Let’s start at the end.  The end of zero percent interest rates, quantitative easing, Modern Monetary Theory, perpetually low inflation, profitless innovation leadership, global expansion, the peace dividend, and rampant speculation – and all these things are likely not coming back anytime soon. This unraveling has led to capital markets experiencing the worst loss for the combination of stock and bonds since our records began in 1926. This decline of both stock and bond markets resulted in approximately $30 trillion in losses to investors globally[i], which is also the worst on record.

The worst combination of stock and bond returns since 1926

Source: Morningstar Direct. U.S. Equity: S&P 500 Index; Fixed Income: 1926-1975 = 65% Ibbotson U.S. Intermediate Government Bonds + 35% Ibbotson U.S. LT Corp Bonds, 1976-Current = Bloomberg U.S. Aggregate Bond Index. Past performance is no guarantee of future returns. It is generally not possible to invest directly in an index.

Inflation

The culprit of this unraveling: inflation. Like all inflation regimes in the past, the Fed has embarked on a campaign of higher interest rates in an effort to quell demand. However, this time around, the Fed has raised the Fed Funds Rate at a faster pace than at any other time in history[ii].  And capital markets have obviously reacted. The fear is that the Fed will be too effective at squashing demand, and that the lag effects of higher interest rates will cause a decline in earnings and a recession. This is an old story, a well-trodden subject matter.  At this point, no one should be surprised about inflation or an economic contraction.

We are so far into this process that inflation now appears to be on a disinflationary trajectory. Since July of 2022, the monthly Consumer Price Index for All Urban Consumers (CPI-U) has ranged between 0% and 0.4%, which would imply a forward 12-month inflation rate below 5%[iii]. Furthermore, expectations for five-year U.S. inflation are now back to just over 2%[iv]. While it does appear that inflation is returning to a lower base, a return to 2% inflation does sound a bit optimistic. Something has changed. Specifically, changes to globalization, onshoring, worker shortages, wage growth, wars, energy transition, and environmental requirements all appear to be headwinds to the dream of returning to 2% inflation.  Inflation returning to a higher for longer base is the new mantra.

When will the Fed stop their march of higher interest rates? History tells us that the Fed must put the Fed Funds Rate above the inflation rate if they are serious about keeping inflation low, and to prevent inflation from returning anytime soon.

Inflation and the Fed since 2000. When will the Fed pause? At the level where these lines cross.

Source: YCharts. Data as of November 30, 2022. Unemployment data through Dec 30, 2022. Inflation data through Dec 30 2022. https://www.cnbc.com/2022/10/04/jolts-august-2022.html.

The Economy

Recession has been the word of the year. And what a loaded word it is. It conjures up images of bread lines, unemployment, the dust bowl – well, let’s not get carried away. No matter how many times you say it, or how forcefully you make your argument, there has been no recession yet. In fact, the economy is surprisingly and mysteriously strong.

GDPNow – 3.8% annual rate of growth expected for real GDP in the 4^th quarter

Source: https://atlantafed.org/cqer/research/gdpnow

Contrast this reality with the expectations of Wall Street strategists. It is such a foregone conclusion that we are experiencing tough economic times that I have heard the statement “We are in a recession” uttered numerous times in the media. 

Odds of a recession over the next 12 months

Source: https://www.bloomberg.com/news/articles/2022-12-20/economists-place-70-chance-for-us-recession-in-2023

Now, I fully acknowledge that we are likely to experience an economic slowdown.  If not now, eventually, of course. However, so far, no recession, only the near unanimous expectation that the economy is about to fall off a cliff…or not.

Sentiment

The impact of inflation and higher interest rates hits consumers in the wallet. They directly and quickly feel inflation and higher borrowing costs. Consumers hate inflation and high interest rates, I think that is safe to say. Clear evidence of this is the University of Michigan Consumer Sentiment Survey hitting an all-time low this year.[v] This implies that more consumers think the current economy is poor than in any other time in history!

Is sentiment contagious? Both fund managers and strategists appear to arguably have the worst opinion about the stock market on record. This is evidenced by strategists, on average, expecting a negative year for the S&P 500® Index in 2023.[vi]. This is the first time since tracking strategists’ expectations that collectively the average expectation has been for a negative year.  Furthermore, fund managers, on average, are the most underweight equities, and most overweighted to cash on record.[vii].

Sentiment has historically been a contrarian indicator. When there is a near consensus of a specific outcome – in this case a recession and a poor stock market – the risk is likely already priced.

Think long term

2022 saw a healthy crash in speculation, much in the same manner as internet stocks did during the Dotcom bust. I call this healthy, because just as in 1999, the speculation had to be wiped out to reach a new base of sensibility.  Some people had to learn the same lesson twice.  Schadenfreude? Maybe.

