First quarter 2022 was marked by myriad macro headwinds, including the senseless and shocking Russian invasion of Ukraine, inflation that surged to a 40-year high, rising commodities prices and a Federal Reserve that began increasing interest rates faster than the market expected. These developments caused volatility to spike with a vengeance, pushing equities lower. The Nasdaq index was hardest hit during the quarter. Investors rotated out of higher-valuation technology stocks into traditional economy companies that traded at cheaper valuations. In general, we believe that the sell-off of many of the high-growth, high price/earnings technology stocks was warranted. However, as is typical of fast-paced technical rotations, the markets once again did not discriminate between companies with bad business models and unsustainable valuations and those with strong unit economics, substantially growing revenues and margins, and durable and increasing addressable markets. Such volatility, while painful, provides disciplined active managers with opportunities to buy or add to positions, thereby setting up for attractive returns in the future.
Investment Returns as of March 31, 2022
|3 Years *
|5 Years *
|10 Years *
|1-3 Year Treasury Bonds
|U.S. Aggregate Bonds
|Global Aggregate Bonds (USD – Unhedged)
|U.S. Municipal Bonds
|U.S. High-Yield Bonds
|U.S. Leveraged Loans
|U.S. Inflation-Linked Bonds
|Global Equity (USD)
|U.S. Large-Cap Equity
|U.S. Small-Cap Equity
|Non-U.S. Developed Equity (USD)
|Emerging Markets Equity (USD)
|Non-U.S. Developed Equity (Local)
|Emerging Markets Equity (Local)
|*Annualized return figures.
Past performance does not guarantee future results.
In terms of market capitalization, U.S. large-cap stocks outperformed small-cap stocks in the first quarter. On a sector level, only two – energy and utilities – of the 11 sectors in the S&P 500 finished the quarter with a positive return. Energy was the best-performing sector as a slowdown in Russian oil purchases sent prices soaring. Notably, crude oil prices increased 30.3% during the quarter. Geopolitical uncertainty struck foreign markets, and once again, a strengthening U.S. dollar was a negative contributor to international returns. In local dollar terms, non-U.S. developed equities actually outperformed U.S. equities.
With regard to fixed income, the first quarter was one of the more volatile in recent memory. The 10-year Treasury yield spiked over 80 basis points from 1.51% to 2.34% and has continued to rise in April to more than 2.8%.1 Annualized inflation in the U.S. has soared to a rate of over 8%, raising expectations that the Federal Reserve will quickly tighten monetary policy. Market expectations call for the federal funds rate to rise above 2% by year-end (vs. 0% at the beginning of the year), and the Fed has announced plans to begin unwinding its massive balance sheet.
The repricing of longer-duration fixed income has been swift, wiping out years of gains in a short time. Interestingly, the Bloomberg Barclays U.S. Aggregate Bond Index (AGG) and the Bloomberg Barclays 1-3 Year Credit Index (a proxy for short-duration credit strategies) now have the same return dating back over seven years to December 31, 2014.2 As recently as September 2021, the AGG was outpacing short-duration credit by over 1% annually (since 2014); however, these gains quickly evaporated in 2022.3
During this volatile time, we are actively engaging with our managers to ensure that the underlying fundamentals of the businesses they own are strong and growing and that their investment theses remain intact. We believe that over the long term, the market will recognize the underlying value of these businesses, but in the short term, stock prices might not reflect company fundamentals. We believe exploiting the difference between price and value is the only way we know how to generate strong returns. More than ever, we must hold true to our disciplined approach of “knowing what we own” and staying invested through the volatility. As always, we appreciate the confidence our clients have placed in us, and we are working harder than ever to generate strong future returns.
As with prior quarters, in response to questions from clients, we sat down with Brown Brothers Harriman (BBH) Chief Investment Officer Suzanne Brenner and Deputy Chief Investment Officer Justin Reed to hear their thoughts about the current state of the financial markets and how developments are influencing portfolio positioning.
The Fed is raising rates, perhaps aggressively, to combat inflation. What is going on in the fixed income markets, and how are you thinking about positioning the portfolio?
Suzanne Brenner: BBH has had a short-duration posture for our clients for many years now, only opportunistically purchasing longer-duration bonds when yields were offering sufficient compensation for the interest rate risk. At times in 2020 and 2021, this stance looked “wrong,” but discipline and patience matter in investing, and this conservative stance set us up well to deploy capital into longer-duration fixed income on much more attractive terms.
While even our more conservatively positioned fixed income mandates have declined in price this year, we have been able to sell some of our short-duration bond position (which declined just over 1%) to build our positions in aggregate bonds (down between 7% and 8%) and, for taxable U.S. clients, municipal bonds (down between 5% and 6%). The last two months have been a buyer’s market in fixed income, where having dry powder has put us in an advantageous position.
