KCS Quarterly Market Review for Q1 2022
April 25, 2022
Has the Bear Come Out of Hibernation Already?
Catastrophe is apparently the new normal this decade, and in that respect 2022 has stayed true to form. Already, we’ve dealt with a war, surging inflation, rapidly rising interest rates, and an ongoing pandemic. We will discuss each of these in our quarterly letter, focusing on their geopolitical and investment ramifications.
But first, looking at the near term, stocks experienced a correction during the 1st quarter of 2022, with the MSCI ACWI at one point falling by more than –12%. The index subsequently rebounded to finish down only –5.4%. Losses were broad-based, but there were some significant outliers. Most dramatic were Russian equities, which became untradable to the Western world after the initiation of sanctions. The result was a repricing of the MSCI Russia index to zero, where it has remained since March 9—representing a complete loss (for now) for shareholders with positions in these securities. Chinese stocks also underperformed this quarter, as the example of Russia led to a broader rethink of geopolitics and investment jurisdiction. Meanwhile, resource-rich economies such as Brazil, Australia and Canada boomed, with Brazil the standout, gaining over +30%. Among sectors, Energy, Utilities and Financials outperformed owing to higher oil prices, a flight to safety, and rising interest rates, respectively. Meanwhile, cyclical and tech stocks underperformed, with Consumer Discretionary, Information Technology and Telecommunication Services each down double digits.
The 1st quarter also holds the distinction of being one of the only quarters in history during which stocks were down but bonds were down even more, as U.S. bonds suffered their worst quarter in more than 40 years. The culprit: precipitously rising interest rates. Yields began rising last October, picked up steam right after the New Year, and accelerated further in March. Their poor return in recent months challenges the notion that bonds are always safer than stocks: bond prices, as measured by Barclays US Aggregate bond index, are now down –10.9% since the start of 2021.
One silver lining to recent dismal bond performance: with their recent price drop, bonds are now back to actually yielding meaningfully more than zero. A 6-month treasury pays 1.3% now, and tying up your savings for 1 year will earn you more than 2%.
To mitigate some of the damage within fixed income, KCS focused on shorter duration bonds and also made some tactical shifts into alternatives (commodity and MLP funds, both of which benefitted from rising energy prices). Our individual equities were helped by our tilt towards value and our avoidance of some of the priciest areas of tech.
“Buy When There’s Blood in The Streets”
Readers may remember that at the end of 2021, there was already a fair amount of stock market agony. As we mentioned last quarter:
… even though equity indices finished within 1% of their record highs, investors felt pain in thousands of individual names by year’s end. For example, over half the companies in the Russell 2000 index of small stocks finished the year down at least –20%, and in the NASDAQ, nearly 1 in 3 stocks ended the year down by –50% or more from their recent highs. Clearly, 2021 was not a year when throwing darts at the stock market page was a successful approach to picking stocks.
Yet the major equity indices fared well in 2021 owing to their concentration in several outperforming mega-cap names. That has not been the case in 2022, with the S&P 500 beginning the year with its 4th worst 48-day start in market history. To put that in perspective, that places it between the starts of the Great Depression years of 1933 and 1935.
But don’t despair; we mention this to focus on the good news. After each of the five other worst start to a year prior to this one (2009, 2020, 1935, 1933 and 1982), markets rebounded strongly during the remainder of the year, with returns of +28% or greater. This enabled each of these years to finish with solid double-digit gains.
We believe that we’re in store for something similar this year. Our “boots on the ground” vantage point (where we regularly look at hundreds of situations) tells us that both stocks and bonds appear attractively priced here. That perspective is bolstered by macroeconomic considerations, which we think also support our bullish stance. We dive into several of these below.
- (Most) Interest Rates Appear Near Their Peaks for the Year
We mentioned above that the current up-move in interest rates has been precipitous: the 10-year Treasury yield has risen from 1.5% at the start of 2022 to over 2.9% as of this writing. While the absolute increase of about 1.4% isn’t that dramatic, given how low rates started, this represents almost a doubling of interest cost on these intermediate-term government bonds.
Rising government bond yields permeate to all other financial categories, and we think the economy will need some time to digest this spike in rates. For one clear example of this seepage, look at 30-year mortgage rates, which have risen from about 2.7% five months ago to 5.3% today—nearly doubling the borrowing costs of home ownership. This obviously impacts affordability: other than the bubble years of 2006 and 2007, we are now at levels of housing cost last seen in the early 90s.
