The second quarter was another difficult quarter for markets, with virtually nowhere to hide, and the first half of 2022 was the worst first half of the year for equities, as measured by the S&P 500, in over 50 years. Investors began the quarter worrying about inflation and an economy that was overheated. By the end, concerns switched to the increased likelihood of a recession, driven in part by aggressive Federal Reserve tightening. The Fed has communicated that it will do whatever it takes to rein in inflation, and after another surprising inflation print in July (9.1% year-over-year increase), speculation abounds as to how far the Fed will go in raising rates at its July meeting. Making matters worse, bonds, which typically protect in a risk-off environment, have generated their worst performance in 40 years.
|Asset Class||3 Months||YTD||1 Year||3 Years*||5 Years*||10 Years*|
|1-3 Year Treasury Bonds||-0.5%||-3.0%||-3.5%||0.2%||0.9%||0.8%|
|U.S. Aggregate Bonds||-4.7%||-10.2%||-10.3%||-0.9%||0.9%||1.5%|
|Global Aggregate Bonds (USD – Unhedged)||-8.2%||-14.0%||-15.7%||-3.6%||-0.8%||0.1%|
|U.S. Municipal Bonds||-0.8%||-5.6%||-5.4%||0.2%||1.3%||1.8%|
|U.S. High-Yield Bonds||-9.9%||-14.0%||-12.6%||0.0%||2.0%||4.4%|
|U.S. Leveraged Loans||-4.5%||-4.5%||-2.8%||2.1%||2.9%||3.7%|
|U.S. Inflation-Linked Bonds||-6.6%||-9.7%||-5.7%||3.0%||3.2%||1.7%|
|Global Equity (USD)||-15.5%||-20.0%||-15.4%||6.7%||7.5%||9.3%|
|U.S. Large-Cap Equity||-16.1%||-20.2%||-10.6%||10.6%||11.3%||12.9%|
|U.S. Small-Cap Equity||-17.2%||-23.6%||-25.2%||4.2%||5.1%||9.3%|
|Non-U.S. Developed Equity (USD)||-14.3%||-19.2%||-17.3%||1.5%||2.7%||5.9%|
|Emerging Markets Equity (USD)||-11.3%||-16.8%||-25.0%||0.9%||2.5%||3.4%|
|Non-U.S. Developed Equity (Local)||-7.6%||-11.1%||-6.1%||4.9%||4.8%||8.8%|
|Emerging Markets Equity (Local)||-8.0%||-12.9%||-19.9%||3.6%||4.7%||6.3%|
|Long/Short Equity Hedge Funds||-8.3%||-12.3%||-12.5%||6.3%||5.5%||5.9%|
|*Annualized return figures.
The large-cap S&P 500 entered bear market territory in mid-June, following the technology-heavy Nasdaq Index and small-cap indices, which were already in a bear market in April and May, respectively. A strong dollar hurt international developed and emerging market equities; local returns were substantially better than their U.S. dollar equivalents. And while we do not own Bitcoin in our policy portfolios, the risk-off trade hit this cryptocurrency hard. It is down 57.27% year to date through June 30, 2022, declining from $46,306.45 to $19,784.73.
Bond markets, as reflected in the inverting of the yield curve, are once again implying that a recession is on the horizon. Despite recession worries, consensus analyst forecasts still expect positive growth in company profits for this year. We are carefully watching as second quarter earnings are released, but we are preparing for further downside volatility, especially if earnings disappoint. As a result, while we have confidence in the underlying fundamentals of our portfolio companies, we are being cautious about aggressively rebalancing portfolios back into equities until we have some clarity around inflation peaking and the Federal Reserve’s forward policy. As always, our managers are embracing volatility to upgrade their portfolios to capitalize on the difference between price and value. While periods like this are uncomfortable, we believe they are creating rare opportunities to compound capital for the long term.
As with prior quarters, in response to many questions from clients, we sat down with Brown Brothers Harriman (BBH) Private Banking 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.
What has BBH been doing during this period of volatility?
Suzanne Brenner: We have made some strategic policy moves as we entered this period of increased volatility. First, in 2021, arguably a bit early, we reduced the equity weight in our Domestic Qualified Taxable Balanced policy portfolio back to benchmark targets, based on our belief that it wasn’t a time to take excess risk in our portfolios. We also have had a short-duration posture in our fixed income portfolios. While we can’t predict interest rate moves, we believed that the probability for higher rates outweighed the possibility of lower rates, which proved to be an excellent decision. We are now finding interesting opportunities to extend the duration of the fixed income portfolio, but we are also making sure that our clients have enough cash in their portfolios (for example, money market funds) and are raising cash from our short-duration bond portfolios in anticipation of rebalancing back to equities. We are also excited about our private investment portfolios and are adding some very compelling strategies, including a recent top-tier venture capital fund and a floating-rate real estate lending fund.
