Thoughts on the Current Environment
First Quarter 2023
by Ralph Segall, CIO
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“Reports of my death have been greatly exaggerated.”
Throughout 2022, this newsletter has addressed the topic of Regime Change, the name we have given to the end of 40 years of declining interest rates around the world. We believe this era, exacerbated by central banks keeping interest rates artificially low for an extended period, allowed an excess of outstanding debt to accumulate globally. This excess, in turn, has increased the risk of a recession for 2023. While often viewed in a significantly negative light, a recession serves to reduce excesses in an economy. In this case, the economy is the global one, and the excess is outstanding debt.
Is the End in Sight?
We have proposed that excessive debt creation has permitted inflation to surge, first in what was thought to be in a “transitory” fashion and now (worryingly) thought to be more persistent. For us, inflation is to central bankers what kryptonite is to Superman: the only thing that can cause him to change behavior. It was the breakout of inflation beyond “transitory” that caused the Federal Reserve (Fed) to end its experiment in zero interest rates and “Quantitative Easing” (a 21st century term for excessive printing of money) in favor of a very dramatic series of interest rate hikes throughout 2022 that will no doubt last well into 2023.
At various times, the COVID pandemic, supply chain shortages, changes in the labor force, and the war in Ukraine have all been candidates for explaining the rapid rise in inflation. We believe that each of these were simply agents that accelerated or slowed the pace of inflation, thereby hastening or slowing the changes to be brought about in the economy. Regime change will occur through a reduction of economic activity and prices of financial assets. While painful, such declines are needed before we can expect a new upswing in global economic growth that can then be reflected in the prices of financial assets. As a result, we have been counseling our clients over the past year more towards capital preservation and protection. As our longtime readers know, it is very rare for us to make broad macroeconomic forecasts, but this one stands out to us as one that needs to be specifically identified.
Needless to say, the most frequent question asked by our clients is how much longer we believe this adjustment process will run. The only honest answer, of course, is we don’t know any more than anyone else. But there are some lessons from history that may help identify guideposts about the “when.” It is this work that we think will be of particular interest.
The 60/40 Model is Alive and Well
We updated our analysis from 2017 on returns available in the U.S. financial markets (the stock and bond markets), looking back 86 years, not just for the entire period but also in varying economic regimes during the period. There was a great deal of commentary written in 2022 about the “death of the 60/40 model” (a portfolio of 60% stocks and 40% bonds), as balanced portfolios did not produce the downside protection that many thought they would provide in volatile markets. We are pleased to report that we think the reports of its death are premature and that the balanced model is alive and well.1 In our original work, we found that balanced portfolios generated annual returns in excess of 5% annually, net of inflation, during the almost 90-year period beginning in 1936. The update of that work through 2022 reaffirms this conclusion, as shown in the following table.
Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital.
In our original work, we were conscious of the question “What if I don’t have 90 years to wait for the data to be proven right?” We therefore broke the returns down in a series of sub-periods: decades, rolling 5- and 10-year periods, bull markets, bear markets, rising interest rates, falling interest rates, inflation, and deflation, to name a few. For each of these sub-periods, we calculated the “batting average” for that group, based on the number of years in each of those sub-periods that the 5% return was in fact earned. Except for bear markets and inflation greater than 4%, the batting average of each sub-group was much more than .500 (i.e., more than 5 out of 10, 50% of the time).
What’s in Store for 2023?
From a policy perspective, we think there are several observations worth noting:
- For the first time in many years, bonds may have true investment merit. Bonds did indeed produce good returns up until 2022, but with the benefit of hindsight, these returns were built on the Greater Fool Theory. This theory reflects the fact that people can get pulled along by the crowd for quite a while before the realities of a situation finally prevail. The increase in interest rates in 2022 has altered the risk-reward calculation for bonds considerably. With the rise in rates that has occurred, bonds are now positioned to provide true coupon return (as opposed to return that arises just from interest rate declines), if not yet a source of contribution to real return. We must walk before we can run, after all.
- As for the equity markets, while stock market declines (i.e., bear markets) are not fun, note from the previous table that they do not tend to last for long (1.3 years on average), certainly nowhere near as long as market upswings (i.e., bull markets, which last 4.5 years on average).
- Last, no matter how we break down the results into various periods, the pull toward the average rate of long-term returns for all regimes seems to be quite strong. If so, the adage of not trying to time the market has some greater appeal. Correspondingly, searching for incremental returns from active management seems to be a much more productive exercise.
Understanding the Past as We Look Toward the Future
Finally, there is an important caveat to make clear here. This exercise is not intended to be a forecast of what investment returns going forward can be or will be. Instead, what we are observing is that in the last 90 years, the U.S. economy and public securities markets have experienced a very wide range of economic and financial regimes and outcomes, which have produced a wide range of investment outcomes. Considering the changes brought about by technological innovation, by social changes, and by more than a few periods of war and peace, this should be no surprise. To the extent one is willing to assume that the range of conditions and circumstances to come in the 21st century will fit, more or less, into this broad pattern closely enough, we can look at the past to gather some clues to inform our judgments for the future.
Think of this exercise as “Predicting the Future is an Exercise in Futility” meets “The More Things Change, the More They Stay the Same.”
A Happy, Healthy, and Prosperous 2023 to All.
January 2022 to December 2022
Source: Bloomberg. Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital. One cannot invest directly in an index.
1 Technical aside here: In the work that follows, we ran the same calculations for portfolios that were allocated 70/30, 65/35, 60/40, and 50/50 (% in stocks/% in bonds). The findings, as you might guess, are consistent and lead to the same conclusions. For that reason, we will just refer to data based on 60/40 going forward.
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