The market narrative appears to be approaching a crossroads after an oddly sanguine few months. The hopeful chatter of a “Fed Pivot” now seems starkly at odds with inflation and employment data.

Despite the fastest pace of interest rate hikes in a generation, the Bureau of Labor Statistics recently reported that the American economy added 517,000 jobs in January, the largest positive surprise versus expectations on record. In fact, the US unemployment rate actually ticked down to 3.4% in January in spite of the Fed’s best efforts to cool the economy.

While low unemployment is usually something to be celebrated, this recent labor market strength is not a welcomed sign for a Federal Reserve focused on returning inflation to their 2% target. With a seemingly strong labor market and national wage growth annualizing at north of 5%, inflation is unlikely to subside to a satisfactory level for Fed officials.

Signs of inflation becoming entrenched emerged last week when the US Consumer Price Index ticked up to 6.4% shattering hopes of a slow and steady grind back to 2%. The hot CPI report was followed a few days later by the Producer Price Index, viewed by many as a leading indicator of inflation, also coming in well above expectations.

Barring a material softening in wage growth and employment, it seems unlikely that the Fed will be successful in returning inflation to more normalized levels. Chair Powell told us as much at his Jackson Hole speech last summer where he spoke of requisite “pain” in order to tame inflation.

The uncomfortable reality is that recent data is telling the “data-dependent” Fed that the job is nowhere near done. In order to achieve their price stability mandate, it appears that the Fed will be forced to hike interest rates higher and hold them there longer than the market is currently anticipating. Markets will need to “price-in” this fact in the near future which will likely engender further asset price volatility.

Strategies for Uncertain Times

The Oxford Investment Fellows™ strive to build portfolios offering robustness to any number of macroeconomic environments. A potential blind spot for more traditional approaches is a period of heightened volatility in growth and inflation. Specifically, periods of high or rising inflation paired with tepid economic growth present challenges for both stocks and bonds, as we saw in 2022.

There are, however, a limited number of “divergent” strategies tailor-made to capitalize from these painful market dynamics. Such Diversifier Strategies actually tend to benefit from high and rising market volatility – a valuable feature in a portfolio context.

One such divergent strategy well positioned for an uncertain future is Systematic Trend Following. We published a timely piece on the strategy here, and we maintain strong conviction in this valuable Diversifier.

A useful historical parallel was the 1980s, when inflation was high and volatile, and growth was challenged. The below visual tracks the real (i.e., inflation-adjusted) performance of the Barclays CTA Index (an index of trend following funds), the S&P 500 and the US Aggregate Bond Index over that frustrating decade. History strongly suggests that maintaining exposure to Diversifier Strategies is prudent with the current macro backdrop.

The information in this presentation is for educational and illustrative purposes only and does not constitute tax, legal or investment advice. Tax and legal counsel should be engaged before taking any action. OFG-2212-13

Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 1.12.23 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2302-10

The -18.1% return for the S&P 500 in 2022 was the fourth worst calendar year return for the broad US large cap equity index since 1973. During challenging equity markets over the past 40+ years, diversified investors that held stocks and bonds benefited from the counterbalance of a bond portfolio that was largely uncorrelated to stocks, or even better, negatively correlated at times. A secular decline in interest rates helped dampen equity volatility and provide a lift to portfolio returns.

Investors felt no such comfort from their fixed income portfolios during 2022 as interest rates moved sharply higher. In fact, this last year saw the steepest drawdown for fixed income in well over 50 years (including the late 70’s/early 80s period when Fed Chairman Volker famously battled inflation in the US). A traditional 60% S&P 500 / 40% Bloomberg Agg Bond Treasury portfolio experienced its worst return since the depths of the Financial Crisis in 2008.

Returns within developed non-US equities fared much better than US counterparts during the year. However, for US-based investors the unrelenting strength of the US dollar masked the outperformance. The MSCI EAFE Index local currency index returned -7.0% in 2022. The same index in USD including the currency impact was -14.5%.

A lone bright spot for traditional markets was real assets, specifically commodities. The Bloomberg Commodity Total Return Index gained +16.1%. Upstream commodity producers continued to benefit from a combination of rising commodity prices and historically cheap valuations.

