The third quarter continued 2022’s downward trend in the markets for both equities and fixed income. After a positive July, global equities and global fixed income declined in August and September to bring each asset class into a bear market, which is defined as a period where asset prices have fallen 20% or more from a recent peak. Near the end of August, markets reacted negatively to Federal Reserve Chairman Jerome Powell’s warning that he expects the Fed to continue to raise rates in order to tackle inflation. The drawdown in asset prices continued in September on interest rate hikes and “higher for longer” rates guidance by the Federal Reserve and a number of its global central bank counterparts.
Investment Returns as of September 30, 2022
|Asset Class||3 Months||YTD||1 Year||3 Years*||5 Years*||10 Years*|
|1-3 Year Treasury Bonds||-1.5%||-4.5%||-5.1%||-0.5%||0.5%||0.6%|
|U.S. Aggregate Bonds||-4.8%||-14.5%||-14.6%||-3.3%||-0.3%||0.9%|
|Global Aggregate Bonds (USD - Unhedged)||-7.1%||-20.1%||-20.9%||-6.2%||-2.6%||-1.0%|
|U.S. Municipal Bonds||-2.3%||-7.7%||-7.6%||-0.8%||0.7%||1.4%|
|U.S. High-Yield Bonds||-0.7%||-14.6%||-14.0%||-0.7%||1.4%||3.9%|
|U.S. Leveraged Loans||1.4%||-3.2%||-2.5%||2.2%||3.0%||3.5%|
|U.S. Inflation-Linked Bonds||-5.3%||-14.5%||-12.3%||0.6%||1.9%||1.0%|
|Global Equity (USD)||-6.7%||-25.4%||-20.3%||4.2%||5.0%||7.8%|
|U.S. Large-Cap Equity||-4.9%||-24.1%||-15.5%||8.1%||9.2%||11.7%|
|U.S. Small-Cap Equity||-2.2%||-25.2%||-23.5%||4.3%||3.5%||8.5%|
|Non-U.S. Developed Equity (USD)||-9.3%||-26.7%||-24.7%||-1.4%||-0.4%||4.1%|
|Emerging Markets Equity (USD)||-11.4%||-26.3%||-27.8%||-1.7%||-1.4%||1.4%|
|Non-U.S. Developed Equity (Local)||-3.5%||-14.2%||-10.7%||3.0%||3.3%||7.9%|
|Emerging Markets Equity (Local)||-8.0%||-19.9%||-21.1%||1.4%||1.5%||4.8%|
|Long/Short Equity Hedge Funds||-2.7%||-14.1%||-13.6%||6.1%||4.3%||5.3%|
|Alerian MLP Index||6.0%||14.4%||10.8%||-4.8%||-6.6%||-6.8%|
|*Annualized return figures.
Past performance does not guarantee future results.
In response to this backdrop, the S&P declined 4.9%, after having risen roughly 14% earlier in the quarter and then posted the biggest intra-quarter drop in decades (-16.2%). On a sector level, only two – energy and consumer discretionary - of the eleven sectors in the S&P 500, finished the third quarter with a positive return. Energy was the best performing sector, despite oil declining 25%, as energy companies reported year-over-year earnings growth in excess of 300% on higher prices and volumes. Consumer discretionary was driven by positive returns from e-commerce and autos, specifically those focused on electric vehicles.
All other equity markets, including the Nasdaq, small-cap stocks, non-U.S. developed equity (USD), and emerging markets (USD) ended the quarter in negative territory. In particular, emerging markets (USD) declined 11.4%, as China continues to face several headwinds such as its zero-covid policy, a downturn in its property sector, and regulatory crackdown on specific sectors. In addition, industrial output has fallen sharply in South Korea and Taiwan as they are large trading partners with China. These three countries make up roughly 55% of the MSCI Emerging Markets Index.
The third quarter was also one of the more volatile quarters in recent memory for fixed income. The 10-year Treasury yield spiked over 82 basis points (bps) from 3.01% to 3.83% and has continued to rise in October to over 4.15%. Annualized inflation in the U.S. soared to a rate of over 8%, raising expectations that the Federal Reserve will quickly tighten monetary policy. Market expectations call for the fed funds rate to rise to over 4.5% by the end of 2022 (vs. 0% at the beginning of the year) and the Fed’s plan to unwind its balance sheet through quantitative tightening hit full stride on September 1 as it increased its monthly roll-off of mortgage-backed securities and Treasuries to $95 billion (up from $47.5 billion per month from June to August). The repricing of longer duration fixed income has been swift, wiping out years of gains in a short time. Interestingly, the Bloomberg U.S. Aggregate Bond Index (the “AGG”) and the Bloomberg 1-3 Year Credit Index (a proxy for short duration credit strategies) now have the same return dating back over eight years from December 31, 2013. As recently as September 2021 the AGG was outpacing short duration credit by 1.4% annually (from December 31, 2013); however, these gains quickly evaporated over the last 12 months.
