• Equity markets have gone up 80% of the time when viewed on a 6-month rolling period. They have experienced 10% or greater declines over a 6-month period approximately 10% of the time.
• Of the worst downturns over the past 60 years, the market has recovered to its past high within 18 months… on average.
• Equity markets reach their low before the worst of the economic downturn.
• Emotional response to market volatility results in investors losing more than 25% of the market’s opportunity.
• The downturns do not necessarily lead to negative annual returns.

We have discussed the instabilities in the markets and the economy. We have been adding to our cash positions since Thanksgiving of 2021 as we looked to mitigate an expected adverse market environment. In the first quarter of this year, some questioned as to why we were not fully invested. Now that the major indices are down 20% to 30%, we are being asked why we are not fully in cash. The answer is we look to be approximately right rather than precisely wrong. To have the confidence to move to an extreme requires much more than a recession. It would likely require a banking crisis.

There is little doubt that the inflation wave we are experiencing and the fight against it will be painful. And the markets will have to reflect it. Which they are. Now.

Investment markets—both equity and fixed income—discount future events. When those anticipated future events are positive, no one questions that discounting. However, when the future becomes darker, the downward adjustments are not easy or graceful. When the market is finding its correct level, the changes are typically abrupt, halting, and clumsy. Of course, dramatic data and big swings between the ups and the downs can make people feel uncertain and out of control. The danger is when feeling like that brings people to act on fear and regret—regret that “I should have sold all of my portfolio in…”

Consider, however, that historical market movements have demonstrated the best time to buy (or sell) is when the opposite action would feel most comforting. Our models, based on pattern-recognition over decades, have been working, so we will continue to follow their unemotional and empirically tested direction.

We firmly believe that market bottoms and tops are processes and should not be viewed as discreet points in time.

The last four months have seen investors move from a futurity (new word for us) approach to a more here-and-now approach. The prices of companies focused on future market dominance at the expense of current profitability have been under severe pressure, while more established companies with visible profitability gained newfound respect. The advent of rising interest rates appears to be pushing investors to value money on a current basis rather than on the dreams of the future.

We are believers in the idea that money is a commodity and, much like any other commodity, its value is dependent on the supply of it and the demand for it. In times of easy money (i.e., low interest rates), the holder does not see money as sacred and can afford to invest it in longer-term (i.e., speculative) assets. And, like other commodities, during plentiful times, people use money less judiciously. However, when money is harder to come by and more expensive, investors start putting their precious funds in more near-term vehicles, never wanting it far from them. In such times, investment discipline comes back into favor.

A big change in the interest rate regime—from consistently lower rates with relatively consistent economic expansion (review our newsletter on the NICE period)—to something less nice (e.g., higher rates and uneven economic growth), needs to be respected. And that respect requires exploring the implications of the shift.

In the investing world, we assess an asset’s sensitivity to rising rates using a measure called duration. Duration is predominantly used to discuss fixed income instruments because they have a set lifespan with predefined income streams. However, duration can be used to assess any asset class since any asset has some expectation of productive life, by which we mean the ability to provide income to the asset owner.

A bit more on duration…

Duration measures the sensitivity to changes in interest rates. Take bonds: the longer their duration, the more sensitive their price will be to changes in interest rate. Obviously, a bond with a five-year maturity has a duration of five years. Or a bond with 10 years left to maturity has a duration of 10 years.

Now, if interest rates rise by 1%, the price of an asset with a duration of 5 years will fall by approximately 5%. By extension, an asset with a duration of 10 years will fall by approximately 10%. Why? Because investors want to pay less for income, they expect to receive in the future than for money today. If interest rates rise, it is as though they are being asked to pay even more for that future income. As such, they demand greater compensation through a greater expected return and therefore pay less for it (as lower prices).

The other major component of the duration calculation is the amount of money returned to the investor each year. The higher the amount returned, the lower the duration. Conversely, the less near-term money returned, the higher the duration.

Now that this (brief) economics lesson is done, let’s get back to the reason duration matters.

The longer a bond’s life, the longer its duration. And in the case of equities, which we want or expect to have a very long life (measured in decades or hopefully lifetimes), duration is even longer, so their sensitivity to interest rate movements is much higher.

To demonstrate the sensitivity of various assets, we looked at how they have responded to past interest rate regimes. We do not directly use the chart below in Auour’s risk-regime algorithm, but it does a nice job of showing why we do what we do.

For purposes of this newsletter, we look only at the period from 1990 through March 2022. Although that time encompasses most of the bond bull market, there were short periods within it where inflation showed itself and the Fed fought it with higher rates. Ideally, we would include more data prior to 1990, but doing so would make comparisons with recent times difficult because economic dynamics were different as the dollar went off the last vestiges of the gold standard.

For the 32-year span, then, we defined a rising-rate regime (characterized by Fed tightening) by the acceleration of the consumer price index and the near-term Treasury market rates’ expectation for future rate moves. Within that timeframe, there were five episodes of Fed tightening. That’s not a lot of data points from which to draw strong conclusions, but the results are eye-opening, nevertheless.