INFLATION FIGHT

The Federal Reserve raised the fed funds rate by 4% over the course of 2022 in an effort to tame inflation that had moved well past the “transitory” kind (short-term supply chain issues) referenced in earlier FOMC meeting minutes. Today we face a stickier and more entrenched variety that emerged within wage growth. Beyond raising rates, the Fed is allowing its balance sheet, which had ballooned to $9 trillion following massive stimulus during the COVID-19 pandemic, to shrink by no longer reinvesting maturity proceeds, effectively removing a massive (and price insensitive) buyer from the market.

While anecdotal evidence of peaking inflation are beginning to show (headline and core CPI fell year-over-year and month-over-month in November), it is clear that policymakers are determined to keep a lid on inflation, even as equity markets struggle. Said differently, it appears the “Fed put,” a belief that the Fed will rescue markets with easing monetary policy, is dead.

On the positive side, breakeven inflation rates, which project the market’s expectations for future inflation, remain contained and are falling. This suggests the market anticipates the current path of monetary tightening will work. Whether the fight against inflation will lead to an economic contraction remains to be seen, though “soft landing” optimism of inflation falling towards the target 2% rate without a US recession seems remote. The bond market certainly does not subscribe to this optimism with a majority of the Treasury yield curve inverted, a condition that historically foretells a recession within 12-18 months.

LOOKING AHEAD

While it might seem overly simplistic, it is worth noting that expected future returns increase with falling equity valuations and rising interest rates. It can be emotionally difficult to live through volatility, but remembering this core tenant along with maintaining a patient, long-term view can help maintain a rational perspective.

Oxford’s portfolio construction philosophy is not contingent on making market timing decisions or attempting to predict recessions or when interest rates will fall/rise. Observing how routinely and far off well-resourced and sophisticated research firms are with their annual market predictions is enough evidence to support this view. Instead, we attempt to build portfolios that are robust to various outcomes while leaning into areas of opportunity and away from uncompensated risk.

As we enter 2023 and face heightened economic uncertainty, below are a few observations:

I. Real yields are real again. Fixed income markets enter 2023 with the most attractive environment in years. Real yields (net of expected inflation) are the highest since 2009. Investors have access to strong absolute yields within portions of securitized bonds and high-yield municipal bonds, along with other areas of fixed income.

II. Higher rates are letting the air out of growth stocks. The move higher with interest rates appears to be the catalyst for a shift in speculative behavior and relative performance between growth and value stocks. The “meme stock” craze is over. The Russell 1000 Value index outperformed the Russell 1000 Growth index by 21.6% in 2022. Importantly, the historical valuation spread between value and growth is still wide by historical measure.

III. International stocks – two ways to win. US equities have significantly outpaced international stocks for more than ten years. It can be tempting to throw in the towel and embrace the home bias, but we believe a global approach to equities is appropriate. While timing is uncertain (see comment above!), there is a meaningful valuation advantage in favor of international markets. Additionally, any weakness in the US dollar would be an additional tailwind.

IV. Value of Diversifiers. When downside volatility emerges at the same time correlations rise between stocks and bonds, the importance of other strategies that can provide more durable diversification increases. Oxford’s approach to constructing a thoughtful portfolio of Diversifiers was tremendously accretive in 2022. This allocation offered a unique return stream not directionally tied to equities or fixed income in aggregate. Importantly, we view this allocation as strategically important across market cycles. In other words, while the value to portfolios was most evident in a year like 2022, this allocation has merit when traditional markets are performing well.

V. Private Markets Discipline. The ability to create long-term value without concern for analysts’ quarterly earnings estimates is particularly helpful during times of elevated equity market volatility. A disciplined, consistent, vintage year approach to private equity commitments is as important as the effort to identify attractive individual opportunities.

On behalf of Oxford’s Investment Management Group, we wish you a happy and prosperous 2023.

Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 1.12.23 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2301-10

**As of 12.1.21
***As of 8.1.22

Read the disclaimers

Last week the Federal Reserve Bank of Kansas City hosted its annual Jackson Hole Economic Policy Symposium. The Jackson Hole Symposium had humble beginnings with then Fed Chair Paul Volker only agreeing to attend the inaugural conference in 1982 on conditions that he be spared time in the schedule for fly fishing in Jackson’s legendary streams. The fly fishing has given way to obscure academic discussions, and the conference is now the most anticipated event in the annual Fed calendar with global investors hanging on every word. How times have changed.

