate issuers whose spread levels are double where they were to start the year. In the municipal bond market, bouts of volatility and indiscriminate selling have produced strong buying opportunities. Intermediate municipal bonds can easily yield a tax-free 3.5%, or 5.8% (assuming a 40% marginal tax rate) on a tax-equivalent basis. In addition to opportunities in municipal and corporate bonds, we continue to allocate to TIPS in client portfolios, believing that the market’s view on long-term inflation is far too sanguine. Looking forward, continued deterioration in the economy could lead us to increase portfolio duration, hasten the rotation into government securities, and eliminate allocations to higher beta asset classes such as leveraged loans.

Fixed Income Focus: Treasury Market Volatility

If lately it seems like interest rate markets are more volatile than usual, it is because they are. In 2022, bond markets have matched the dramatic movement of equity markets as inflation and an aggressive Fed have driven interest rate volatility. When looking at basis point changes in the 10-Year Treasury, daily interest rate fluctuations in 2022 are almost double what they have been in prior years. In 2022, the average daily move in the 10-Year Treasury has been six basis points (0.06%), but it has been commonplace to see daily fluctuations of 10-20 basis points (0.1%-0.2%). The increase in volatility is corroborated by the ICE BofA MOVE index, a measure of Treasury market volatility that is at its highest level since 2009. There have also been indicators showing a lack of Treasury liquidity in what is supposed to be the world’s most liquid bond market.

The suspected reasons for increased volatility and diminished liquidity are varied. Increased regulation has shifted market-making away from big, deep-pocketed players like banks, the supply of Treasurys is greater as budget deficits have increased, a strong dollar is increasing the cost of Treasurys for foreign investors, and the Fed is stepping away from its bond purchase program. When you add in expectations for higher rates and inflation, it is no wonder that data from the Fed shows commercial banks and foreign accounts sharply reducing their holdings over the last six months. While we think interest rates have limited room to increase from here, outsized volatility and a lack of liquidity speak to a structural issue that may need fixing down the road. Most solutions proposed to date include regulatory changes and central clearing, but progress has been slow to develop.


Equity Market Outlook: Long-Term Opportunities Developing

The stock market is often referred to as a roller coaster, but the rise and fall in the third quarter of 2022 was so dramatic that the Tower of Terror (a haunted elevator that hurtles up and down) seems like a more comparable ride.  The quarter began with stocks soaring in expectation that inflation was peaking and the Fed would soon pivot and begin to balance its inflation fight with economic support.  The S&P 500 stock market index rose by 13.9% in the first half of the quarter before plunging 16.5% to close at a new low for the year as the grim reality set in that the Fed would risk a recession if necessary to control inflation.  The resulting 4.9% decline in the S&P 500 doesn’t quite capture the level of uncertainty reflected in financial markets over the past quarter, which likely left some investors feeling like they had actually just stepped off the Tower of Terror.

Unfortunately, it seems likely that investors may be stuck in this amusement park on a variety of stomach-churning rides for some time.  The economic outlook has deteriorated, and recession is now likely with the yield curve inverted and the year-over-year change in the Leading Economic Indicators in negative territory.  Inflation, however, remains stubbornly elevated and the Fed appears resolved to continue restricting economic activity until inflation is steadily declining towards their stated goal of 2%.  The result is an unusually wide range of potential outcomes for equities.  Barring some sort of financial accident given the extraordinary level of cross-asset volatility in recent weeks, we believe guidance for corporate profits in the upcoming earnings season is the key to the short- and intermediate-term outlook for equities.

Last quarter we noted that equities finally seemed to be reasonably priced relative to current earnings after years of elevated valuations in a low interest rate environment, but that earnings estimates appeared overly optimistic given the economic outlook. Earnings estimates for 2023 did decline by a few percent during the quarter, but they now rest roughly where they began the year and still reflect expectations for profit growth of 8% next year. Our expectation is that earnings will remain flat or decline modestly next year. Markets are beginning to price this in, but we expect ongoing volatility as expectations for corporate profits become more realistic. As a result, our allocations within equities remain biased toward relatively stable large US companies that seem best equipped to manage through an increasingly challenged economic backdrop. Our disciplined approach to stock selection could also serve us well in this environment, given its focus on high-quality companies with reasonably valued shares and solid growth prospects.

While short- and intermediate-term tactics get more attention when markets are volatile, there are also long-term implications of rising recession risk.  The chart at bottom provides a list of all US recessions since 1980 and selected S&P 500 returns following these time periods.  There are three primary observations from this data:

  • The stock market has historically moved in advance of the economy. The stock market has often reached a trough in the middle of recessions when the economic outlook was at its bleakest.
  • S&P 500 total returns in the 5 years following a market bottom during recession have been unusually strong, with an average of 17.6% annually.
  • Even investing early in a recession, six months prior to an S&P 500 trough, has historically generated outsized returns over the following five years, with an average of 15.6% annually. This may be a useful comparison to where we currently stand with the stock market already down significantly while the economy seems to be slipping into recession.