During such challenging times, we continue to reevaluate our asset allocation, manager selection, and underlying investment holdings. We are stress testing our portfolios in various ways, seeking to actively engage 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 be reflective of company fundamentals. We cannot predict when the markets will turn, but what we do know is that a long-term, disciplined investment approach that is grounded in fundamental research and is not reactive to short-term noise is the best way to preserve and compound capital over time.
As with prior quarters, in response to many questions from clients, BBH Private Banking Chief Investment Officer Suzanne Brenner and Deputy Chief Investment Officer Justin Reed share their thoughts about the current state of the financial markets and how developments are influencing portfolio positioning.
Persistently high inflation and Fed policy continue to drive volatility within equities and fixed income. What has the Federal Reserve done so far to quell inflation? What are some future scenarios for the Federal Reserve and how the markets may perform as a result?
In September, the Federal Reserve raised the federal funds rate by 75-basis points (bps),1 its third consecutive 75-bps hike. This brought the targeted range to 3.0% to 3.25%, the highest since the first quarter of 2008. Compared to previous rate hiking cycles, this is the fastest the Fed has raised rates in the last 40 years. While investors expected a 75-bps increase in September, they did not expect a more hawkish Fed dot plot,2 which shows the median forecast of rates by Fed officials to be 4.4% at the end of 2022 and 4.6% in 2023, up from June’s forecast of 3.4% and 3.8%, respectively.
Below is a diagram that highlights three scenarios for the Federal Reserve’s interest rate policy and the possible impact to equities and fixed income. While it’s difficult to predict when the Federal Reserve may pause its rate hiking cycle, our best estimate is sometime next year between March and June, based on the fed funds futures curve. However, that does not mean investors should allocate their capital based on one scenario or try to time the next “Fed Pivot.” We find that market timing is challenging for all investors, no matter how sophisticated. We adhere to the adage that “it is about the time in the market, not timing the market” which allows investors to best position themselves for strong long-term results. A long time horizon that benefits from the power of compounding is much more impactful, and generally more successful, than the mirage of market timing. We believe that instead of trying to time the market by monitoring broad market, economic, or political indicators, investors should utilize a bottom-up, fundamental approach with a long-term horizon to select high-quality individual securities trading at discounts to intrinsic value estimates.
At BBH, we construct our portfolios to have strategies that should perform well in different environments, so that we can preserve and grow capital over time. In anticipation of, and during this period of, rising rates, we have added strategies across equities and alternatives that reduce portfolio duration while maintaining exposure to long-term growth opportunities. We are focused on investing in high-quality equities with pricing power, which we believe helps protect against long-term inflation. We are also disciplined with our investment criteria; we focus on investing in opportunities where there is a meaningful discount between the market price and our estimate of intrinsic value.
Interest Rate Scenarios and Market Response
|Optimistic Case||Base Case||Pessimistic Case|
|Market Impact||Market Impact||Market Impact|
|Source: BBH analysis. Data as of 9/30/2022.|
The odds of a recession seem to be trending higher. How common are recessions? If we are in a recession, should I sell equities and re-invest later?
Some investors assume that the stock market cycle is the same as an economic cycle. In our view, it is important to separate the two. A recession is an extended period of declining economic output, wages, employment, industrial production and retail sales, and it is officially determined by the National Bureau of Economic Research (NBER). Stock market performance is based on future expectations of cash flows and growth of the included companies. Said differently, the economy is not the stock market, and accordingly, a recession is not the same thing as an equity down market.
Recessions are fairly common and are a normal part of the economic cycle. Since the end of World War II, there have been 13 U.S. recessions, occurring roughly six years apart, on average. Typically, recessions are a negative for corporate earnings as GDP growth declines. Since 1957, the median EPS change in the S&P 500 during U.S. recessions has been -18.1%. Of the last 13 recessions, earnings have declined for each one; however, the same cannot be said for the stock market. In fact, the S&P 500 has produced positive returns during seven of the 13 recessions since 1945, and the index has gained 3.7% on average during recessions. Your next question would be – why is that? Well, markets usually begin declining before the start of recessions and trough before their conclusion. Typically, the worst is over for stocks before investors are officially made aware that they are in a recession.