We first look at the experienced return and risk of different types of assets during those periods (within the 32-year span) of lower or neutral rates (i.e., an accommodative rate regime, so not when the Fed is tightening). The graphic below depicts what we know as a typical association between assets: assets with higher volatility (and higher assumed duration) produced higher returns. More stable and secure investments, such as short-term bonds from the U.S. Treasury, produced low relative returns, but at a much lower level of volatility and duration. On the opposite side are emerging market equities, where investors were betting on future growth and future profitability.

Source: Auour Investments, Nobuya Nemoto

The next chart presents the same timeframe but during periods of rising rates and with a Fed focused on tightening monetary conditions. This chart shows the same assets but with a noticeable change in their experienced return. Although their duration and volatility are almost aligned with the accommodative regime time periods, the experienced returns are dramatically lower and, in most cases, negative.

Source: Auour Investments, Nobuya Nemoto

In this chart, investors’ desire for more near-term payoffs is reflected by the shunning of assets dependent on the futurity of profits and market dominance.

The above two graphs are likely the best visualization for why we believe in regime-based investing—that there are distinct periods, or regimes, that can bring about very different outcomes. Our ability to determine those regime shifts provides an opportunity to optimize client funds for different market environments. The next two graphs illustrate why we move into higher levels of cash as our primary defensive mechanism and look cockeyed at the traditional belief in static asset allocations.

In building portfolios, the interplay between different assets is critically important. If the assets held happen to react the same in all environments, there is little diversification provided and the entire portfolio may suffer from an adverse event. It is a mainstay in the investment world that we must understand that interplay to protect against correlation in returns when one is hoping for a more diversified positioning.

The graphs below highlight the correlations amongst various types of assets. The darker the shades of blue, the more the two corresponding assets will move in concert. The lighter the color, the more the assets will move independently. One can see, in the graphic on the left, the overall area of blue shading is lighter (i.e., less correlated), and equities and fixed income classes are relatively independent of each other.

Source: Auour Investments, Nobuya Nemoto

However, in the graphic on the right, one can see that when we have experienced higher sustained inflation—and a tightening cycle in interest rates ensues—there is a higher level of correlation between all assets. Another way to say this: in times of increasing interest rates, investors become increasingly risk averse, no matter the asset type, and they look for areas of safety, of which there are few besides cash.

Some parting thoughts.

Immense wealth has been built over the ever-lower interest rate environment of the past four decades, with just short and infrequent episodes of rising inflation and rising rates. This success established a consensus on how wealth is created through leverage and time to amplify the return of rising asset prices. But what if a change in the regime from ever lower rates moves to one with ever higher rates? Our experience is that the victors of past market regimes may become the victims when the winds change direction. For us, we need to take a critical view and be respectful of longer economic history, which spans more than just one half of an interest rate cycle.

The NICE period likely produced an anchor bias over the past 40 years of lower rates, and it has embedded itself into our perceptions of reality. Inflation and rising rates will change what we think is normal. Of course, the problem with calling a change in regimes is that what has occurred for 40 years can always continue for a bit longer.

We cannot predict with precision the changing regimes the investment cycle will experience but we have built in safety features that allow us to buffer portfolios during times of instability and changing risk attitudes. Over the past six months, we have become increasingly conservative with cash balances comfortably above 25% of all strategies. We are waiting for opportunities to reinvest as opportunities present themselves.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

– Gary Friedman, Restoration Hardware CEO March Earnings Call

In late 2019, as we were de-risking portfolios ahead of what turned out to be one of the top 10 downturns of our lifetime, we used a musical chairs analogy to describe the situation. We said we were grabbing our coats to go as we saw the number of chairs shrinking, knowing that whenever the music stopped, it would be painful. Now, with inflation running high and war likely to cause permanent changes in how nations cooperate economically, the central banks find themselves in an increasingly undesirable predicament with even fewer chairs at the party. The need for central banks to combat inflation with higher rates in the face of growing uncertainty adds credence to the idea we may be entering a far different period than experienced over the past few decades.

Destruction vs Disruption

Emotions have been running high this first quarter of 2022. The Russian invasion of Ukraine heightened pre-existing economic concerns about growing inflationary pressure and the awareness that interest rates would be rising.

Unsurprisingly, the rising tension has brought on higher levels of volatility. One day people want full risk exposure. The next they want completely out of the market. As we have expressed throughout our history, though, emotional responses to market swings are not the best way to protect and build lasting wealth.

We need to consider separately the (hopefully) short-term impact of war on the global economy and the longer-term potential disruption that the redefining of trade relationships brought on by war and increasing interest rates can cause.

Global markets reacted quickly to Putin’s mind-numbingly destructive invasion of Ukraine, and, as is typically seen with historical events, the markets partially recovered from the lows fairly quickly. We present a table below, produced by Mizuho Securities, showing past market-moving historical events, with their near- and intermediate-term impacts on equity prices (displayed in the chart as percent change from the bottom in various timeframes). In most cases, the markets recovered within months from the initial downward moves. However, in a few situations, the markets continued the downward trend for a year.

