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As we started the year 2022—beginning to look at the pandemic restrictions in the rear view mirror—most of us were looking forward to enjoy what our ‘new normal’ may look like. Fast forward to today, and the world is presenting us with a very challenging year on so many fronts. We are having to deal with international war conflicts, increased geopolitical tensions, persistently high inflation, and disappointing investment returns—just to name a few. It is the latter of these issues that I want to take a deeper dive into, and address some of the factors that are affecting investment markets, how they are impacting MEIRA’s portfolios, and what we are doing about it.
A Brief Overview of the Current Economy and Markets
Despite the first two quarters of the year registering a slightly negative GDP growth, the US is not officially in an economic recession as defined by the National Bureau of Economic Research (NBER). The third quarter GDP numbers are not official yet, but positive GDP growth is expected. However, it feels as if we were already in a recession based on a variety of other factors. One of them is investor sentiment, as measured by the University of Michigan survey, which is at depressed levels not seen since the bottom of the 2008 Financial Crisis. A low investor sentiment reading typically means low confidence and likelihood in making any investment decision. In addition, consumers in the US and around the World are facing the highest inflation rates since the 1970s, which leads to your dollars buying you less of the things you need to buy to live on. There are encouraging signs that inflation may have peaked, yet it is likely to stay elevated for longer than desired and originally expected. Another interesting data point is that Google search trends are registering the highest search volume for the word “recession” in more than a decade.
In conjunction with all this, there is a paradigm shift going on in terms of the repricing of money and the cost of capital; specifically, the implications of a rapid and significant increase in interest rates. We are experiencing the fastest and steepest increase in rates in history. As interest rates rise, we experience not only a decrease in the ability for many businesses and consumers to borrow to finance purchases but also a domino effect that effectively reprices all investments. This is because valuations for all kinds of assets are priced based on the present value of future dollars that are expected to be received, and as interest rates go up, the present value of those future dollars goes down. There are a lot more nuances to this, yet it is good basic framework to use. This repricing of the cost of money is the primary driver of the temporary decline in the price of all bonds and has played a role in the decline in stocks around the world.
All the above observations have had their impact across investment markets. More than 90% of all investment asset classes, as defined by Morningstar, are registering negative returns so far year-to-date.
Through the third quarter of 2022, it is the first time in history of the US Barclays Bond Aggregate Index and S&P 500 where both have had three consecutive quarters of negative returns. We are likely going to end the year as the first full calendar year ever with double digit declines in both markets. Needless to say, the traditional framework of having a balanced conservative portfolio of 50% stocks and 50% bonds is not working this year and investors following that approach are experiencing the worst year ever.
Is There a Bright Side?
While there are many reasons to think things will get worse, the reality is that we can’t know for sure. Timing the market is notoriously impossible and any attempt to do so could lead to missing some of the best return days, dramatically altering one’s long-term return outcome. One thing that we can do is to look back in history to see what happened in the 12-24 periods immediately following markets that have exhibited similar factors to the ones we are experiencing now.
Firstly, the current depressed levels of investor sentiment have typically been a good contrarian indicator to invest in the stock market. Meaning, whenever investors have such a low confidence in the markets, the next 12-24 months of returns have a very high likelihood of being positive, often double digits. Secondly, since 1947, there have been 12 instances when the US economy registered two consecutive quarters of GDP declines. In all instances, the US stock market experienced positive returns 12 months afterwards, with the average increase being around 22%.
Additionally, since 1926, whenever US inflation has peaked, the following 12-month returns in the US Stock market have generally been positive, with an average of 21% (see enclosed file “Performance following peaks in inflation”).
Lastly, let's assume for a moment that we are actually in the midst of a recession. Under that scenario, we are more likely to be within the 2nd half of the recession and—based on history—it is during this period of time that US stocks have enjoyed the strongest average monthly gains.
Looking at bonds or fixed income, the situation also looks better from this point onward. Investors may remain concerned over the Federal Reserve continuing to raise rates (and they may continue to do so); however, the majority of bonds and interest rates across different maturities have already priced that in. Most importantly, it is the current starting yield that has the biggest influence in the return you are expected to receive from your bond investment. Since the average bond within the US Barclays Aggregate Bond index is now paying over 4.0%, that is the type of return you should expect from that bond investment as long as you hold to maturity.
What Are We Doing In Your MEIRA Portfolios?
It is during times like this that we encounter questions from clients, who'd understandably like to know what we are doing differently to mitigate these losses or react to these challenging market conditions. Special client circumstances aside, we have used our disciplined, research-driven approach to do a lot over the past number of years to prepare portfolios for a challenging year like 2022. As a result, we are not overreacting to the more irrational market movements on a month-to-month, or quarter-to-quarter basis. To some extent, some of the changes we made to portfolios over the past 5 years felt “early” and were done with the goal of creating a more robust and better diversified portfolio for unknown outlier events like 2022.
