Our 2022 Q3 Investment Update

By Brian Tall | Oct 13, 2022 |

For our Q3 2022 Investment Update, Brian Tall, our Chief Investment Officer, addresses the performance of our portfolios and core market segments, takes an in-depth look at what is driving negative performance of fixed income markets this year, and provides an update on the relative performance of value vs. growth stocks.

1. Historical Expansions/Contractions

This chart shows the growth of a moderate risk portfolio—with a 60% weighting to stocks—since the peak of the market before the global financial crisis.  The bottom half of the page shows the length and magnitude of expansionary and contractionary periods during the 15-years shown.[1]



Key Takeaway:

We’ve heard some scary headlines throughout the first half of the year.  For example, the aggregate bond market suffered its largest drawdown in history, and the US Stock Market suffered its worst first half since 1970.  These type of headlines make it sound like we haven’t seen this type of volatility before.  But this is the 6th time in the past 15 years a diversified portfolio has experienced a drawdown of 10% or more.

If there’s one thing that’s always important to remember, it’s that volatility is a normal part of investing.  And despite these temporary setbacks, capital markets have a long history of rewarding investors for the capital they supply. It’s also important to remember that events that only happen once every 30, 50, or 100 years happen all the time.  And the financial media has a way of slicing and dicing data to make everything sound more scary than it needs to sound because that’s what gets us to click on articles, and that’s how they get paid.  This isn’t to say we shouldn’t read the news, because it is important to be aware of issues that are taking place…but don’t let headlines hijack your emotions.  It’s moments like this where attractive investment opportunities start to show up.

2. Portfolio Component Performance

This chart illustrates year-to-date performance for the core market segments within our portfolios.[2]

Key Takeaway(s):

  • In the first quarter, equity markets suffered a 10% correction but recovered sharply in the last two weeks of the quarter—despite Russia invading Ukraine and the Fed’s first interest rate hike in March.
  • The relief was short-lived and both equity and fixed income markets trended lower in Q2, with stocks falling into a bear market (defined as a decline of 20% or more).
  • Q3 was a tale of two halves.  Equity markets initially rallied 13% off their June lows; but firmer-than-expected inflation readings laid the groundwork for the Federal Reserve to aggressively hike interest rates at a rate that far exceeded expectations, triggering a renewed selloff in equity and fixed income markets.
  • As of quarter end, the US Aggregate Bond Market Index was down 14.6%, the MSCI All Country World Stock Market Index was down 25.7%, and a hypothetical portfolio consisting of 40% bonds and 60% global equities would be down about 21.2% year-to-date.
  • Brighton Jones portfolios are outperforming basic index strategies with comparable weightings to equity and fixed income, owing to strong outperformance of our global equity managers and broader diversification among fixed income market segments with less duration risk (a measure of sensitivity to changes in interest rates) than the US Aggregate Bond Market Index.
  • The outperformance of our global equity allocation can be attributed to our exposure to index-like investment strategies that overweight stocks with low price-to-book ratios (i.e. value stocks) and companies with high profitability. In the current environment, growth stocks and unprofitable companies have declined most from recent highs.
  • Note: the foregoing information does not reflect the potential impact of client-specific personalization e.g. the exclusion of certain sectors or companies.

3. US Treasury Yield: Re-Rating of Interest Rate Expectations

The chart below visualizes the treasury yield curve as of 12/31/ 2021 (gray), 3/31/2022 (blue), and 6/30/2022 (yellow), and 9/30/2022 (red).[3]

Key Takeaways:

  • The primary driver of fixed income returns has been a sharp re-rating of forward-looking interest rate expectations.
  • As we entered the year, consensus expectations were calling for three interest rate hikes of 25 basis points in 2022 followed by another three hikes of 25 basis points in 2023. In other words, based on information available at that time, market participants believed increasing interest rates by 1.5% over the course of a year and a half would sufficiently slow economic activity enough to alleviate building inflationary pressures (in conjunction with expected easing of supply chain bottlenecks).
  • Following Russia’s invasion of Ukraine in February, market participants reassessed their inflation expectations as oil prices jumped over $120 per barrel. At the end of the first quarter, the market was anticipating seven interest rate hikes this year and two hikes next year, along with the possibility of one or two 50 basis point increases. This outcome would put the Fed Funds target at 2.25% in Q1-2023.
  • Throughout the 2nd and 3rd quarters, inflation showed signs of broadening beyond the normally volatile food and energy categories, while employment numbers proved to be resilient in the face of rising interest rates. In response, the Federal Reserve hiked the Fed Funds rate by 75 basis points at three consecutive policy meetings. At the end of the 3rd quarter, the Fed Funds target rate stood at 3.0%-3.25%, and futures markets were pricing in a peak range of 4.5%-4.75% following the February policy meeting.
  • Because higher interest rates tend to impact economic activity on a lagged basis, it remains unclear what effect the current interest rate policy will have. Anecdotally, the housing market is beginning to show signs of cooling, while many companies are announcing hiring freezes and/or layoffs. For this reason, some Federal Reserve officials have suggested it might be prudent to slow the pace of interest rate hikes in the new year.
  • Important Note: Expecting that interest rates will go higher is not a reason in and of itself to sell bonds in advance of that happening.
    • In order to earn excess profit from a view that you have, your view must be different from consensus expectations.
    • It isn’t enough to say “I think interest rates are going higher so I’ll sell my bonds.” You’d have to say “I think interest rates are going to go up faster and by a larger magnitude than what the consensus expects.”
    • The profit potential available is always going to be proportional to the degree to which your view differs from the consensus. In order to make a lot of money, your view has to be so different from the market consensus that pretty much everyone is going to call you crazy unless you’re eventually proven right.
    • Looking ahead, the prevailing consensus view is that the Fed Funds rate is going to be more than double what it is currently. Unless you think the Fed will increase rates materially higher than that, you shouldn’t sell out of bonds.

4. Market Expectations for Future Rate Policy

This chart is a probability distribution table showing where the market believes the Fed Funds rate will be following upcoming Federal Reserve Interest Rate Policy Meetings, the dates of which are listed in the column on the far left. The probabilities listed in the table are all derived from the prices of Fed Funds Futures Contracts that trade throughout the day.  The logic behind the calculations is that the current prices of various Fed Funds Futures Contracts only makes sense if these probabilities correctly reflect investor expectations.[4]

Key Takeaway(s):

  • The market is pricing in about a 63% probability the fed will again raise interest rates by 75 basis points at its next meeting.
  • The consensus believes the Fed Funds target rate will be 4.25-4.50% at the end of 2022, and will peak at a range of 4.50%-4.75% in Q1-2023.
  • For investors, the most important question is “what’s being priced in”.
  • A more aggressive pace of interest rate hikes than shown here would likely put further downward pressure on fixed income and equity markets; while a less aggressive pace would likely be welcomed by investors.

5. YTD Performance of Morningstar Style Boxes

This chart displays the Year to Date performance of Morningstar Style Box Indexes.[5]

Key Takeaway(s):

  • In a reversal of fortune from previous years, value stock are outperforming growth stocks significantly in 2022.
  • Our core equity strategies are outperforming owing to a structural overweight to value stocks.

6. Brighton Jones Equity Exposure Comparison

This illustrates how our exposure to equity style boxes (right) compares to popular indexes.[5]


Key Takeaway:

  • Certain indexes like the NASDAQ 100 and S&P 500 have heavy exposure to large cap growth stocks.
  • Looking under the hood, these indexes also have high exposure to just a small handful of companies. For example, about 40% of the NASDAQ was concentrated in Apple, Amazon, Microsoft, Google, Facebook/Meta, and Tesla at the start of the year.
  • The equity exposure in a Brighton Jones portfolio is more broadly distributed among the style boxes, with a material underweight to Large Cap Growth Stocks relative to the S&P 500.
  • The last two years have been favorable as we’ve seen value stocks come back in favor.

7. Performance by Select Themes

This chart compares the performance of popular themes that we have been asked about to the Total Stock Market Index.[5]

Key Takeaway(s):

  • In late 2020 and early 2021, some investors felt like they were missing out on exception returns in baskets of stocks that try to take advantage of certain trends, like working from home, and everything related to FinTech, Blockchain, and Disruptive Technologies.
  • Like clockwork, many of these once popular themes have imploded (as bad as some of these numbers look, they don’t even capture the full peak-to-trough decline because a lot of these categories reached their highs outside of the year-to-date window shown).
  • The investment community often equates discipline with not selling during market corrections or bear markets. But not chasing returns and piling into potential bubbles during strong markets is what sets us up for success in down markets.