Whether the event’s market impact is short- or long-term might come down to whether the market perceives the event as a momentary (though harsh) period of destruction or as an event that will likely cause an ongoing period of disruption.

A destructive event, of course, will carry long-lasting implications for those directly involved. For example, even if the war ended today, Ukrainians face decades of rebuilding and many will carry the scars of war for life. But the regional impact of a destructive event does not always spread to the greater global economy.

On the other hand, we are defining disruptive events as those that interrupt the global economy’s current path with a new factor or phenomenon that permanently changes the direction of growth. The disruptive event acts like a jump ball in basketball, a reset where suddenly both teams must adjust to a new potential direction and tempo of play. We have discussed in past writings some signs the economic backdrop is changing, including a shifting trade environment after China’s takeover of Hong Kong and, recently, rising inflation and the scarcity of non-discretionary goods. With Russia’s aggression, we will need to add a changing energy supply and new East vs. West tensions to the mix.

For us, the trends of the past confirm that in most circumstances we must stay calm and be patient as we weather short-term destruction from war and increasing market volatility. However, in some instances, when the event brought a delineation between one global economic environment and another, past trends and market momentum become harder to trust given the changing landscape. We highlighted in the chart the few instances of this, such as the building of the Berlin Wall that marked the start of the cold war, the oil embargo of the 70’s, and the destruction of the World Trade Center towers on 9/11, as examples that brought about a more enduring and global change to economies. The current situation shares some characteristics of those events, as Russia and China expand their adversarial stance against the West. We maintain our focus on potential longer-term disruptions to the economy that may present new opportunities for profitable investing.

Rising Recession Risk

We are going to let the pictures do the talking to underscore our concern about the risk of recession. Below are four charts that we think highlight that growing risk.

As the Federal Reserve starts raising interest rates, Deutsche Bank’s chart, above, makes the case that tightening cycles provide the backdrop for asset deflation (or busts). With financial leverage being high across the globe, as economic disruptions increase and monetary policies are tightened, the risk of a crisis increases.

Even with aggressive investment in renewable energy, the world today is still highly dependent on fossil fuels, in particular, oil. The chart above shows how previous quick, upward movements in oil prices have coincided with recessions. History isn’t necessarily followed precisely, but we think its patterns deserve respectful consideration.

Consumer expectations are volatile and not a sound predictor of recessions, but with low unemployment and wages growing, it is interesting to see a rising nervousness among the population.

Germany, one of the larger developed economies, is also flashing warning signs. Its economy is slowing from very high levels, and future expectations are negative. The chart above shows the evolution of current and future economic expectations in Germany since 2017. They are moving into a precarious position.

Conclusions

Long-term averages of investment markets show a historically strong return after the impact of inflation, leading most to believe in a static “stay in the market and wait it out” approach. However, within those averages are periods encompassing wars, high inflation, and economic recessions that can test one’s resolve that the future could look anything like the past. In most cases, over the last 40 years of economic growth, the market recovered before market volatility brought one to the breaking point. Those few episodes we identified where the markets did not recover quickly were during periods of rising inflation. And that brings us to the present moment: this chance that we are today in one of the rarer but inevitable market shifts that takes longer to play out calls for, as suggested by our quantitative indicators, cautious positioning in Auour’s portfolios.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

The oil market is a great example. A tight supply situation was exacerbated by Russia’s invasion of Ukraine. Prior to the invasion, there was a push toward renewable energy at the expense of traditional oil production. De-investment by large capital pools, such as public pensions and sovereign wealth funds, produced a deficit in new production. Now, take away the Russian supply and the imbalance worsens.

The demand side of the equation deserves some attention also. The global shutdown due to the pandemic threw a curveball, dramatically reducing oil consumption around the world as miles driven plunged. That turned out to be short lived relative to the supply side issues, as demand for oil is now above pre-pandemic levels.

Two recent events suggest that the supply/demand imbalance will not be temporary.

California is planning to give money to each resident so that they can afford gas. That’s well-intentioned but ill conceived. Providing funds for making purchases will keep demand higher than if the funds were not available. Normally, some would choose to lessen their usage as prices rise, but with this extra money, buyers will become less price sensitive, and demand will stay high.

In an attempt to bring prices down by increasing supply, the U.S. government has announced it will release oil from its strategic reserve. But the oil industry sees it differently. The release of oil from the reserves is limited in scope and, therefore, viewed as temporary. The oil producers know this and have stated that they will likely not respond quickly to increase capacity since prices are being manipulated downward. Why spend funds now to grow capacity when the oil will sell for less? Why not wait until the government has reduced its inputs so that prices rise, and then add capacity?

Such well-intentioned acts by governments are doing nothing to fight inflation. Instead, they are only building up the inflationary pressure.

Though the initial shock can be alarming, the longer-term market returns from the point of incursion suggest that the market builds into prices the threat of war before the actual war starts. It is not foolproof as there were times when the market did not fully incorporate the value destruction. The three events (shown above) where the markets continued dropping were post the 2000 technology bubble and the periods involving the OPEC oil embargo. It should give us pause that those have some commonality with the situation we face ourselves today.