Let's highlight some of these portfolio changes that have taken place in the past 3-5 years that are helping client portfolios “win more by losing less.”:
- Bonds: In 2016-2017, we incorporated a more flexible bond investing approach across all portfolios. We were purposeful in keeping a shorter duration and maturity bond portfolio, even at the expense of giving up some yield, because we felt it was important to reduce the potential price swings in the events of interest rates rising. In 2022, this has worked nicely in having a reduced drawdown.
- Non-Traditional Lending: In 2018, we incorporated across all portfolios Stone Ridge Alternative Lending, which invests in marketplace originated loans that have a high yield and short duration. This investment is one of the most successful ones to date, with a 3-year annualized return of 14% and a positive year-to-date return of 2.8% (the US Bond Index is down 15%).
- Stocks with a Dividend Focus: We have always had a bias towards good quality companies that pay dividends over time. In 2020, we added a specific strategy that focuses on companies with a history of growing their dividend over time. We have these stock dividend focused strategies in US large companies (Vanguard Dividend Growth) as well as US small companies (Victory Sycamore Small Company) and both have outperformed their index by almost 10% so far in 2022.
- Hedged Stock Strategies: In mid 2020, in the midst of the pandemic, we incorporated across most portfolios, stock strategies that use options to reduce or limit the downside while also giving up the upside. This was applied in US, International, and Emerging Markets. We were not very happy about the upside that these strategies gave up during 2021, as the markets roared higher. On the other hand, they are now are providing much needed downside protection in 2022 as markets have gone through major corrections. These hedged stock strategies were not meant to be in place permanently, so we are patiently waiting to sell them in the coming months and buying into other stock strategies that will provide full exposure again, hopefully helping enjoy a meaningful stock market recovery.
- Alternative Strategies: We have been investing in different alternative strategies for almost 10 years now. Our goal with these has always been to increase diversification of risks, by reducing the dependency of the portfolio to stock returns, and to a smaller extent bond returns. The truth is, there were many years that these alternatives were questioned for not keeping up with the stock market. They were not meant to do so. Now, many of them are proving to be valuable by having returns not correlated to the stock and bond markets. In fact, two of these multi-alternative strategies found in portfolios are almost flat for the year, while stock and bonds are recording double-digit losses. We continue to believe in the value of diversification and will continue to have a variety of alternative strategies in the portfolio.
- Private Market Investments (Real Estate and Credit/Lending): Over the past 2-3 years, we have recommended to some clients investments in a high quality private real estate portfolio (Blackstone Real Estate Income Trust) as well as a portfolio of different private credit/lending funds (Blackstone, Carlyle, Variant). While these investments may not be ideal for everybody, the ability to access very high quality managers in specialty complex markets, has proven to be extremely valuable. Both of these different strategies are reporting positive returns year-to-date in client portfolios.
In addition to these investment oriented actions, we have also been working on increasing the tax savings for our clients. For clients with taxable accounts, we have been doing tax loss harvesting to capture capital losses that will help offset future capital gains, and up to $3,000 against your ordinary income this year. In addition, for some clients, we are recommending doing partial Roth IRA Conversions to take advantage of lower share prices in converting funds to a tax-free account.
Are we exploring any other immediate changes to portfolios? Yes, we are always evaluating what type of portfolio adjustments and strategy changes we should be making. As always, we review portfolios periodically for rebalancing opportunities, which may entail some buying into stocks in the coming months. This is our disciplined approach of “buying low and selling high." In addition, for clients distributing cash from their portfolio, we are being very purposeful in setting aside around 10-months worth of cash needs to avoid having these monies subject to any market volatility.
We know this is a challenging year on many fronts. How are you navigating through these challenges? Are you seeing yourself not wanting to look at your accounts for fear of being afraid of what you may see? Or, are you becoming increasingly stressed over the declines in portfolio values and being pushed to react and do something? Both reactions are normal and part of our “fight or flight” response mechanism hardwired in our brains since the dawn of time. It just so happens that our ancestors didn’t have to deal with a 24-hour news cycle and emotional investors trading around the clock in a hyper-connected world. Whichever reaction feels more natural to you, we are here available to listen to any concerns or questions you may have and discuss any changes that may be appropriate to your particular situation. Ultimately, it is about you feeling comfortable that your money is being managed and invested in alignment with your life's financial goals. If you feel any of your goals or priorities have changed, let's have a conversation.
Best regards,
Jorge Padilla
Principal | Senior Client Advisor
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