|Feb 1945-Oct 1945||27.7%|
|Nov 1948-Oct 1949||4.1%|
|Jul 1953-May 1954||27.6%|
|Aug 1957-Apr 1958||-6.5%|
|Apr 1960-Feb 1961||18.4%|
|Dec 1969-Nov 1970||-3.7%|
|Nov 1973-Mar 1975||-13.1%|
|Jan 1980-Jul 1980||16.4%|
|Jul 1981-Nov 1982||10.0%|
|Jul 1990-Mar 1991||7.6%|
|Mar 2001-Nov 2001||-7.2%|
|Dec 2007-Jun 2009||-24.2%|
|Feb 2020-Apr 2020||-9.3%|
While investors may fret when seeing that the probability of a recession over the next 12 months is 60%, long-term investors recognize that recessions can offer remarkable opportunities to purchase high-quality companies at a significant discount to intrinsic value. In our view, staying invested and not timing the market is the best way to grow capital. A recent BBH analysis shows that a hypothetical $1 investment in the S&P 500 Index from January 1, 1990, to September 30, 2022, would have compounded to $19.69. However, if you missed out on the 10 best trading days during this time period, a hypothetical $1 investment would have compounded to $9.02. Interestingly, our analysis shows that the 10 best trading days during this time period all occurred during recessionary periods (seven occurred between October 2008-March 2009 and three occurred between March – April 2020). As it turns out, and we get that this is unexpected, recessions can actually be dangerous periods NOT to be invested.
Investments exhibiting higher growth have been hurt over the past year, what do you think about these types of investments? What type of growth companies should we invest in during a recession?
It is important to preface the answer to this question by explaining how we view the “growth” vs. “value” debate. We believe characterizing stocks and funds as either “growth” or “value” does not add meaningful insight into a manager’s risk or return profile, as it seeks to draw precise boundaries where none exist. At the most basic level, because all stocks can trade at bargain prices relative to their intrinsic value, applying the term “value” only to stocks that are cheap on the basis of historical accounting earnings (which can be manipulated in a variety of ways), or current balance sheets is not appropriate. Instead, in our opinion, all good investing is (or should be) value-oriented investing. That is, all businesses, whether fast- or slow-growing, cyclical or highly predictable, should be purchased with reference to the gap between current market price and a conservatively calculated estimate of the business’s intrinsic value. Our investment philosophy focuses on buying assets at less than they are intrinsically worth.
When it comes to investing in higher growth stocks, which we characterize as companies that are increasing their revenue or earnings at a faster rate than the average business in their industry or the market as a whole, it is important to take a long-term view as it may take several years for a thesis to come to fruition. As we sit here today, higher growth stocks have realized one of their largest year-to-date drawdowns in over 20 years. There are several reasons for this development. First, these stocks tend to have valuations that are more sensitive to rising rates as the duration of their cash flows is longer and as rates rise, the present value of those future cash flows declines. It is also worth noting that many of these stocks realized a “pull-forward” in revenue from the onset of the pandemic that drove accelerating earnings growth, which in turn, drove multiple expansion. Once these metrics began to normalize, the forward multiple awarded to these companies began to decline.
As the main driver for year-to-date’s equity performance has been multiple compression, we continue to believe that earnings growth is the best way to offset multiple compression. When looking out to 2023 earnings growth estimates, we see that commodity-linked sectors (i.e., energy and materials) and health care are expected to see year-over-year earnings declines while the remaining eight sectors in the S&P 500 are expected to generate year-over-year earnings growth. We also see sectors where earnings are estimated to decline in 2022, such as communication services and consumer discretionary, but are estimated to see their earnings rebound in 2023. As a whole, earnings for the S&P 500 are estimated to grow approximately 7% and 8% in 2022 and 2023, respectively. While we cannot predict when the market will bottom, equities now are more attractively priced, particularly for sectors that are estimated to see earnings growth in 2023.
Interest rates and inflation are having a large impact on fixed income markets. How is the fixed income portion of your portfolio positioned?
The post-Global Financial Crisis (GFC) market environment (2009-present) has been characterized by low interest rates and low inflation where the Federal Reserve (the Fed) has struggled to meet its 2% inflation target. In a short period of time, all that has changed, and we now live in a market where the Fed is rapidly raising short-term interest rates to combat surging inflation, while long-term interest rates have also risen. This rapid increase in rates has led to weak performance across all longer duration fixed income sectors. The Bloomberg U.S. Aggregate Index is down 14.6% YTD, for example, while the Bloomberg Muni 1-15 Index is down 9.2% and the Bloomberg Muni 1-10 Index is down 7.7%. The extremely low level of starting yields meant that that there was little income generation available to offset price impact of the rise in yields (bond prices and yields move inversely) while the speed of the rise in yields also contributed to the sharp year-to-date price declines.