The Russian invasion into Ukraine is looking to take on a more lasting impact. Not entirely due to the war but the change in attitude of European leaders. Western Europe’s willingness to placate Putin and to become increasingly dependent on Russia for commodities appears to be ending. European countries had become complacent to the threats of aggression from their eastern neighbor. The last two weeks have signaled a change in that attitude as Germany and other NATO members announced a significant drive to increase defense spending. The graph below shows the average spend on defense by various countries. In the case of Germany’s announcement, they will be doubling their spend.

It should go without saying that we hope that peace will prevail sooner rather than later. The drop in global markets may be short lived but the impact of a changing economic focus by Western Europe is likely to bring about a more lasting result, promoting a stronger defense against authoritarian regimes.

“True security lies in the unrestrained embrace of insecurity—in the recognition that we never really stand on solid ground, and never can.”

“Uncertainty is where things happen.”

Over the past two long-drawn-out years, we have discussed the idea that market participants swing between uncertainty and complacency. We have also observed that most investors believe asset prices will be protected by central banks, a phenomenon pundits call the “Fed put.” Investors have had good reason to become complacent and believe in the Fed put because the past two decades have trained them to look to the Fed whenever asset prices drop materially. However, that was during an environment of low inflation, or even deflation, when the Fed had the luxury of acting without igniting an inflationary fire.

The Federal Reserve Bank of the U.S., or the Fed, the dominant central bank in the world, has two mandates: (1) maintain a stable value of the U.S. dollar by fighting off inflationary pressures, and (2) maximum employment. As we have presented over the past few months, the Fed had 40 years of deflationary forces—the Non-Inflationary Consistently Expansionary (NICE) period—that allowed it to dampen economic volatility and reinvigorate a bullish spirit through lower interest rates. And as the next recessionary threat came along, the Fed continued to lower rates because it worked so well the previous time. Investors have been trained like Pavlov’s dogs to gobble up more speculative (riskier) assets when the Fed rings the lower rate bell, and with asset pricing being higher than at almost any time since World War II, the dogs have gotten fat.

The sustained lower rates have reduced investors’ sensitivity to “here and now” cash flows, pushing them into higher risk, more speculative investments. What happens if the next bell to be rung is for higher rates?

We now sit at zero interest rates. Even more importantly, we are experiencing high inflation that could be argued is structural in nature rather than transitory. As uncertainty continues to build with war in Ukraine and an ongoing pandemic, many prognosticators look at the playbook of the last 40 years and assume the Fed will continue down that same path of low rates to protect asset pricing and reinforce speculation, pushing inflation control to a much lower priority.

That assumption seems excessively complacent from our perspective and suggests an anchor bias that could present issues into the future. The anchoring of one’s economic view to only the last 40 years omits the stagflation of the 1970’s and it’s impacts on discretionary spending, economic growth, and the rising uncertainty that plagued the investment markets. We sit with conditions that are far different than those over the past four decades. An underinvestment in energy production along with rising tensions between economic and military parties is a clear deviation from the inclusionary tailwinds experienced since the early 1980’s.

To shake off that anchor bias, we recommend Nassim Taleb’s book Antifragile, written in 2012. Antifragile, very haphazardly summarized, posits that most systems exhibit swings or variations due to system stress, and it argues that such stress, although uncomfortable, can help build long-term resilience and strength into the system. Some will see the “swings” as flaws, or system bugs, and will look to limit the system’s negative feedback. When the Fed moves to dampen economic volatility via lower interest rates, it is doing just that. And we are concerned that such efforts could lead to increased economic instability (which would also surprise many) once rates start trending higher.

Reducing the natural variation that stresses a system prevents adaptation and protects inherent flaws, creating fragility under the appearance of everyday steadiness. The ultimate result is a more chaotic eventual path when larger stresses that can’t be “managed” present themselves. The changing attitude to forest fire prevention presents a wonderful analogy. Today we ignite small, localized fires as a means of controlling undergrowth. The small fires remove latent fuel so that accidental fires have less fuel and are therefore easier to control. Several decades ago, however, the idea was only to prevent all fire, which meant larger, more fierce fires when they did come, which were uncontrollable and devastating to the environment.

In his book, Taleb argues that when large, uncontrollable events occur, there are not only some actors within the system that can withstand the turmoil, there are some that benefit from the periods of increasing fragility. He calls them the antifragile. More on this is a second…

As mentioned above, we contend that the last 20 years of Fed increasing actions to thwart the natural volatility within the economy and the markets have led to a perception of lower uncertainty built into the valuation process of risk assets. It worked because they had the inflation headroom to adjust rates lower. A whole generation of investors have been trained to see lower rates as a solution to market turmoil. We are increasingly concerned that the NICE period is behind us, and the Fed will be forced to focus on inflation fighting.

We are not the only ones discussing this conundrum and what it means for the economy and asset prices. Incremental investors are more and more on the lookout for antifragile assets while distancing themselves from fragile assets. By fragile asset we mean those that have their value arriving in the distant future rather than ones that generate (and protect) value in the here and now. Some recent phenomena suggest a move away from fragility. For one thing, growth stocks have come under increasing pressure. Also, blockchain instruments have been halved since the beginning of the year. And innovation stocks are down 60% to 80% over the past year.

