The S & P 500® was up 2.5% during the quarter, the MSCI All-Country World Index® declined by -0.8% and the Bloomberg Global Aggregate Bond Index declined by -5.1% as economic strength and sticky inflation in the US put upward pressure on US interest rates which reverberated across equity and bond markets around the World. US Mega Cap Growth stocks rose by 6.8% while the equally weighted S & P 500 index fell by -1.8% and the S & P 600 Small Cap Index fell by -0.7%, as investors sought refuge from the global market volatility by buying the “Magnificent Seven.” Returns among other asset classes beyond equities were mostly negative as well. Short-term Bonds (-2.3%) and Long-term Bonds (-16.1%) also showed significant divergence as longer maturity bonds, being more sensitive to changes in interest rates, had a greater reaction to the rise in US rates, with Global Bonds(ex-US) down -6.4% as well. Material stocks (-12.2%) were the worst performing sector this quarter as investors expressed concerns over a global growth slowdown. Most sectors were down this quarter: Industrial Stocks (-2.2%); Consumer Staples (- 4.6%); Healthcare (-10.3%); REITs (-8.0%) and Utilities which were down (-5.5%). In the positive column, Consumer Discretionary Stocks (+12.2%); Financials (+7.1%); and Technology (+3.2%) all gained. Precious metals were down slightly (Gold -0.4%) while the broad Commodities indices were up about 1%. The Global 60/40 portfolio returned -2.5% for the quarter reflecting the aforementioned weakness in both stocks and bonds. Most of our risk model portfolios performed ahead of their weighted benchmarks for the quarter with the remainder in-line.
With the US election settled more decisively than expected, the equity market rallied strongly in November but then ran into a wall in December as the Federal Reserve cut the Federal Funds rate despite further evidence of sticky inflation and a stronger than expected US economy (which puts upward pressure on the required real interest rate). Unlike prior cutting cycles, the Fed has been cutting short term rates into economic strength rather than weakness. The chart to the right from JP Morgan shows how the bond market’s reaction to this cutting cycle has been very different to the prior six cycles. Furthermore, the Fed acknowledged both the strength of the economy and the lack of further progress in reducing inflation by reintroducing the concept of two- sided risk to their management of the Federal Funds rate. That is, they explicitly stated that they would be willing to raise interest rates again if inflation expectations began rising on a persistent basis. Investors responding to this by reducing their expectations for Fed Funds rate cuts this year from four to one, which added to the downside volatility in December.
Those concerns are best illustrated by looking at the changes during the fourth quarter in the 10- year US Treasury yield:
Source: Federal Reserve Bank of Cleveland, Factset
Despite the volatility caused by the back up in interest rates, the benchmark 10-year Treasury Bond is as close to “normal”, when looking at the median statistics over the last 42 years, as it has been in since the Great Financial Crisis (“GFC”) in 2007-2008:
Source: Federal Reserve Bank of Cleveland, Factset
In fact, we would argue that much of the recent bond market volatility stems from investors thinking that the 15 years post the GFC were normal (or the new normal), yet zooming out and looking at the longer-term financial history of the US would show that those years were an anomaly. As an aside, we believe that the US Government’s decision to finance government operations using short-term instruments such as three- and six-month T-Bills post-Covid and a general unwillingness to extend the maturity of our debt during that time, will be viewed through the lens of history as a once in a generation opportunity to improve the fiscal budget deficit that was squandered. In the chart above/right from JP Morgan, you can see we are about 10 years away from the cross-over point where mandatory expenditures (e.g. Medicare/Social Security) and net interest costs exceeds US Government revenues (Taxes, etc.).
In fact, one could argue that with such a flat yield curve (2 bps) between the Federal Funds rate and the 10- year Treasury bond, the Treasury should still take advantage of the current conditions and increase the mix toward longer dated maturities.
In the table above, we’ve also included the same statistics for the decade of the 1990s. We’ve taken the position for a while that current economic and financial conditions remind us (fondly) of the 1990s.
The table below looks at a comparison that includes statistics for the S & P 500 in addition to statistics for economic and financial conditions:
Source: Federal Reserve Bank of Cleveland, Factset
What we see in the table above is that financial conditions are loose as measured by the Federal Reserve (FR) of Chicago’s National Financial Conditions Index (NFCI); productivity is currently running ahead of its long-term median; together allowing the economy to run at about 105% of its potential. US corporate growth (earnings and dividends) rates are in-line to slightly ahead of their long-term medians. Lest you think we are cherry picking the statistics, please review the following broader list which is a sub-set of the statistics we track:
Source: St. Louis Federal Reserve
During the decade of the 1990s, stocks as measured by the S & P 500 compounded at 18.2% and bonds as measured by the Bloomberg US Aggregate returned 7.7% (similar to its starting yield of approximately 7.9%). In contrast, during the first five years of this decade, stocks have returned 14.4% and the Bloomberg US Aggregate returned -0.3% (with a starting yield of only 2.0%). What stands out the most in the S & P 500 valuation data on the table above is where we are today. We’ve discussed how the current valuation of the size-weighted S & P 500 is historically high at nearly 25X last twelve months earnings. By way of contrast, the S & P traded at 15.2X earnings in December of 1989 and 20.2X earnings in December of 2019. We have never believed valuation to be a useful timing tool — one can grow old (and insolvent) waiting for investors to care about valuation – until they do. We prefer to look at valuation more as a risk management tool as history has shown that starting valuation has a high correlation to long-term returns. That is, low starting valuations result in high compounded returns 10 years later and vice-versa. One of the best representations of this relationship we have seen comes from JP Morgan via Howard Marks/Oaktree Capital Management’s year end letter to clients and while this chart uses forward earnings vs. trailing earnings – the negative relationship between valuation and long-term returns is clear (measurement period is 1988 to 2014). Source: JP Morgan and Oaktree Capital Management
If the size-weighted S & P 500 is facing a head-wind in terms of its valuation – then what isn’t? Fortunately for us, just about everything else. The chart below is from JP Morgan and shows most other global markets are historically attractive vs the S & P 500. For us, this is a great time to be diversified both globally and across asset classes.
We at Twelve Points Wealth hope you and your families are well. Please call or email if you have any questions.
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