The outlook for rates and fixed income markets is uncertain as always. The market has clearly priced in an aggressive pace of rate hikes by the Fed, but inflation remains stubbornly high, and the well-discussed kinks in the global supply chain may take longer than anticipated to work themselves out. While 10-year Treasury yields have reacted swiftly, the yield curve still remains quite flat. As we write this, a three-year Treasury yields 2.66% today, while a 10-year Treasury yields just 2.81%. This suggests the market anticipates that inflation will come back down to more reasonable levels in the next two to three years. This viewpoint is also supported by the Treasury Inflation-Protected Securities (TIPS) market, where a 10-year TIPS has a breakeven inflation rate of 3.02%. While we are certainly seeing more opportunities to extend the duration of our clients’ fixed income portfolios, we still retain a semiconservative stance on interest rates. We would like to see the long end of the yield curve react even more before reaching a full position in longer-duration fixed income. Thus, we still have capital held back to deploy if the sell-off in fixed income worsens. Even in this scenario, however, clients should rest assured that we will always retain a meaningful position in short-duration bonds as a source of liquidity and stability.
There was a period in early April (albeit quite short) where the yield curve inverted. Does this inversion concern you? Does it imply that a recession is on the way, and has it changed anything about how you are managing the portfolio?
SB: Those are great questions. To back up a bit and add some background, in early April, the yield of a two-year U.S. Treasury note briefly rose above the yield on the 10-year U.S. Treasury note. The market calls that dynamic a yield curve inversion. The market often takes such an outcome as an indicator that investors are more pessimistic about the long term than the short term, and accordingly, that a recession is imminent.
We have looked at historical inversions, and there does seem to be a predictive relationship between yield curve inversions and recessions, although the onset timing of the eventual recessions ranges. At the end of the day, we are bottom-up investors, but we do worry top down about the macroeconomic environment. As I mentioned, our fixed income portfolio remains conservatively positioned, and this positioning is constructed via bottom-up security selection and valuations, not cycle predictions. However, it is not lost on us that this positioning also makes sense given some of the macroeconomic risks we are facing.
Justin Reed: We cannot predict whether or not the Fed will be successful in engineering a soft landing. However, we have looked at periods in history when the two- and 10-year yield curve inverted. In six of the nine times this occurred, the U.S. economy did experience a recession in the following two years.
|Month the two- and 10-year U.S. Treasury yields inverted
|Recession in next 24 months?
Yes, Nixon Recession (December 1969)
Yes, Oil Crisis (November 1973)
Yes, Energy Crisis (January 1980)
Yes, 9/11 (March 2001)
Yes, Global Financial Crisis (December 2007)
Yes, COVID-19 (February 2020)
Past performance does not guarantee future results.
However, we also looked at the S&P 500’s returns in the 12 months after inversion. In just three of these nine periods were the returns not positive
Past performance does not guarantee future results .
S&P 500 12-Month Return
|Month the Two- and 10-Year U.S. Yields Inverted
|S&P 500 Total Return 12-Month Forward Return
Past performance does not guarantee future results .
As fixed income is declining, we are seeing equities experience the same dynamic. Why is that happening?
JR: It’s fair to say that over a decade of easy money policy has largely benefited equities. In the economic regime of steadily declining interest rates, the present value of future cash flows increased as discount rates continued to decline. This led to higher valuations, particularly for companies with more of their value reliant upon future growth. As we enter a new economic regime, one defined by higher interest rates, we know that valuations will contract, all else being equal. And that is what we’ve started to see. The only way to offset that dynamic is through growth in earnings. Our managers are focused on investing in companies that have strong future growth prospects that have the potential to offset the multiple compression over time.
It’s also helpful to pay attention, as we do, to some of the other equity-related consequences of higher interest rates. As an example, we spend a lot of time talking with our managers about how rising rates will increase the cost of capital for their respective portfolio companies and what that means for capital allocation decisions, such as reinvesting in the business, doing share buybacks or deciding to acquire related companies.
What should clients do to protect their portfolio?
JR: We always start from first principles when thinking about questions such as this. The first step for clients is to review asset class targets to ensure that their portfolio composition remains appropriate for their needs, goals and objectives. Next, we believe that you have to invest with the select few managers who seek to generate strong absolute and relative returns over full market cycles. On the public equity side, for example, to accomplish that goal, we partner with managers investing in high-quality companies run by great management teams with attractive free cash flow growth profiles – that can be bought at a discount to a conservative estimate of intrinsic value.4
We spend a lot of time understanding the underlying fundamentals of the investments. When we look at the moat any business has, we try to ascertain how sustainable those competitive advantages are, relative to their competition. The long term is our focus. We are investing in businesses, not trading stocks. Sometimes this approach makes us contrarian, but we know this is how wealth is compounded over the long term. The benefit of this approach is that we focus on value, as opposed to price. A business’s fundamentals are what matter in the long run, as many studies evidence how prices track fundamentals over time. In the short run, it’s anyone’s guess. We are certainly not market timers! I would also note that we have invested through volatile markets before, and while we never want to see negative returns on a page, bear markets provide the best investment opportunities. As one manager said in a recent letter: “The risks to investments actually decline as markets fall.”