One issue with defining anything as fragile or antifragile is that the definition will be dependent on the system one is looking at and the factors that drive it. What was once antifragile may turn out to be fragile under a different context. During the financial crisis, U.S. long-term sovereign debt was a safe haven. Can that be true in a rising rate environment? The jury is still out.

What we at Auour do know is that cash, the basis for valuing almost all assets, is likely to be antifragile if we see pricing of all assets needing to adjust to an inflation-fighting Fed. Our strategies currently hold roughly 25% cash as we continue to crave antifragility.

Supporting this argument is the impact from an aggressive move to renewable energy as demonstrated by Germany. The graphic below shows the changes within German energy production. Since the early 2000’s, Germany has been driving an aggressive campaign to renewables, taking share of production from base-level sources such as nuclear and fossil fuels.

This has resulted in Germany power prices being among the highest in the world and, perversely, increasingly dependent on the pricing of fossil fuels as depicted in the scatter plot below.

As investments within the fossil fuel space continue to languish as major sources of capital (sovereign wealth funds and pension funds being two examples) reduce their investment into the space, it is not obvious how this move to higher energy pricing abates.

Let’s start with the idea that inflation is not fleeting, as hoped, but rather it’s becoming embedded in the economy. In our recent newsletter, we discussed the events leading to scarcity, and, we argued, they appear to be driven more by structural causes than by the money-supply. (Money supply has played a large role, but we think it merely amplified the underlying structural issues.) We sit in an unstable position, then, if you believe history is to be respected.

The chart above highlights this instability. The green line shows the long-term historical relationship between inflation and interest rates. The purple line depicts the same relation only for the period encompassing the pandemic. Even if you believe inflation (shown as “core CPI,” on the x axis) is only temporarily elevated, it still argues for a 200bps adjustment in the 10-year Treasury note—from its current 1.8% interest rate to something around 4%. (As an aside, interest rates on mortgages are traditionally tied to the 10-year Treasury interest rate. Could you imagine a world where mortgages were in the 5% to 6% range?)

The distortion is, as has been well-publicized, driven by the world’s central banks pushing down rates. They do so by purchasing government bonds as a means of propping up prices, which lowers interest rates. Their influence is demonstrated in the declining share of sovereign debt held in the hands of private investors, who traditionally are the natural buyers of fixed income instruments.

Global central banks outside the U.S. have been about the only buyers of sovereign debt for the past decade, blurring the distinction between central banks and political bodies. This suggests one of two paths: that central banks will stop buying sovereign debt, letting the private markets once again control the price of that debt and letting risk-free rates move to market-determined levels; or, that political will wins, central banks lose their independence, currencies risk their value retention and inflation continues to run hot.

Central banks, through their massive buying of debt, have created a blackhole in risk-free rates, drawing all income-producing vehicles into that hole. If central banks need to give up on an easy monetary environment to fight inflation, rates across all income-producing products will increase, leaving little opportunity for fixed-income instruments to appreciate. This has some market strategists arguing that more equity within a portfolio is necessary. However, in our view, that comes with its own set of risks.

The first among such risks is over-valuation.

No matter what metric you choose to measure equity values now, we are seeing historically high valuations. The above chart highlights the CAPE (cyclically adjusted price to earnings) ratio, which is horrible at predicting timing, but good at demonstrating severity when (not if) market participants return their focus to values-based investing. While it is true that the future might be different in unknowable respects from the past, the last 100 years of data should humble us all. The chart below looks at 10-year forward returns versus experienced CAPE. All 10-year forward returns from valuation levels near what we are seeing today have been negative. This is also true for 5-year forward returns. (These last two charts should look familiar because we have presented earlier versions before, and they continue to become even more extreme with updated data.) Extremes typically last longer than many expect, but that doesn’t make them any less extreme.

We are not arguing to avoid equities completely. Instead, we are highlighting the need for caution. The 10-year returns following high CAPE periods of the past come mostly from the dotcom bubble, and a few data points are from the late-1960’s. Many of us are not old enough to remember the 1970’s—the period that returned to valuation sensitivity, but a lot of us remember the 2000’s quite well. We do not see the same disparities in valuations as we did during the dotcom period. The dotcom bubble was localized in technology and communication companies, and during that period one could buy tobacco company stocks with double-digit dividend yields and industrial companies at single-digit earnings multiples (i.e., really, really cheap). Not today. The low interest rate environment and the central bank blackhole have brought almost every asset category to historically high valuations.

We sometimes hear that low interest rates drive a lower risk premium and therefore a higher normalized valuation level. But this has only been true over the past 40 years, in the presence of low inflation when rates were normalizing after the Volker period. If inflation persists and rates move higher, history suggests rather that valuations will drop, even for growth companies, a phenomenon the U.S. experienced in the 1970’s.

If inflation picks up, the graph below does not auger well for valuation levels. A negative relationship between P/E (price to earnings valuation) and inflation has existed for the last 100 years. The higher inflation is, the lower the valuation multiples are that the markets will pay for equities.