Recessions have historically represented both short-term risks and long-term opportunities. As a result, while we remain underweight equities, we also remain within strategic equity allocation guidelines.  This disciplined approach has been critical to portfolio recovery in past downturns as the bargains on offer during recessions can prove fleeting. Investing just after a recession has not generated the unusually strong returns highlighted above. The same analysis conducted 6 months after the S&P 500 bottom results in a 5-year annualized total return of 11.9%, which is similar to historical average equity returns. The bottom line for our equity market outlook is that we remain cautious from a short-term perspective given earnings vulnerability, but also skeptical that anyone can predict the market bottom perfectly, and cognizant that we are entering a time period that is likely to provide attractive long-term investment returns.  Like the passenger on the Tower of Terror, equity investors may be well served to keep their seatbelts fastened and shift their focus to the horizon to steady themselves.


Sustainability Spotlight: IRA – A Green Gamechanger

After nine months of failure to move climate legislation forward following the COP26 UN climate conference in Glasgow, US Senators Chuck Schumer and Joe Manchin surprised everyone with a breakthrough in late July. The 700+ page Inflation Reduction Act (IRA) is the most significant and comprehensive climate legislation ever passed in the US, touching virtually every major greenhouse gas emissions driver in the economy. Beyond the obvious long-term benefit of a cleaner environment, the IRA creates tremendous incentives for the private sector, which should lead to opportunities for investors. 

It’s important to state up front that while analysis of the Congressional Budget Office (CBO) scoring of the IRA points to a net deficit reduction over the next decade of $238 billion, private estimates vary widely. One Wall Street auto analyst estimates the value of just the clean vehicle purchase credit likely to be captured by GM and Tesla annually by mid-decade at two times the total outlay for the clean vehicle program over a decade. If the Wall Street analysis turns out to be accurate, the shift in this single provision alone would cut the deficit reduction in half. The name of the IRA is also somewhat misleading; economists from Moody’s and University of Pennsylvania’s Wharton School point to an initial inflationary impulse and any potential inflation reduction occurring many years in the future, though with a low level of confidence. While inflation and budget dynamics are debatable at this stage, it is clear the IRA will be a significant accelerant for decarbonization in the US with many associated benefits. 

An analysis by the Princeton University Zero-carbon Energy Systems Research and Optimization (ZERO) Lab found that the IRA could cut annual emissions in 2030 by 1 billion tons relative to the existing policy pathway. This reduction in emissions would get the US two-thirds of the way to the nation’s net-zero pathway and stated 2030 target of a 50% reduction relative to 2005 emissions. The most significant drivers of decarbonization in the Princeton analysis are acceleration of clean electricity and clean vehicle deployment, together representing 65% of emissions reductions. 

With decarbonization largely based on electrification throughout the economy, a shift toward a zero-carbon power sector is foundational. Clean power provisions in the IRA replace the past practice of short-term incentive structures for wind and solar power projects, creating over a decade of visibility for developers and system owners. Incentives take the form of up-front investment tax credits (ITCs), or production tax credits (PTCs) captured over time as power is produced, with increased flexibility to choose the type of credit most appropriate at the project level. Full capture of the new credits requires paying a prevailing wage to workers and meeting apprenticeship requirements. Beyond attractive ITC and PTC levels, there are a series of bonus credits that can further improve project economics. 

In the transportation sector, the IRA transforms a limited 200,000-unit tax credit by manufacturer into an open-ended program centered on a point-of-sale purchase credit for consumers. While in theory this program should level the playing field, there are devils in the details. The full $7,500 credit is limited to consumers below certain income caps based on taxpayer status and will only be available on sedans below $55,000, and trucks and SUVs below $80,000. Additionally, only vehicles assembled in the US are eligible, and then, only if they meet tightening US-based battery production and material sourcing requirements. The legislation clearly favors large manufacturers with scale production in the US and the foresight to invest in battery technology and local manufacturing. Many large manufacturers and most newer entrants will likely be strategically disadvantaged under this new incentive regime. 

Beyond the headline-grabbing clean energy and clean vehicle aspects of the IRA, there are dozens of other credit and financing provisions that will fundamentally alter the growth path in several areas from EV charging, green hydrogen production, building systems, and carbon capture. Local content provisions for the power sector and domestic manufacturing and material sourcing provisions for clean vehicles should drive significant development of US-based supply chains. The significantly expanded Department of Energy loan program and newly created GHG Reduction Fund should support emerging technologies. 

Taking a step back, the big difference between the US approach with the IRA and approaches to development in other parts of the world can be described as carrot vs. stick. The IRA provides incentives for private capital deployment, which will likely lead to many multiples of spending across targeted areas. The Princeton ZERO Lab analysis points to an incremental $4.1 trillion in energy-supply-related infrastructure spending alone, not counting residential investment or multipliers from supply chain development and new technology financing. Further, ZERO Lab estimates net energy-supply-related job growth of 1.7 million through 2030. 