Justin Reed: It is also important to note that our team is having more frequent conversations with our managers, and we are pleased with their responses to these volatile markets. We like the positioning of our managers, all of which have the same core investment philosophy. They are long-term thinkers and fundamental analysts that have the majority of their money invested alongside our clients and are taking advantage of this period of volatility to upgrade their portfolios.
For example, Select Equity Group (SEG) has sent its teams to Europe to re‐underwrite all of its holdings. Being conservative, the firm has adjusted the intrinsic values1 of the businesses it owns to reflect the new economic regime in which it is operating. Despite these adjustments, SEG estimates that the portfolio is trading at a 45% discount to intrinsic value. It has also added some compelling holdings to the portfolio, which were previously too expensive. For patient investors, these are very attractive valuations.
We have seen that the yield curve is once again inverting. Does this mean we will have a recession?
JR: I want to back up a bit and add some background. An inverted yield curve means that short-term bonds are paying more than long-term bonds. We saw just this past week that the two-year Treasury yield, which is more sensitive to changes in monetary policy, traded to 3.14%, while the benchmark 10-year Treasury was at 2.92%. Historically, the inversion of the yield curve has been a fairly reliable predictor of recessions.
Some might ask why the inversion of a yield curve is a good predictor of a recession. The logic is that investors expect the Federal Reserve to push up interest rates so much in the short run to fight off inflation that it ends up causing a squeeze on consumer and business spending, which results in a recession. The market then anticipates that the Federal Reserve will have to reverse those rate increases later. As a result, the high short-term interest rate is driven by expectations of Fed rate increases, and the long-term rate is driven by expectations of recession, a subsequent drop in inflation and Fed rate cuts later on.
SB: Another way of framing this question is: Will we have a recession, or will the Fed engineer a successful soft landing? The answer is, we don’t know. But we have looked at periods in history when the yield curve inverted, particularly focusing in on the curves for the 10- and two-year Treasuries that Justin just mentioned. In six of the nine times this occurred, the U.S. economy did experience a recession in the following two years, so the yield curve could be forecasting another recession in 2022 or 2023. What’s interesting this time is that the current economy appears relatively strong. We have added 2.7 million jobs over the past six months, and wages are rising 5% year over year. As a result, we do not anticipate a sharp recession currently, like the global financial crisis or 2020 COVID-19-driven recession. But we can ensure that there is a 100% probability of lingering uncertainty, which is very uncomfortable for investors.
If we believe we will have a recession or continued uncertainty, should we sell equities now?
SB: We have always stressed that the greatest advantage we have as investors is time horizon. As one manager put it in his most recent letter: “The dilemma an investor has is between what the immediate trend and mood seems to suggest over the next six to 18 months against what the outlook might be over the next five to 10 years. If we didn’t have daily prices that marked us to market, most of us wouldn’t care. With daily prices, everyone becomes ultra-short term in a bear market. Just as they think ultra-long term in a bull market. The cycles feed themselves. They are either virtuous or vicious. That’s why, for long-term investors, markets should be about going against the flow.”
JR: Going against the constant negative barrage of news and staying invested is extremely important to compounding capital for the long term. However, we recognize how difficult it is to look at a statement and see your wealth declining. It is hard to stay invested when the mood is bearish and uncertainty abounds. The majority of people throw in the towel and succumb to these pressures, selling out of equities at exactly the wrong time, locking in losses and then, of course, missing out on the eventual turn, which is often quick and always unpredictable.
When you have a long-term view, periods such as the one we are experiencing now can be full of opportunity. Active managers can add to declining positions that are getting cheaper or upgrade their portfolios to higher-quality stocks that were previously too expensive. As Mark Massey of AltaRock said: “While potentially nerve-wracking, we don’t consider market corrections all that important for long-term investors such as ourselves, except as they allow us to improve our eventual IRRs.”
We are getting questions from our clients about the underperformance of many of our equity managers relative to their indices during this downturn. Can you help us understand what is going on?
JR: I’m glad you asked this question. Obviously, no one likes underperformance, but I think our investment philosophy helps us better understand what we should expect and how we should think about performance in a larger context. One of the core principles of our investment philosophy is that we stress the importance of reducing the likelihood of a permanent loss of capital, which is a useful definition of risk. However, we do not see this as synonymous with minimizing short-term volatility. In fact, another of our core principles is the belief that volatility is not risk. Volatility, to us, provides opportunity.