The question comes down to the path investors take to get to those lower valuations. In some cases, it is through companies growing their earnings into a more reasonable valuation. In others, it will be a resetting of prices to reflect a more modest growth in earnings. The latter is already showing itself in those companies that benefited from the pandemic as some of the benefactors have seen drops of 50-80% from their highs. No matter which, history suggests that the path taken will not be without volatility.

Conclusion

Though valuations can become anchored, making any normalization to historical averages take time, we suspect we will see periods that resemble the shorter corrections (i.e., one- to three-quarter long corrections, not multi-year ones) we have experienced over the past 10 years. Our suspicion lies in the complacency within the investment markets. This complacency has led to high leverage as many believe that central banks will defend assets prices rather than follow their overarching mandate to protect price stability.

If that is not the case and central banks prioritize price stability above all else, it will put significant pressure on those that have leveraged bets to the contrary with the result being margin calls. Correlations of all assets drive towards one when margin is called, fear takes hold, and people run for the exits.

We sit with a 20% allocation to cash across our strategies, expecting better opportunities to move back into a fully invested position.

In our May 2021 newsletter, Breaking Windows, we discussed inflation and its impact on the investment markets. We said the primary drivers of inflation were the large stimuli injected unevenly into the global economic system through governments and central banks. That newsletter focused on one side of the equation—demand—and in it we noted: “There is an argument to be made that persistent inflation is unlikely without a scarcity of core, non-discretionary inputs. (Think back to oil in the 1970’s).”

In May, we hoped inflation in the U.S. would be transitory as the world reopened with pent up demand. However, what we fear now is that pockets of scarce supply will continue to put upward pressure on prices because ongoing pandemic-induced precautions and changing priorities by governments around the globe appear to be entrenched.

Over the previous four decades, the world’s population has experienced a fantastic non-inflationary, consistently expansionary (NICE) economic landscape. The term NICE was coined (pun intended) by the former head of the Bank of England, Mervyn King, who said, in 2008, that the U.K. was likely exiting this golden period. He was speaking only of the U.K., but he could have applied his assertion to most developed countries. Up until the Global Financial Crisis, the U.K. and the world at large had been experiencing moderate global inflation and relatively smooth economic expansion. Since his comments, and until the present moment, inflation has continued to be moderate, but economic growth has become more volatile as economies increasingly depended on easy monetary policies and financial leverage. Today, with inflation perking up and unstable economic growth, Mr. King’s end-of-NICE concerns might finally be coming to fruition.

The global NICE period started in the mid to late 1970s as the U.S. started a wave of privatization, deregulation, and the breakup of government-enforced monopolies (e.g., Ma Bell), all of which reduced barriers to entry, expanded the competitive landscape, and drove a multi-decade investment cycle focused on creating better, cheaper, and faster solutions.^[1] It was not only the U.S. that saw this low inflation period of growth. We saw it, too, with the fall of the Berlin Wall, and with the integration of the Iron Curtain countries into the Western European economy as both end markets and centers of manufacturing. The period got new momentum as communist China opened a bit, offering a large untapped labor force and, over more recent decades, a prosperous consumer hungry for Western goods.

Once static industries were able to opportunistically adopt technological innovations and cross borders to source optimal labor and service new end markets, economies of scale brought more value to an expanding addressable market. Over the course of three decades, the world witnessed a dramatic decrease in extreme poverty. More than a billion people moved up the wealth curve, producing new consumers along the way. The immense new resources allowed for a non-inflationary environment to flourish even as economies across the globe grew rapidly.

Today, we might be in a different situation. The political big bang of expanding individual freedom and freer trade has stopped, and the data indicates individual rights and the freedom to transact seem to be contracting. The Institute of Democracy and Electoral Assistance (IDEA) recently released a report showing that the number of democratic governments in the world has declined, and a growing number of those still democratic are under threat. The most obvious examples are Russia and China, who are restricting economic freedoms to further their political agendas, constraining economic energy and diverting it to less productive areas. As one example, China has stopped importing coal from Australia, forcing power outages across the country, because the Australian government promoted an international investigation of China’s handling of Covid-19.

The IDEA report also highlights that the pandemic has led to a surge in authoritarian behavior by even the most democratic governments, as many around the globe experience mandatory lockdowns and travel restrictions. Pandemic-induced scarcity through restricted movement has caught many’s attention, but other factors not necessarily related to Covid have led to a material change in the availability to economic inputs.

Let’s use three examples—the global energy sector, U.S. supply chains, and the global labor market—to explore this cause and effect.

Regarding energy costs, governments around the world have been pushing for greater reliance on renewable energy. Developed market countries have quickened the prioritization of renewable energy as they feared the impact of their use on the environment. The U.K. moved aggressively into wind power, simultaneously reducing their investments in fossil fuel facilities, which resulted in energy shortages recently when the wind wasn’t blowing. Europe has been aggressive in moving away from traditional energy sources, as well. France—which has the second largest reserve of shale gas in Europe—banned fracking in 2011, and in 2017, it banned all new oil development, setting the stage to cease all production by 2040. Germany enacted legislation in 2011 to move away from nuclear energy, causing a heavier intermediate-term reliance on fossil fuels at the same time the government was also restricting investments in that space.

