“Every new beginning comes from some other beginning’s end.” Seneca, the Elder
“The equity market is engulfed in a fog so dense that we can’t navigate with confidence… Given that and the lack of reliable coordinates, we should opt for a large, seaworthy vessel.” Michael Goldstein, Empirical Partners
Happy New Year… and farewell to a historically challenging year in financial markets. How challenging? Equity markets entered bear market territory with the S&P 500 falling 18% for the year. Small cap stocks fell 20%. Large cap technology stocks, the businesses which have led markets higher over the course of the last decade, fell over 30% as investors questioned stretched valuations and earnings expectations. Irrational market behavior around meme stocks, crypto and other deeply speculative areas within the market, while not eradicated, has been penalized.
Equity market corrections, and even bear markets, are normal in the context of a market cycle. It is in fixed income markets where 2022 can be characterized with that familiar term, unprecedented. While traditional portfolio management theory suggests bonds should act as a ballast in a more challenging equity market environment, the past year ran deeply counter to history and theory. Traditional fixed income markets experienced their worst performance going back to the 1920’s. This past year also represented the first year in modern market history where equity and bond returns were both down double digits in the same year.
Given this backdrop, I am particularly proud of the work our investment team at Heritage has done over the course of the last couple of years to position client portfolios to “weather the storm”. While Heritage client portfolios have not been immune to falling markets, declines have been mitigated through our focus on quality and risk management. Foundational to our investment philosophy, we strive to participate in rising markets while remaining focused on preserving capital in more difficult markets. We can make no promises about the path forward, but we will work every day to execute this philosophy to help our clients achieve their long-term objectives.
This is the time of year when our industry is prone to make prognostications about the coming year. While predictions must always come with a healthy dose of humility, it is instructive to contrast today with where markets and the economy were a year ago. A general assessment of the landscape a year ago included strong economic momentum and accelerating inflation. Interest rates remained at low levels as the Federal Reserve was signaling but had not begun to raise interest rates. In this environment, valuations were extended with speculation pervasive across asset classes including, but not limited to, equities (public and private) and real estate. In a sense, markets were priced for perfection supporting our bias to focus on quality and risk management. Fast forward twelve months to an environment that is distinctly different, albeit more difficult to discern the path forward. “Fogbound”, with a nod to our partners at Empirical Research, is an appropriate characterization of the current environment.
What do we know? Challenges remain: geopolitical risks remain acute internationally and domestically; leading economic indicators are weakening, although labor trends remain strong; money supply has turned negative; inflation is decelerating but wage growth remains persistently high. The Federal Reserve has been transparent and consistent in raising rates to lower inflation, suggesting market hopes for a Fed “pivot” seem misplaced. It is difficult to envision meaningful additional fiscal stimulus given a fiscal deficit approaching 5% at the start of a weakening economic environment.
On the positive side, valuations have rerated over the course of the last year in the face of rising interest rates. Prices are now approaching levels associated with more attractive future returns. After more than a decade of “TINA” (There Is No Alternative, in this case to equities), we appear to be entering a new era. Tighter labor markets and supply chains suggest the disinflationary environment of the last forty years is shifting. As interest rates normalize in this environment, we will see competition for capital between equity and fixed income investments. The rising cost of capital for businesses across markets will impact capital investment decisions. While we believe this is healthy for markets and future returns, markets may continue to experience volatility as they adjust to shifting macroeconomic trends.
In this environment, we believe fundamentals matter. Earnings expectations for 2023 have come down materially but continue to reflect profit margins well above normal levels. Weaker revenues associated with weaker economic activity suggests additional risk to earnings. Given a wide range of potential outcomes coupled with no clear valuation opportunities, our bias is to remain focused on quality and risk management across asset classes. We believe we are leaving the era of “free money” and entering into a new era where discipline will be paramount for business owners, managers and investors alike. While this adjustment will likely result in continued volatility in financial markets, patient investors will be able to take advantage of opportunities in public and private markets as we navigate the way forward.
We thank you for the confidence that you and your family have placed in our firm. Please do not hesitate to reach out to your wealth advisor or a member of the Investment Advisory team with any questions.