It has been said that “housing IS the business cycle”, and if that holds true then we think near-term economic growth will be challenged. But at the same time, this suggests that rates have likely peaked for this cycle, and that should help future stock and bond returns. There are other reasons why we think that rates are not likely to go up much from here, at least for the rest of 2022, but they are really arcane and involve debt-to-GDP ratios, the Federal Reserve dot plot, the size of the Federal Reserve balance sheet and the impact of shrinking it, and other mind-numbing technicalities. Suffice to say that we think that rates near the middle of the yield curve (2 to 7 years) are likely to stay near their current levels, while yields on the short end (below 2 years) and on the longer end (above 7 years) still have some climbing to do. Later on we talk about how KCS is positioning portfolio based on these assumptions.
- Don’t Fear the Inverted Yield Curve
You may have heard that the yield curve “inverted” recently and that this portends a recession. “Danger ahead!” shouted the financial news pundits. We say, “Not so fast!”
First, an “inverted yield curve” simply means that short-term interest rates are higher than long-term rates, which is the opposite of what is usually seen. (Investors typically demand higher interest rates for longer-term bonds in return for tying up their money longer.) But sometimes this relationship reverses, most often when the Federal Reserve raises short-term rates to cool inflation. Although this hasn’t happened yet, bond markets are already anticipating a year’s worth of Fed rate increases.
Using yield curve signals is not without merit, as history suggests that yield curve inversions do have some predictive power. In the chart below, we show the spread between the 10-year and one-year treasury going back to 1973. Inversions, or when the one-year rate was higher than the 10-year, are depicted in red. Recessions are shaded gray. As you can see, yield curve inversions typically preceded recessions.
But before you rush to sell your equities, it’s important to put these signals in context. The following table shows S&P 500 returns after the yield curve inverts (in this case, the 2-year vs. the 10-year Treasury). In 2/3 of cases, markets rose significantly over the following one and two years, even though a recession eventually followed. Therefore, selling in response to the yield-curve inversion “signal” can cost you a lot in foregone returns. Even if we do experience a recession down the line, it probably won’t happen for a couple of years, during which stocks will likely continue their upward trajectory.
Furthermore, it’s hard to call what just occurred a true yield curve inversion. All those that preceded past recessions lasted several weeks or more. The recent one barely lasted for 2 days. Looking at the far right of the graph below of the spread between 10-year and 2-year Treasury rates, you can see that not only was the recent one really brief, it reversed with breakneck speed. It thus seems more like a false alarm than a true signal to us.
- Inflation Will Be (Partly) Transitory
Closely related to interest rates is inflation. Unless you’ve been living under a rock, you are probably aware that prices for nearly everything have been skyrocketing lately, with the most recent reading of the US CPI (Consumer Price Index) pegging the year-over-year inflation rate at 8.5%. It’s likely scant comfort to know that this is not just a US phenomenon: in Europe, Canada and most of the rest of the world, inflation is also at 6% or greater.
Lost in most recent discussions has been the transitory portions of these price increases. While we do believe that inflation will remain elevated for another year or so, we also believe that a significant part of the current price surge is temporary. This is a result of the combined effects of pandemic shortages, supply chain bottlenecks, and the recent war-related price shock in oil and other commodities. We expect inflation from each of these sources to lessen toward the end of 2022. Notably, transitory pressures were already starting to ease in February, before the war within Ukraine hit commodity markets (see below).
While we expect today’s unusually high inflation rates to cool down by next year, don’t expect a return to the minimal price increases of the last decade anytime soon. Some components of the CPI will continue to rise at a hotter-than-normal clip for a while, most notably housing costs, which make up about 30% of CPI. This will likely cause overall inflation to stay at least slightly above the Fed’s 2% target for a couple of years at least.
- The Tragedy in Ukraine Will Force Changes
We have been concerned about geopolitics for some time. Last quarter, we noted:
Of course, there are always risks worth watching for. The biggest risks are those we can’t predict, but there are some knowable ones we are keeping our eyes on. Geopolitical issues seem to be particularly likely as a source of potential sell-off, with troubled hot spots including Taiwan, Ukraine, and more recently, Kazakhstan. Other potential problems we are watching include prolonged semiconductor or labor shortages. And of course, there’s always the possibility that yet another COVID variant shows up and again disrupts life. Where feasible, we are striving to reduce risk in our portfolio from such potential adverse events.