Restricting production does not correspondingly change demand, however, which has continued to grow in these countries. As a result, France and Germany have become increasingly dependent on Russian natural gas at a time when Russia is flexing its muscles politically and economically in direct opposition to European democratic ideals.

Our second example is the U.S. supply chain.

Monetary and fiscal stimuli allowed for greater consumer demand during the pandemic than expected, forcing companies to play catchup after depleting inventories at the start of the pandemic. Many firms are also changing their supply strategies from a pre-pandemic, just-in-time approach to a post-pandemic, just-in-case one. Even so, misjudging demand does not explain why port congestion— understood to be a major contributing factor to the U.S. supply chain problem—is worse on the West Coast than the East Coast. The East Coast (representing about 19% of U.S. import capacity) is not experiencing the same level of congestion as ports in California (that represent about 28% of import capacity). If we look under the hood, the problem may exacerbate the downstream effects of California’s regulation of ride-sharing companies.

The American Trucking Association estimates that the U.S. is short about 80,000 truck drivers. Yet, reports estimate that more than 460,000 commercially licensed truck drivers resided in California in 2019 and only half of them are operating right now. The shortage might be due to many California truck drivers—especially those that worked as independent contractors at the ports—having either left the state or taken other jobs because of a 2020 state law requiring companies to classify independent contractors as employees, increasing the cost burden on an already stressed system. The law had ridesharing apps in its sights, but truckers were in the line of fire also, leaving many to move on to less restricted job opportunities. Because California is the entry point to well over a quarter of the U.S.’s imported goods, it’s regulations can have a ripple effect throughout the U.S. economy.

Government laws are also impacting the more general labor force. The near-term consequences of virus-based restrictions are, for better or for worse, producing labor scarcity. With each new variant, the threat to labor is renewed.

This challenge is not unique to the U.S. The Philippines have instituted a “no work, no pay” rule for their unvaccinated population. Canadian employers are responding to an expected government mandate by firing or putting on leave unvaccinated employees, even as they experience a tightening labor market. The U.S. has set a January 4 deadline for large employers to have their employees either fully vaccinated or tested on a weekly basis. In other words, the global labor shortage, amplified by mandates, is becoming an ongoing issue.

A very rough estimate is that unvaccinated adults make up about 20% of the U.S. labor force. A little over a third of the unvaccinated have responded to polls saying they will leave their jobs if their employer mandates a vaccine or weekly testing. We are not sure how this will end, but we can see the likely initial result is more scarcity in labor.

The shift to a more regulated environment reminds us of the philosopher Zeno’s dichotomy paradox, which argues that a person walking between two points must first walk halfway. And before they can walk halfway, they must first walk a quarter, and then an eighth, and then a sixteenth. Zeno extrapolates this to the point where a person must walk an infinite number of infinitesimal distances to get to the destination. And the one thing we know about infinity, it’s a long way away.

We bring this up not because the distance is impossible to complete, but because the rules put onto the mission, and the myopic perspective they encourage, produce what seems to be an impossible objective. We see something similar in our world today, with blunt laws, rules, and attitudes combining to artificially and illogically increase the distance to our objective, which in this case is reducing scarcity.

The likelihood that scarcity will continue, and inflation will remain higher for longer is becoming embedded into the fixed income markets. We mentioned in late summer the degradation we saw in the credit markets as Chinese property developers were experiencing rising rates of default. Credit markets have continued to deteriorate, overcoming the positive momentum in world equity markets. We have long highlighted investment markets lacking fundamental valuation support and, currently, we are adding the observation that credit markets are showing fatigue. We see it as a time to increase our level of conservativism. We have recently moved the portfolios to be a bit more cautious, raising cash levels to 20% across all strategies.

1. We are firm believers that evolution towards better outcomes is a never-ending process yet over modern times, we have experienced innovation cycles where the advancement in cheaper, better, faster accelerates and decelerates. We think this graphic does a better job than we could at depicting the recent cycles in technological advancement. ↑

In this tale of cartographers unintentionally helping to create a landmark, we see an interesting analogy to today’s global economy.

The Federal Reserve and its central bank brethren have moved interest rates to nearly zero as a means of reigniting economic activity. In so doing, they have unintentionally built an ecosystem dependent on low financing rates, which has caused some to claim they have given up on their main mission of price stability.

This newsletter will highlight one example of this low-rate dependency, as well as a potential change in the environment we should all watch, and last, it will touch on an unintended consequence resulting from the low-rate environment.

Evergrande: China’s Lehman Moment?

Headlines have been filled with the news that the largest property developer in China, Evergrande, is struggling with very significant debt and low liquidity. In 2021, Evergrande’s stock price has declined 85% as the markets fear an eventual default. With more than $300 billion in liabilities, should there be a bankruptcy, it would be one of the largest on record.

To put such a default in context, Lehman’s bankruptcy resulted in a bond default of $150 billion. Now, Evergrande’s potential corporate bond default would likely come to less—approximately $200 billion of their liabilities are in buyer deposits and supplier payables—but no matter, the bond default would still approximate $90 billion, almost four times the largest default experienced since 2011.

