Quarterly Commentary - Q2 2022
Q1 2022 Review
The first quarter of 2022 saw a decline in every major asset class except commodities (up 33%). It was the worst first quarter for US bonds in 40 years and global bonds did slightly worse. Inflation continued to soar unabated as the headline CPI rate spiraled upward recording a reading of 7.48% in January, 7.87 % in February, and 8.54% in March.
In response, the Federal Reserve in March finally raised the Federal Funds rate by 25 basis points for the first time since December of 2018. It is widely anticipated to raise the Federal Funds rate again by 50 basis points at the May 3-4 meeting and another 50 on June 14-15. Ultimately, the market is anticipating the Federal Reserve will raise the Federal Funds rate 6 more times this calendar year (at each meeting) up from 3-4 anticipated last quarter. This would put the terminal rate of this rate hiking cycle at somewhere between 2.5% and 3.0%.
In addition to the direct upward pressure on the “short-end” of the yield curve, the Fed also announced it would begin quantitative tightening – a process to reduce the massive $9 trillion of Fed holdings of US Treasuries ($5.7 trillion) and mortgage-backed securities ($2.7 trillion) through a combination of letting existing bonds mature and potentially selling directly into the bond market at a recently announced rate of $95 billion per month. About $5 trillion of the total $9 trillion matures in greater than 5 years.*1
Austin Private Wealth Model Changes
The Russian invasion of Ukraine and massive Chinese COVID lockdowns have exacerbated the already difficult commodity pricing pressure worldwide. Wheat, oil, and natural gas in particular, all pressed higher. And as we discussed last quarter, wages and home prices continue to rise at very high historical rates. Even the Federal Reserve now acknowledges that inflation is no longer temporary in nature.
Generally in financial markets it is impossible to predict short-term price movements. Even when something seems incredibly self-evident, the underlying nature of the market structure means that it is often “already priced in”. Sometimes, facts play out just differently enough to cause a zag when everyone is certain a zig is about to occur.
We believe what is occurring in the bond market at present is neither of those scenarios. The train coming down the tracks in the form of Fed rate hikes and Quantitative Tightening can only lead in the short term to one possible mathematical outcome … continued falling bond prices.
One additional consideration impacting bond yields is the recent collapse in the Japanese Yen relative to the US dollar. In January of 2021, ¥104 could purchase a single US dollar. Today it takes ¥128. This may not seem important, but Japanese pension and institutional investors are the largest foreign holder of US Treasuries, by a wide margin.*2 The Fed, we can only assume, was hoping that they would be major buyers of the balance sheet reduction. The large fall in the Yen makes it difficult for these investors to continue to purchase Treasuries at scale because the currency hedging costs have made the trade less profitable.*3
The question we are asking therefore is not IF bond prices will fall… it is already happening. The question is how much more and for how long? The potential countervailing forces at play are that the Fed action (and fear of future action) curtail the broad US consumer demand that is causing inflation. And/or that supply improves due to Russia and Ukraine reaching a peace agreement, China stopping its crushing Zero Covid policy, and a myriad of other factors in the global supply chain begin to improve. We simply don’t believe that any of those events are likely in the coming quarter. By the second half of the year we hope to have more clarity.
Eventually the yield on all of these bonds could rise sufficiently to provide attractive returns net of inflation. Already, 10-year US Treasury Inflation Protected Bonds are starting to climb above 0% real yields. As this number climbs, Treasuries should once again become a true alternative to stocks, particularly for conservative investors. In the meantime, we see little opportunity in fixed income.
Stocks on the other hand tend to move much faster. Already the pullback in every class of equities has created pockets of value. Small Cap US Value stocks for example are trading at 86.6% of their 20-year average price to earnings. Also, as we have pointed out for almost a year now, the relative valuation gap between US equities and global equities continues to widen. In addition, there are significant sectors of the market (e.g. Financials and Energy) that have historically been more positively correlated to rising interest rates.
While we have been reluctant to make large strategic shifts with the recent fluidity of economic and geopolitical news, there are a few longer-term themes that are beginning to crystalize.
As a firm, we continue to evaluate new and innovative ways to express our investment convictions while maintaining our core investment principles. Over the coming year, we hope to bring many of these new ideas to you as individual investment proposals and as part of our broader portfolios.
Austin Private Wealth, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Austin Private Wealth, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Austin Private Wealth, LLC unless a client service agreement is in place.