Russia’s invasion of Ukraine has already created a humanitarian tragedy. This time, in contrast to its past military excursions (Crimea in 2014; Georgia in 2008), Russia appears to have miscalculated. Sanctions placed against it by much of the rest of the world have been swift and consequential, effectively isolating Russia from much of the global economy. The contraction to its GDP over the next 2 years will likely be at least 10% (for context, US GDP only fell by about 4.3% during the entire global financial crisis). Ukraine will fare even worse, however, with an expected contraction of nearly 35%.
Given the increasingly unlikely chance of a speedy resolution, we think Russia’s invasion will lead to longer-term geopolitical and economic ramifications. Perhaps the most important will be in how companies reevaluate their dependence on certain countries for raw materials and manufactured goods. The world may also need to adjust to living without many of Russia’s key exports, some of which are significant in terms of global market share.
Except for palladium, all these commodities are readily available from other countries, and production is already shifting in many cases. For palladium (used in catalytic converters), by increasing South African production, substituting platinum (also from South Africa) and continuing the move toward electric vehicles, the world could learn to live without Russian commodities. For now, however, exports continue.
International Stocks Again at Extremes
It’s also worth noting that international valuations are now at even more extreme levels of undervaluation relative to the US, at more than 2 standard deviations cheaper than historical averages. Said another way, international has only been this cheap about 2% of the time in modern history. Unless valuation relationships are truly broken, we think now is an especially attractive time to increase your weight in international equities.
Yes, we know that we’ve said this before, and for a time last year and early this year, it appeared that international stock valuations would start their journey toward mean reversion, gradually catching up with the US. The war in Ukraine threw yet another wrench into this process. But then something interesting happened: professional investors who were formerly bullish on non-US stocks became more cautious, the exact opposite of what one would expect given the huge valuation disparity. A contrarian take on this is that we’re finally close to the turning point. Once the mean reversion process starts, it is likely to move remarkably quickly.
KCS Portfolio Positioning
For the past couple of years, KCS investment portfolios have been underweighted in US tech names. While this hurt performance immediately following the 2020 COVID shutdown and bear market, it has been most helpful during 2021 and so far in 2022. This is because rising interest rates are particularly hard on the stocks of companies with rapidly growing earnings. Think of a growth company as being like a bond with a very long duration: the bulk of the interest payments (earnings) occur well into the future. When rates rise, prices of long duration assets fall more than those with shorter durations.
As an example, look what happened to Netflix recently. Owing to subscriber growth coming in below expectations, that stock has plummeted: since the beginning of 2022, it has dropped a staggering –65%. Its price is now back to where it was in early 2018. For many years, we thought it was overpriced and never owned it. Just this week, we started buying a small position in many accounts because its price finally looks reasonable, and we think the company still has a bright future. There are many other examples of high-flying growth stocks (not all in tech) that have come back to earth in recent months and are looking more attractive. We will continue to focus on finding value in our equity investments, attempting to buy stocks that appear (relatively) cheap and selling or avoiding those that seem overpriced.
In fixed income, we have for several years focused on shorter duration bonds and areas of the bond market that are outside the mostly government, mortgage and investment-grade corporates that populate the major indexes. This, too, has served us well as interest rates rose. Now, as interest rates in the “belly” of the curve appear ready to stabilize, we are shifting more into bonds with maturities between 2 and 7 years, and even nibbling on some longer-duration bonds with attractive yields. At the same time, we are trimming bonds at the short end of the curve where rates still have a lot of room to rise while improving the credit quality of the portfolio in case the Fed becomes too aggressive and causes financial stress to less creditworthy companies.
The world faces a number of challenges today. Economically, the most important of these are the war in Ukraine, supply chain disruptions from COVID and its aftermath, a shortage of qualified workers, inflation, and central bank tightening. None of these is insurmountable nor likely to lead to recession, and all of these are well known and to a large extent, priced into both equity and fixed income markets. To us, the greatest foreseeable risk is a monetary policy mistake in which the Federal Reserve (and perhaps other central banks) raise interest rates too quickly or too much and push us into a recession. This has happened so many times in the past that it is almost predictable. Given that, we will be watching for this closely and making tactical investment changes if we think that the Fed has gone too far. Stay tuned.
The KCS Investment Team
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