Currently, Evergrande has missed their September payments on U.S.-dollar denominated bonds. Looking at what’s due in future monthly payments suggests the problem will only get worse.

Many are asking if this is China’s “Lehman moment.” Is this the domino that falls and topples other fragile institutions causing greater value destruction and liquidity constraints? We don’t think this is quite that bad. Lehman was uniquely situated to cause collateral damage because, as a global investment bank, it served as a middleman in transactions amounting to trillions of dollars across the globe. Their default spread across large swaths of global GDP. Lehman’s downfall also happened very quickly, and the U.S. regulators lacked the authority to thwart the collapse.

Evergrande’s troubles are not as far-reaching as Lehman’s, and they have been known for years. Also, China, with its controlled economy, can likely address the property developer’s liquidity issues through its state-owned enterprises.

Just because it is not likely a Lehman moment doesn’t mean the boomtown mentality will hold up within China. Asian property developers, such as Sunac and Greenland (no relation to the country), are experiencing funding shortages while there is concurrently a slowdown in home sales in China. If sales wane, prices likely will fall, too, and the results could be uncomfortable for many.

China’s economy and the wealth derived from it are highly tied to the real estate market. Unlike in the U.S., where housing assets represent about a quarter of household wealth, in China they represent more than 60% of wealth. Housing and the industries tied to it represent about a quarter of China’s GDP. We have discussed the implications of the wealth effect on U.S. consumption, where declining wealth leads to declining consumption. One should assume the same is true for China’s consumers.

With respect to pricing, China’s housing market looks fragile. We were young when it burst, but we still remember the many justifications given for the bubble in Japanese real estate in the late 1980’s, and we hear the same reasons today being used to describe the property situation in China. Economic activity and low rates can create a nice backdrop for optimism, but long-term reality may lead to some sorrow. Chinese home prices as a percent of income are the highest in the world. Low rates allow buyers to think about how much in monthly payments they can afford. However, if rates start to move up, householders’ attention may well move to how much debt they have tied to an expensive asset.

Interest Rates

The push for lower and lower interest rates appears to be in the rearview mirror. The rapid rise in inflation and concerns that it will linger has contributed to global central banks taking the foot off the accelerator and at least modestly tapping the breaks.

Rate hikes are now outpacing cuts (albeit off a low number). Some will see this as a tepid move to a more normal rate environment, but we believe it warrants attention because the global investment markets have become accustomed to easy money. The incremental tightening of money availability may be considered by some to be a radical change. Financial leverage is high and modest shifts in cost of debt and its availability could bring about dislocations to global markets.

The chart above looks at liquidity as defined as the Federal Reserve balanced sheet minus the money that is being placed back with them as a means of finding a safe place to store it. The continued growth in the Fed balance sheet is well known; less publicized is the amount of money going back to the Fed for safe keeping. The purple line is the net liquidity offered by the U.S. central bank. It peaked in April of this year, and we have been experiencing a declining liquidity environment with the rate of decline accelerating.

Keep in mind that the Evergrande troubles were showing themselves long before the modest U.S. liquidity drain shown above and before rate increases were becoming significant.

Blockchains and Digital Assets

The Agloe analogy really hit us as it pertains to the blockchain ecosystem. The unintended consequence of a few cartographers brought about the birth of a real place on the map.

Central banks, in their attempt to stabilize economies, have caused some to create a new town that is independent of central bank dictates. The low-rate environment has brought about concern that governments are in a race to debase their currencies to placate their populaces. The fear has generated a desire by some for an asset that has finite units and therefore a hope that it would retain its value relative to fiat currencies. Bitcoin is the poster child. We are not believers in this fear, at this point, as central banks are still independent institutions that continue to state their main objective of providing price stability. We will see if they can regain trust.

However, the bitcoin phenomenon has birthed a technology idea (blockchain) that has gathered adopters for purposes other than dollar-replacement assets. Blockchain, as a technology, intrigues us as we witness the development of new business models because of it. As personal computers moved computing power to the individual and away from the glass walled mainframes, we see an opportunity for blockchain technologies to drive a continued evolution to decentralization.

The caveat to this intrigue is that we are early, and history has not been kind to the first movers. In the late 1990’s, the internet was promising but nascent. We remember the pitch of many brokers that one should buy a basket of names to participate in the long-term theme of the internet. The idea was to build a portfolio of internet leader that included companies such as JDS Uniphase, Worldcom, Corning, Sun Microsystems, AOL, Yahoo, Cisco, Intel, VerticalNet, Pets.com, Netscape, etc. Many of these were monsters in their respective spaces yet went on to become lackluster performers or outright value destroyers. The returns did not match the enthusiasm and the benefits did not accrue to many of those companies.

We offer this up as an example that optimism on an idea does not always reflect positive future returns to current players. Yet, the optimism is real and some new things are here to stay. Optimism can bring about a new order upon which life is lived. We will continue to investigate the opportunities and threats that may result from blockchain technologies.