A healthy crash in speculation

Source: Y-Charts. S&P 500 ETF – IVV iShares S&P 500 ETF

Meanwhile, back here on earth, we all know that, usually to be a successful investor, one must be a long-term investor. Not only do investors need to think long-term, but they also need to look long-term and into the future. The future is often a bit scary because it is unknown, and we tend to extrapolate the recent past events into the future. Being human, we are often only concerned about the future after recent bad outcomes. However, if you look forward to two years, five years and so on, the future often feels more concrete. When in our lifetimes has the future not improved? There have always been rabbit holes to spiral down into, and today it appears that we are living in a perpetual minefield of rabbit holes. But this is the hallmark of the digital age that we all must operate in.

Today, there are obvious headwinds for stocks. Inflation, higher interest rates, higher wages, supply chain expenses, onshoring, and an expected recession can all eat into corporate margins and profits. I say these are obvious because we have already established that this is almost unanimously expected –and that is why stock prices are already down.

At this point, it is just the degree of contraction that it is expected that should be debated. We can certainly speculate on a slowdown and the demise of earnings, but “Wall Street” is finally taking earnings estimates down rapidly. This is a healthy acknowledgment of the slowdown that might be before us. Historically, when earnings estimates are reduced, this is often a sign that the door is more open for positive surprises. Again, at this point, only marginal bad news has yet to materialize. The result is that stock markets around the world are left with lower prices.

So too is the case for the prices of credit bonds. Bonds with ties to the economy, like corporate bonds, high-yield bonds, and floating rates notes all now offer historically reasonable yields. Today, the yield on the ICE BofA High Yield Bond Index is close to 8%, which will likely turn out to be about twice the return of inflation.

Sure, asset prices can always fall more on worse than expected outcomes, but, a year into this well-covered cycle, it could be postulated that we are closer to the end than the beginning. We just have to get through this earnings minefield with outcomes that are not as bad as everyone is expecting.

Portfolio positioning – Beyond the 60/40

For most of our careers, stocks and bonds have exhibited a reliable inverse relationship. When stock prices have fallen, bond prices have risen. This occurrence has led to an entire industry relying on stock and bond ratios for risk management and diversification. A 30% stock and 70% bond portfolio is thought of as being a lower risk portfolio than a 70% stock and 30% bond portfolio. But what if stock and bond correlations are positive? In 2022, some 30% stock and 70% bond portfolios lost more money than some 100% stock portfolios. Is this the new norm? Consider this, for most of recorded stock and bond history, stocks and bonds have exhibited positive correlations.

The return of positive stock and bond correlations (1960 – 2022): The need to redefine risk management

Source: Frontier Asset Management

With correlations on stocks and bonds appearing to remain positive, diversification and risk management can no longer be reliably defined by simple stock and bond ratios alone.

Now, consider that asset price returns occur in an inordinate manner. Much of the return that investors can capture often occurs after bear markets, or at times like this. However, the need for risk management is a constant–bad things can occur at any time. Robust portfolios need to be able to achieve solid returns when the returns occur, yet still, be able to maintain reasonable risk levels in the event that conditions worsen.  A fine line indeed, and today is no exception.

Inordinate returns follow bear markets

Source: Morningstar Direct. All returns are monthly, except 2022 information which is daily. Past performance is no guarantee of future returns.

In this environment, we all need to think deeper about portfolio positioning, or lack thereof. At Frontier, we have made use of new research, specific manager strategies, new asset classes, and dynamic management in an effort to better maintain more robust diversification plans and to maintain risk management. We are ever researching and refining our portfolios to adapt to an ever-changing market environment. An ethos of constant improvement is the defining difference between an investment management company versus a “product” shop.

The takeaway

To wrap up this “brief” The Download, inflation appears to be abating, the Fed is likely near the end of their tightening cycle, the economy is still strong, “Wall Street” is bearish, earnings are declining, but maybe not to the degree that pontificators expect, and prices have already reacted to some degree. Finally, the portfolio that got you here, may not get you there. To walk the line between risk management and opportunity, dynamic management simply must evolve, and that my friends is Frontier’s specialty.

Thank you for taking the time to read this entire article in this time of digital and information overload. History would imply, everything is going to be alright. Buy low, keep buying low, and never sell. Surf Wyoming.

• Geremy van Arkel, CFA, Director of Strategies, Frontier Asset Management

[i] https://www.calcalistech.com/ctechnews/article/r0qnufevb

[ii] https://fred.stlouisfed.org/series/FEDFUNDS

[iii] U.S. Bureau of Labor Statistics

[iv] https://fred.stlouisfed.org/series/T5YIFR

[v] https://news.umich.edu/slowdown-in-inflation-buoys-consumer-sentiment/

[vi] https://www.bloomberg.com/opinion/articles/2022-12-07/equity-predictions-for-2023-look-negative-and-are-probably-correct?leadSource=uverify%20wall

[vii] https://www.bloomberg.com/news/articles/2022-11-15/bofa-survey-shows-stagflation-fears-with-no-fed-pivot-in-sight