All that said, we always look for ways to optimize the portfolio based on the opportunity sets and the macroeconomic environment. As we say, we invest bottom up, but we worry top down. We are keenly aware that in this environment it is even more important to focus on investing with a robust discount to intrinsic value. Overpaying for stocks in any regime is a recipe for long-term capital impairment; however, in today’s environment, the risk of overpaying is even more prominent, as it is unlikely that investors will be protected by loose monetary policy, as they have in the recent past. We are also cognizant of the inflationary pressures in the economy currently, with a recent Consumer Price Index print of over 8%. We have conducted a number of studies that confirm the best long-term protection against inflation is not commodities or gold (although in the short term, they have worked), but equities that have pricing power that can pass on inflation to customers.
Outside of public equities, we are looking for other investments that will benefit in the current economic climate. As an example, we’ve been spending more time on real estate opportunities, which have provided some inflation protection, and direct lending and other floating-rate investment opportunities, which benefit as rates rise.
In addition to inflation, the markets are grappling with a war in Ukraine. This is likely putting increasing pressure on the European economy, which is dependent on Russian oil, whose prices are skyrocketing. Should we stay away from European investments?
SB: There is no doubt that GDP growth estimates for Europe have declined, and it is likely we will see further downward revisions. Many European companies will suffer as a result. However, as our clients know, we don’t invest in an index of companies, but in a select group of businesses that are fundamentally sound and growing. We stay away from companies that will be challenged. For example, our managers generally do not own European companies that have significant exposure to increasing energy prices and whose margins will be pressured, such as those in the cement, steel, chemicals and auto industries. They also are wary of banks, as many European bank balance sheets will likely be stressed because loan defaults typically increase in a recessionary environment. Instead, our managers are finding attractive investment opportunities in companies that happen to be domiciled in Europe but are global businesses with diversified revenue streams.
Interestingly, one of the non-U.S. developed equity managers on the BBH platform states that its European companies generate approximately 80% of their revenues outside of Europe – in North America and Asia. Moreover, the companies it is finding attractive are in value chains such as enterprise software, payment processing, renewable energy, life sciences tools and equipment, to name a few – those that the manager believes can “make their own luck” in uncertain times. We note favorably that the manager has sent teams of investment professionals to re-underwrite its European holdings and has stress tested the portfolio, adjusting its valuation assumptions down in light of the ramifications of the Russia-Ukraine war. The manager continues to see a 40% to 50% discount to intrinsic value, which is comparable to the fair value it saw in March 2020 after the pandemic sell-off. We are happy to be invested with an active manager that is doing the work to ensure that the fundamentals of the businesses in which it invests remain sound. With the recent share price declines, the manager has actively deployed capital. As always, we believe that volatility in share price enables our managers to buy more shares of companies at increasingly attractive prices. Being able to exploit market volatility is one of the keys to producing attractive long-term returns.
How should clients go about developing a private investment portfolio? Is this a good time to invest in private investments?
JR: For those investors who can invest in private investments, we think they can be prudent additions to a well-constructed portfolio. Manager selection is critical across all asset classes, but it is particularly important in private investments. The dispersion of returns between top- and bottom-quartile managers is quite large, and partnering with high-quality investment managers provides additional excess return potential that can enhance overall portfolio returns and provide valuable diversification. Moreover, in exchange for illiquidity, managers must be able to generate an attractive illiquidity return premium compared to the relevant public market equivalent. That is why we believe in investing with only the highest-quality managers that have identifiable competitive advantages as it relates to sourcing, diligence and value-add capabilities.
There are many different types of private investments, and all must be evaluated individually to see if they make sense for a given client’s liquidity needs, risk tolerance and desired rate of return. Buyout, venture capital, real estate and direct lending are different forms of private capital investing with vastly different risk-return profiles that may or may not help a client achieve his or her goals. For example, core real estate funds are generally cash flowing, and investors could expect to receive cash distributions fairly early into a fund’s life. By contrast, venture capital funds invest in early-stage companies usually pre-profitability. Investors are unlikely to receive any distributions until a liquidity event occurs, which often takes many years. As always, we are working hard to identify the best private investment opportunities for our clients’ portfolios and expect to have several attractive opportunities each year.
With regards to timing in private markets, it is important to partner with the right investors and to commit consistently. In private investing, vintage year diversification is important. It is difficult, if not impossible, to predict if any given vintage year will be a particularly good or bad time to make private investments. The obvious question is “Why?” Private funds generally deploy capital over a three- to five-year investment period. While valuations may be frothy during the beginning of a fund’s investment period, as many think valuations are today, the opportunity set can quickly become more compelling. For example, private equity funds raised while markets were at then all-time highs in 2007 were able to make investments at the bottom of the market in 2008 and 2009. We encourage clients to avoid market timing and to instead invest at a consistent pace to private capital partnerships, creating vintage year diversification and reducing the risk of outsized commitments to what may ultimately prove to be a less attractive vintage year.
Thank you, Suzanne and Justin, for the update.
1 One “basis point” or “bp” is 1/100th of a percent (0.01% or 0.0001).
2 12/31/14 to 4/14/22. AGG and 1-3 Year Credit Index up 1.64% (annualized).
3 12/31/14 to 9/15/21. AGG up 3.31% vs. 1-3 Year Credit Index 2.28% (annualized).
4 Intrinsic value is an estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.
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