Q3 2022 Compass Review
According to the University of Michigan Consumer Sentiment Index, consumers feel as bleak as they did during the great financial crisis 15 years ago. At the same time, it’s still nearly impossible to get a restaurant reservation on a Saturday night, find reasonably priced airfare, and I-95 is chock full of return to the office commuters and trucks delivering commerce.
If the war in Ukraine continues its current path, Europe may be without gas come March. China’s list of problems grows daily as its zero Covid policy, real estate bubble, and supply chain disruption all come bearing down on soon to be reelected, Xi Jinping. The US is headed towards a bruising mid-term election next month where a coin flip will determine who will run Congress the next 2 years.
Globally, there’s this pesky problem called inflation that won’t seem to go away. Central banks, led by the US Federal Reserve, are increasing short-term interest rates to try and slow growth, which in theory, should cause prices to eventually stop going up.
Following suit, the 2-year Treasury rose from a low of .17% in 2020 to finish the quarter at 4.28%. That’s over a 2,000% change in less than a year in the world’s safest security. For comparisons sake, coming out of the financial crisis in 2008 the 2-year did not sustainably break above 1% for 7 years, and never broke above 3% until this year. Clearly the combination of events leading up to and following Covid had a materially higher inflationary impact.
Higher rates in the US also led to a much stronger US Dollar, forcing the world to respond. The Bank of Japan is buying yen for the first time since the Asian financial crisis in 1998. Meanwhile, the Bank of England is talking out of both sides of its mouth, raising interest rates while simultaneously buying government bonds to try and slow the plunging pound.
Speak to 100 different economists and you’ll get 100 different answers as to why there’s such a discrepancy between consumer confidence and travel activity. Why it took so much longer to recover from the great financial crisis than Covid. Why the Federal Reserve is moving too fast or too slow. Why it’s still nearly impossible to find quality employees. Or what it means for the world that the Chinese economy will have its lowest consecutive growth rates in 3 decades.
As we said back in March, the fact is the times are a changing. After 15 years of unprecedented monetary intervention, we are playing a new game. The days of cheap money and accommodative capital markets will remain in the rearview mirror for some time. Inflation will slow, but it will likely remain stubbornly high as the new world order unfolds. If history is any guide, Warren Buffet will again prove correct that “Only when the tide goes out do you discover who’s been swimming naked.”
Growth stocks were the first victim, as higher yields meant it was time to pay attention to valuation again. The leading growth manager, Cathie Woods, saw her ARKK Innovation Fund fall 75%. Next to go are the debt addicts. The high yield and leveraged loan markets ballooned over the last decade. Alternative investments that promised higher yields and less risk saw mass inflows, but the combination of slower growth, alongside large amounts of floating rate debt could make for an ugly ending.
The good news is that the public markets are extremely good at pricing in these challenges. The tech heavy NASDAQ is already down 32% for the year, while the broader S&P 500 is down 25%. Even the aggregate bond index is down 15%! Yet fear remains high, confusion reigns, and the urge to cash out and shelter from the storm is tantalizing.
Fortunately, we prepared for this moment. Each economic downturn is different, but they are always defined by what you did in anticipation of the inevitable turn, and then how you react during the most painful moments of crisis.
The golden rule every long-term investor subscribes to is survival. This starts by creating an asset allocation designed to prevent selling stocks during down markets. We do this during the good times so that we are prepared for the challenging ones. For those living from their portfolio, that means having enough cash and maturing bonds to fund living expenses, and only dipping into the core equity portfolio in an emergency scenario.
It also is a reminder about the importance of investment discipline, something very difficult to adhere to over the past 5 years. For a while the only trade that worked were the FAANG companies, followed by the work from home stocks. Assets were no longer purchased based on traditional valuation. There was just too much money chasing too many of the same momentum driven trades.
We are not without our missteps, but by in large, holding a portfolio of good companies purchased at reasonable prices, kept us away from the worst of the carnage. The best companies used the past few years to reduce their interest expense and extend their debt maturities, so an increase in rates will have little impact on their operations. Most of our companies should weather the storm, continue to pay their dividend and interest payments, take market share, and come through the slowdown stronger.
Remember that over the last 100 years, the average bear market decline is about 33%. With the market already down 25% and knowing that markets always turn long before the economy bottoms, the opportunity to shift to an offensive stance is rapidly approaching.
While we have no idea how long this downturn will last or where the worst damage will come, we know that it is unlikely that the last crisis will be the same as this crisis. Despite complaints about regulation, the US banks are in good shape, with much of the current risk pushed into the shadow banking system. Europe may have a few more issues with their banks, but nowhere near the scale of 15 years ago.
In a world where inflation remains elevated, ironically growth becomes an even more important factor for investment. Fortunately, we are finally seeing reasonably priced technology stocks that we will be adding to the portfolio in the coming months. The same is true for faster growing medical technology companies and industrials serving electric vehicles, semiconductor manufacturing, and 5G networks.
In Nassim Taleb’s book Skin In The Game he states that “Not everything that happens happens for a reason, but everything that survives survives for a reason.” The best we can do is be prepared for a long recovery, full of head fakes, attempted rallies, and widespread fear. Still, the long-term opportunities for our companies to come through the current challenges remains intact. Some of the best investments we’ve ever made were during times like these. We look forward to doing it again.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.