Bringing those two core principles together, we do not find it useful to focus on outperforming indices during downturns. However, we believe that the high-quality nature of our managers’ holdings, their valuation discipline of buying stocks that trade at a discount to their estimate of intrinsic value and their ability to hold cash when unable to identify compelling investments allows us to generally expect to outperform relevant indices in most declining markets.
In addition, I should add that many of our managers are quite concentrated in terms of the number of underlying holdings within the portfolio. That is a result of a focus on managers who know, at a very detailed level, what they own and why they own it. We believe this deep fundamental research is part of what allows our managers to generate strong absolute and relative returns in the long run, and actually best optimizes for the preservation of capital. However, this also leads to situations where our investment performance looks nothing like the broad market benchmarks over shorter time periods – both in up and down markets.
Public equity manager outperformance during market downturns will not always occur over every period but the silver lining is that as long as we have conviction in our managers and their underlying holdings, we believe we will be rewarded with strong long-term results on an absolute and relative basis. We still very much believe that this focus on investing with managers who do extremely deep research to understand their underlying positions and ensure they are buying stocks at a discount to intrinsic value, and who also have the vast majority of their own net worth invested alongside us and our clients, will continue to leave us in the best position to preserve and grow capital.
SB: To elaborate on Justin’s point, concentrated managers have periods (sometimes several years) of underperformance. If any of our managers go through such a period, part of our job at BBH is to understand the reasons for the underperformance. Has the manager lost his edge? Is the manager distracted? Has the firm undergone change or taken in too many assets? In those cases, we will terminate the manager. However, we don’t fire managers for underperformance if the manager is implementing his investment process consistently with our initial underwriting. All of these managers have gone through periods in their investing history where they have not outperformed their index, yet over the long-term, they have been able to generate returns that exceed the indices.
I would also note that we cannot think about equity managers in isolation. We seek to build portfolios of different asset classes that have different roles. For example, fixed income typically protects portfolios in deflationary periods. Private investments, like distressed debt, have performed extremely well during this declining equity period, as have our private equity investments. Not all parts of the portfolio perform well at the same time. Creating well-constructed portfolios plays a significant role in helping us preserve, and then grow, client capital over the long term.
What are some of the opportunities you are seeing going forward? What additions to the portfolio should we expect?
SB: We are always opportunistic and looking for ways to capitalize on market distress. We have a team of individuals that is scouring the universe of investment opportunities to be able to identify those areas that are undergoing stress in the short term but are compelling long-term investments. I will give you a few examples. In general, we are developing an interesting pipeline of private investments. Data compiled by Cambridge Associates suggests that portfolios with private investments in excess of 15% generally outperform those with only public investments.2 Within private investments, we believe that distressed debt will be a very interesting opportunity over the next few years, as many companies who are over-levered will be pressured in a slowing economy with higher interest rates. We have also made investments with return patterns that are independent from equities and fixed income, like reinsurance and floating-rate loans for real estate. We are continuing to look for others like this. And we are excited about some of the high-quality equities that have declined in price, but whose fundamentals are improving. Our managers are adding to those equities as they are offered up at very compelling prices.
JR: While we are making changes when they are compelling, the most important thing we have done is stay the course. It is tempting to sell everything that hasn’t worked and follow the herd to invest in what has. We resist that temptation because we believe in what we own and have confidence that high-quality, fundamentally durable investments will ultimately be recognized by the market and result in compelling long-term returns for our clients.
As Howard Marks said at a recent Oaktree Capital Management conference, and I paraphrase: “The most important thing we can do as managers is to be investors, which means staying invested. We should buy and hold investments that we think will be profitable in the long term, as long as we still believe in the thesis or until something better comes along.” We agree wholeheartedly, and we are thankful for our clients that are patient and understand our investment approach.
Investors should be able to withstand short-term fluctuations in the equity markets and fixed income markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
S&P 500 Total Return – The S&P 500 Index is an unmanaged, weighted index of 500 stocks providing a broad indicator of price movements. The index is not available for direct investment.
1 Intrinsic value is an estimate of the present value of the cash that a business can generate and distribute to its shareholders over its remaining life.
2 Shukis, David, and David Thurston. “The 15 Percent Frontier.” Cambridge Associates, April 29, 2022. https://ca-cambridge.adkalpha.com/insight/the-15-percent-frontier/.
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