Activity across industries will be broad-based, with many utility, industrial, and material companies most likely able to capture benefits, though in certain areas there will be structural winners and losers. Beyond more obvious clean-tech-focused companies, there will be opportunities for legacy industrial and energy companies to transition, in some cases rapidly. There will also surely be plenty of greenwashing and glaring instances of misallocation of capital with a program this far reaching. As IRA funding works into various sectors and companies, our investment team will be watching closely for both opportunities and risks across public and private markets.


Alternatives Outlook: Uncertainty & Opportunity

While private markets are slower to react to news relative to the public markets, they cannot escape macro factors such as broad economic conditions and interest rates. The growing uncertainty in the outlook has caused private market investors to question their assumptions on valuations, growth prospects, financing costs, and a variety of other key investment factors, all of which are causing purchase and sales activity to slow and valuation multiples to stall, if not decline. The general feeling is that near-term upside has been capped while downside risks have increased. We emphasize that valuation pressures of today are the opportunities of tomorrow. For investors with fully allocated private portfolios, market conditions will likely be a headwind that will reduce IRRs for existing investments, particularly as the likelihood and potential avenues for exits in the near-term seem bleak. However, as activity slows, the market is working to find a lower valuation equilibrium, which is what creates the opportunity set for current and future vintages to allocate capital. A prudently deployed venture capital commitment today will be allocated over the next 3-5 years and deal structures and valuations have already improved materially to account for increased macro risks. The same can be said of private equity. Other opportunistic and liquidity providing strategies (distressed, secondaries) are waiting for over-levered or overly illiquid portfolios that may need to seek liquidity. Overall, markets have sobered up in 2022 and we see the opportunity set broadly as more compelling than it has been in several years. Lastly, a more capital-constrained market is causing fund managers to take longer to raise their capital. Thus, investors have ample time to assess available funds relative to more constrained timelines in previous years.

Similar to prior quarters in 2022, late-stage venture capital and growth equity investments remain the most challenged private market investments. Much of the valuation decline experienced YTD relates to the public market exposures in those portfolios, though we have begun to see proactive markdowns of private investments before additional funding rounds have taken place. Some of the premier venture-backed companies have three years of cash on their balance sheets, allowing them to purchase cash-strapped peers/competitors. Other venture-backed businesses with less cash on hand, have focused on extending their runways by reducing their cash burn rates and taking venture debt. Venture debt and other structured capital providers represent a booming portion of the market as liquidity providers offering minimal dilution can achieve equity-like returns with greater seniority and downside protection, all while the companies and investors can avoid disclosing a decline in the prevailing valuation.

For private equity, the conflict between higher input costs, supply chain issues, and labor cost/availability, has so far generally been outpaced by passing costs through to consumers. That said, the market respects that these dynamics are somewhat fragile, and economic conditions are likely to be worse over the next 12 months than they were in the prior 12 months, particularly as the US consumer has begun tapping into savings. In addition, all private equity businesses are being negatively impacted by higher interest rates given leveraged balance sheets. Private debt funds, notably the middle market direct lenders that finance deals, are showing their concern as well by pulling back from mega deals, increasing underwriting fees and reducing the maximum leverage at which they are willing to lend. The net effect of these actions is that private equity will need lower clearing valuations and higher margins for error for future deals to occur. So far, activity has migrated to tuck-in acquisitions where investment rationales are supported to a greater degree by operational synergies than financing gimmicks.

The environment for private credit has shifted dramatically. Higher rates have led to a pronounced slowdown in capital markets activity, with extremely limited new issuance and banks struggling to find buyers for hung deals that were arranged at indicative early 2022 pricing levels. Performance has been strong as valuations in portfolios have held up remarkably well, as most investments are short duration and floating rate in nature. Given that private market valuations often operate on a lag, we have seen little in the way of markdowns across the sector, with most portfolios still marked at par. We believe the current moment represents a poor time to be allocating fresh dollars to ramped portfolios of legacy credits originated under the prior economic regime. While we are not sounding the alarm for future distress in this asset class, we believe the risk/reward to be skewed, particularly as investors have opportunities to achieve moderate yields in more liquid instruments. Our current emphasis is on managers raising new funds, especially those with opportunistic investment mandates as substantially more companies are likely to require creative and tailored financing solutions over the coming quarters.

So far, real estate has also held up well. However, dispersion among property types and across regions has increased, with some cap rate expansion in lower growth markets and cap rate stability in higher growth markets where investors have aggressively pursued rental increases. Multi-family activity remains strong, but the market is preparing for a large round of multi-family deliveries in 2023 that will likely put a damper on rental increases over the medium term. In addition, while ecommerce activity remains heightened and industrial occupancy remains high, the news that Amazon is rationalizing some of its excess warehouse capacity has dampened market exuberance. Across asset types, we expect development activity to slow given the rise in financing costs. While much of the initial move in interest rates was more than overcome by rental increases, the latest move in rates and anticipations of weaker fundamental conditions has negatively impacted projected baseline returns more directly.


Market Diary: Global Market Returns