At BBH, we demand adequate compensation in the form of higher yields and credit spreads to take interest rate risk and/or credit risk. Because there have been few opportunities to do this in the last 10 years, our portfolios have generally remained short duration and investment grade quality. Along the way we have seized upon short-lived but attractive opportunities to extend the duration of our portfolios in market sell-offs, such as those that occurred around the 2016 election, the rise in rates in Q4-2018, and in early 2020, at the onset of Covid-19.
We have no edge in forecasting interest rates, but we remain comfortable investing in longer duration bonds when the yield compensates our clients adequately. In early 2022, we began extending the duration of our muni bond portfolios from a position of strength, with most of our purchase activity taking place from March – May when 10Y AAA muni yields averaged roughly 2.5%. We will continue to be opportunistic and reinvest capital in muni bonds if yields stay at compelling levels. While the rapid increase in yields has caused pain in fixed income, our portfolios were positioned to mitigate losses and we can now go on the offensive and invest in high quality fixed income that produces higher levels of yield.
What portfolio changes have you made recently and what changes are you contemplating at the moment?
BBH has made several portfolio changes in recent years as a result of the unprecedented market environments we have experienced. A few that come to mind include:
- In mid-2020, we reduced the total equity weight back to targets in our model portfolios after the market had recovered from the covid-19 market selloff. Our belief was that while markets had recovered nicely, there was still a wide range of outcomes present in the economy and financial markets that was not consistent with an overweight to equity.
- In 2021, we focused on adding new private investments to complement our public equity offerings. These included a large investment in the reinsurance space that we believe will prove to be uncorrelated with other risk factors in our portfolio, an investment into a private equity fund that spun out from a well-established firm, and an investment in a top tier venture capital fund. We believed that the 2021 – 2024 timeframe, over which these funds will draw down most of their capital, will prove to be an attractive time to make new investments.
- In 2022, we made changes to our fixed income portfolios including increasing our cash weights as well as cautiously deploying capital into intermediate duration munis. Overall, our fixed income positioning still remains underweight the duration of the index, and as the opportunity set evolves, we may make further changes.
- During 2022, we added a new internal strategy (equity income) that focuses on high quality companies with an emphasis on dividend growth, and a long-tenured mid/large equity manager that imposes a strict valuation discipline to invest in high quality growing companies.
As always, our team is evaluating a range of new managers to add to our portfolios that span both public and private investments. We are particularly excited about several opportunities we have to partner with an experienced private equity manager as well as a distressed debt manager that we believe is particularly well suited to capitalize on the potential for market disruptions in the coming years.
What parting thoughts do you have about this difficult economic environment? Do you expect the market to decline more from here?
We are not market prognosticators, nor do we think there are speculators who can reliably predict short term movements in the markets. That said, while we would not be surprised to see markets decline more from here, we remain excited about the long-term opportunity set. As mentioned above, we adhere to the adage that “it is about the time in the market, not timing the market” which allows investors to best position themselves for strong long-term results. A long time horizon that benefits from the power of compounding is much more impactful, and generally more successful, than the mirage of market timing.
Unfortunately, while we cannot predict when the market will bottom, we do know that the equity markets are cheaper today than they were a year ago. We are in the first extended bear market in over a decade; while painful, bear markets have historically been a great setup for higher than normal future returns. The most important thing now is to stay invested and not to try to time the markets. Those that sell must make a second decision as to when to buy back into the market, which is difficult. Bear markets are a normal feature of equity investing, each one is caused by unique factors, and this time is no different. For this reason, we construct portfolios with investments that perform differently in various market environments –both in public and private investments.
We also continue to look for inefficient areas to invest where we can partner with talented investors to take advantage of those inefficiencies. In this new regime, not everything will go up, supported by endless amounts of quantitative easing. Active management should shine in this environment, where sorting great investments from the mediocre will prove to be crucially important. As a result, we are rigorously re-underwriting all of our managers’ processes, the fundamentals of their investments, and the consistency of their organizations. It is because of this deep, ongoing research that we have the conviction to stay invested through down markets and we believe that this approach will ultimately produce results that are consistent with our goal of growing our clients capital over time.
1 One “basis point” or “bp” is 1/100th of a percent (0.01% or 0.0001).
2 The Fed dot plot is a chart that records each Federal Reserve member’s projection for the central bank’s key short-term rate. The dots reflect what each Federal Reserve official thinks will be the appropriate midpoint of the fed funds rate at the end of each calendar year three years into the future.
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.
Past performance does not guarantee future results.
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.
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.
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