8. What it Takes to Recover

This chart shows the return an investor needs to “get back to even” on a position or portfolio for a given decline.  For example, a position or portfolio that declines 40% needs a 67% subsequent return to fully recover.[5]

Key Takeaway(s):

  • Historically, diversified portfolios owned by disciplined investors have weathered a great deal of uncertainty en route to earning attractive long-term returns.
  • In our view, chasing niche themes and picking individual stocks introduces considerable risk that often goes uncompensated.
  • Over the past year, investors have seen crypto currencies collapse; once-hot stocks like Zoom, DocuSign, Netflix, Robinhood (and many more) have fallen by more than 80%; and niche themes like IPOs, Cloud Computing, Work from Home (and many more) have also declined considerably more than the total stock market.
  • The road to recovery for risky behavior can be much longer and uncertain than a broadly diversified investment strategy.

9. Calibrating Portfolio Positioning

With large movements in fixed income and equity markets, clients might be wondering what we look for when considering adjustments to our investment strategy.  The diagram on the left illustrates how we characterize the investment environment using a quadrant chart with inflation-adjusted treasury yields on the horizontal axis and equity valuations on the vertical axis.  Along each axis, we denote the breakpoints used for segmentation; and within each quadrant we identify at least one period that stands out as having historical significance. We then calibrate our allocation positioning according to the quadrant chart on the right.  When equity valuations are low (bottom half), we want increased exposure to stocks, all else equal.  When real interest rates are high (right half), we want increased exposure to bonds, all else equal.  For the past several years, the investment environment has fallen in the upper left quadrant, which is indicative of low prospective returns. One of our key investment principles states that when high returns aren’t in prospect, we don’t want to invest as if they are.  Hence, we have maintained a “moderate conservative” posture towards risk.

Key Takeaway(s):

  • Despite rising interest rates and declining equity valuations for the year-to-date period, we have not categorically shifted into a different investment environment.
  • Nominal interest rates have increased dramatically but real interest rates remain negative adjusted for inflation. Equity valuations have retreated significantly from a year ago, but do not represent the type generational buying opportunity seen in 1982 and 2009.
  • While the forward-looking return environment has improved since the start of the year, we believe our current portfolio positioning has us appropriately balanced for the time being.
  • Of course, we will consider adjustments as warranted by a changing investment environment; but we do not make changes for the sake of making changes.

 

Data Disclosures

[1] Moderate Risk Portfolio: 5% Short-Term Bonds, 5% Intermediate-Term Bonds, 4% Inflation-Protected Bonds, 4% Multisector Bonds, 4% Floating Rate Bonds, 4% High Yield Bonds, 4% Preferred Securities, 34.5% US Stocks, 18% International Stocks, 4.5% Global Real Estate, 3% Master Limited Partnerships.  The foregoing information is provided for discussion purposes only and should not be relied upon as indicating any expected or projected returns. Hypothetical back-tested performance does not represent actual performance, trading costs or the impact of taxes and should not be interpreted as an indication of such performance.  Data source: Morningstar Direct.
[2] Taxable Bond Portfolio: 50% Vanguard Short-Term Bond Index + 50% Vanguard Total Bond Market. Tax-Exempt Bond Portfolio: 50% Vanguard Limited-Term Tax-Exempt + 50% Vanguard Intermediate-Term Tax Exempt. Inflation-Protected Bonds: Vanguard Inflation-Protected Securities. Multisector Bond Strategy: PIMCO Income. Floating Rate Bonds: Fidelity Floating Rate. High Yield Bonds: PIMCO High Yield. Preferred Securities: Nuveen Preferred Securities. US Equity: DFA Core Equity I. International Equity: DFA World ex US Core Equity. Global Real Estate: DFA Global Real Estate. Data source: Morningstar Direct.
[3] Source: US Treasury, CME FedWatch Tool
[4] Source: CME FedWatch Tool
[5] Source: Morningstar Direct

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