Last year was a tumultuous year in capital markets, with historical reference points that reached back decades, even a century. Inflation accelerated to levels not seen since the stagflation of the 1970s, and the Federal Reserve’s tightening program was the most aggressive since that period as well. The impact on capital markets was severe, as both the equity and bond markets declined precipitously in value. Since 1926, coincident stock and bond market declines have only occurred in approximately 2% of rolling twelve-month periods.
As we begin 2023, the US economic outlook remains mixed, with a majority of forecasters still expecting a recession this year as a result of the Fed’s extraordinary tightening program. The inverted yield curve is also predicting a recession as short-term maturities outyield long-term maturities, implying that slower economic activity will lead to substantially lower rates in the future (i.e., today’s high short rates are only transitory). While the current Fed Funds rate reads 4.5%, the San Francisco Fed estimates that the effective Fed-driven benchmark rate is actually above 6% after accounting for the impact of the Fed’s “quantitative tightening” program (i.e., reducing its balance sheet by allowing fixed income holdings to mature). The sharp turn in rate-sensitive sectors such as housing and autos is a highly visible response to the policy, but overall demand across goods and services has been effectively dampened to the extent that inflation rates are expected to fall throughout 2023. While the Fed cannot impact the supply-driven components of inflation as directly, those pressures have also abated as supply chains continue to normalize, contributing to the disinflationary trend in 2023.
The unemployment rate, however, has remained relatively constant and low. Whether the Fed will pursue a softening of the labor market despite positive results elsewhere remains an open question, given its stated goal of “maximum employment.” The Fed is currently projecting an unemployment rate of 4.6% at the end of 2023, up a little over 1% from today, and for that rate to hold for the next two years. A potentially more likely outcome, if the Fed pushes harder on the brakes, is the self-reinforcing pattern of job losses leading to demand destruction leading to corporate retrenchment leading to more job losses, ultimately arriving at a recession and an unemployment rate well above 4.6%.
Where’s the good news? The good news is that 2022 is over and the difficult times that the market expects in 2023 and beyond are largely already “priced in.” Historically, markets bottom well in advance of economic troughs, and the best opportunities for long-term return are often presented when the outlook is bleak. The well-known Buffet quote, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful,” is worth considering in this context. Market pricing across asset classes has dramatically reset lower in the last 12 months, and we are optimistic about the opportunities ahead.
Cash and Equivalents: Income Rises Again
Finally, after a decade-long wait, compensation for holding cash and ultra-short high-quality investments exceeds 4% as T-Bill yields are at their highest level since before the Great Financial Crisis. Yields on money market mutual funds, traditionally preferred cash management vehicles, are lagging the yields available by holding T-Bills directly, primarily as a result of the mechanics of funds and their natural lag in resetting to current market rates. This represents an opportunity for investors to improve yields by shifting money market holdings into US Treasuries without the historical opportunity cost of being so short and high quality. Also, income from Treasuries is largely state tax exempt.
Fixed Income: The Fed is Almost Done, but Credit Risk Looms
While fixed income markets have experienced a substantial increase in yield overall, we remain cautious about credit quality and the risk of potential further price declines if credit spreads widen. The vast majority of price declines in fixed income in 2022 were caused by the impact of rising rates, while price declines as a result of increased credit risk played a very small role. We do not currently believe that fixed income markets have appropriately considered credit risk, so the potential downside of widening credit spreads is not worth the additional compensation paid for investing in riskier bonds. This trend could quickly reverse if credit spreads widen to a point where we believe that the advantages of adding credit risk outweigh the potential downside.
Equities: Near Fair Value, but Earnings Under Pressure
Since the initial selloff in the first half of 2022, the US equity market has vacillated between short-term rallies and declines as investors struggle to assess the future earnings picture. So far, the vast majority of the equity market decline has been the result of price-to-earnings ratio compression rather than a decline in earnings. The price-to-earnings ratio of the S&P 500 Index fell from 21x at the beginning of 2022 to a low of 15x in October, settling at around 17x today. This makes sense in a historical context as P/E ratios, now generally at or near long-term averages, should generally be lower in a higher rate environment. Earnings, however, may have further to fall. S&P 500 Index projected earnings for the next twelve months have fallen slightly, from a high of $238/share in June to $228/share today and additional downward pressure on earnings would have a negative effect on stock prices.
Looking abroad, developed international markets experienced turmoil as well, with similar inflationary and interest rate pressures to the US, but against a backdrop of the largest armed European conflict since World War II. Relative to the US, near-term headwinds appear stronger and the opportunity for recovery and growth appears weaker. Europe’s energy crisis and uncertainty over the outcome of the Ukraine war will likely continue to depress activity for the foreseeable future.
Thus, we believe the best opportunities in global equities are in relatively undervalued sectors with either (1) secular or demographic tailwinds (e.g., emerging markets), (2) headwinds with an end in sight (e.g., domestic small cap), or (3) niche opportunities supported by favorable economic trends (e.g., MLPs and infrastructure).
Real Assets: While Not as Apparent, Opportunities Remain in Real Estate
The real estate sector in general has benefitted from several factors in recent years, including low financing rates, favorable demographics and eager equity capital providers. COVID accelerated or changed some of the intra-sector dynamics, as the patterns of life adjusted to increased residential mobility, less urban office usage, and more logistics-focused infrastructure, but capital was still freely available and financing costs were low. Today financing costs are materially higher and equity capital, while available, is more discriminating and cautious.
While opportunities in real estate are not as apparent as they were in prior years, existing exposure with sound capital structures should continue to provide return and diversification benefits going forward. Additionally, patient investors can benefit by committing to managers who understand target markets, will wait for cap rates to stabilize, will not be forced sellers, and will be opportunistic and flexible across the capital structure. Managers who lack discipline with their underwriting assumptions (e.g., unreasonably low exit cap rate or financing assumptions) will likely see challenges going forward.
Private Equity: Focus on Manager Selection in a Challenging Market
While less visible than the public equity market, private equity experienced a challenging 2022 as well. The combination of higher financing costs and the translation of public market multiple compression into private transactions has dampened enthusiasm on the M&A front while also reducing the value of portfolio companies in existing funds. Within private equity, the degree of challenge equates reasonably with the degree of relative risk in each strategy. Smaller and earlier-stage strategies have faced the greatest headwinds, and the strategies focused on larger and more mature companies have faced the least.
The ability to underwrite potential investments with an eye on purchase price will be paramount in 2023 as the valuation expectations of sellers remain elevated. Secondary managers, who can take advantage of forced sellers (especially in a downturn) remain in a strong position to generate attractive projected returns by buying mature assets at a discount. Niche managers with a high level of expertise in a specific sector remain able to capitalize on inefficient markets and generate returns through leveraging professional networks and value-add capabilities. As always, vintage year will have a bearing on performance, and maintaining vintage year diversification remains paramount.
Private Debt: Getting Close to Attractive
For the past few years, opportunities in private debt have been limited. While sector specialists and niche opportunities have remained promising, traditional direct lending has faced headwinds in the form of deteriorating covenant requirements and, more recently, spiking interest rates. We believe that once these trends begin to reverse, and we have seen signs that they have, direct lending strategies will become investable again as long as investors focus on managers who concentrate on underwriting to new rate and economic assumptions, covenant quality, and low principal loss.