The Jackson Hole conference has grown in importance over the years as the main venue where central bankers elaborate on their current thinking and major monetary policy changes are often announced. The 2022 conference, the first in-person event in three years, was much anticipated as a window into how aggressive the Fed intends to be towards their current inflation dilemma.

Fed Chair Jerome Powell capped off the week with a brief presentation that indeed shed light on how the current Fed is thinking. Powell’s speech outlined three main lessons guiding the Fed’s actions.

I. Central banks can and should take responsibility for delivering low and stable inflation.

The price stability component of the Fed mandate has for years benefitted from the disinflationary forces of ever-improving technology and globalization. These disinflationary tailwinds allowed central bankers to focus on full employment mandates with increasingly aggressive monetary policy and little concern of inflationary repercussions. In a supply-constrained world with globalization on the run, the Fed’s dual mandate has become more challenging to achieve, and may at times require sacrifices. It seems unlikely that the Fed can tame the current inflation without meaningfully slowing aggregate demand by sacrificing, to a certain degree, their full employment mandate.

II. Inflation expectations can become self-fulfilling.

Inflation feeds on expectations and can become self-fulfilling if consumers shift forward purchases for fear of higher future prices. The fear-driven spike in short-term demand, particularly when supply of crucial commodities is tight, can lead to persistently high inflation. Workers expectations of elevated inflation often creates pressure for higher wages as well. Higher wages in response to challenging inflation risks spurring what economists call the “wage-price spiral” whereby increasing wages leads to increased nominal demand which leads to yet more inflation. The risk of a wage-price spiral is why central bankers currently appear more focused on taming inflation as opposed to maximizing employment.

III. History suggests the Fed must tighten policy until the job is done.

Nobel Prize winning economist Milton Friedman maintained that monetary policy operates with “long and variable lags.” It takes time for the effects of monetary policy to work through the economy, and short-term perspectives can lead policymakers astray. Previous Federal Reserve Chairs William McChesney Martin and Arthur Burns learned this lesson the hard way in the 1960s and 1970s as premature policy easing allowed inflation to linger. Two decades of painfully high inflation resulting from “Stop-Go” monetary policy ultimately required the steel resolve of Paul Volker. The larger-than-life Fed Chair’s aggressive policies indeed “broke the back of inflation,” but at the cost of a brutal recession in the early 1980s. Jerome Powell fancies himself a Volker-esque Fed Chair, but for history to share that view he must first avoid being Arthur Burns.

Our read from Jackson Hole is that the Fed is committed to reducing inflation. History suggests that to do so monetary policy will need to be tighter and for longer than current market pricing implies. Chair Powell has repeatedly indicated that inflation is the Fed’s current priority in their dual mandate of price stability and full employment. An inflation-focused Fed suggests that monetary policy may be less responsive to slowing growth and rising unemployment than most market participants have become accustomed to in recent years. The “Fed Put” is ever present in markets, but the Fed is telling us that it’s further out of the money than most think.

The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2208-23

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” –Warren Buffett

Among Warren Buffett’s many insightful investment lessons, this is among the most important. The “weighing machine” reflects Buffett’s belief that assets, over the long-term, will reflect their fair value. The “voting machine” reference acknowledges the reality that market prices, in the short-term, are influenced by factors other than their fundamental value. Investors who are able to determine when prices diverge from fair value are able to both reduce risks and identify opportunities.

May’s Consumer Price Index came in above expectations at 8.6%, leading the Federal Reserve to increase the federal funds rate by 75bps. The prospect of the Fed further increasing interest rates in the face of slowing economic growth has resulted in a 22% drop in the S&P 500 from its high in early January. Investors are reassessing fair value for US stocks in light of an inflationary environment unlike any experienced in recent history.

The US stock market valuation has traded at elevated levels relative to its long-term history for most of the past three decades. The average Shilller P/E Ratio has been 27x from 1990 to 2022, well above its average of 15x from 1960-1990 and its long-term average of 17x. The Shiller P/E looks at earnings over the prior 10 years, adjusted for inflation.

Several explanations have been offered for higher valuations in recent years:

The Fed Put
Put options provide investors with downside protection against losses. The Fed put refers to the belief that the Federal Reserve will step in to support asset prices when they fall. While the Federal Reserve does not have a mandate to support financial asset prices, the frequency with which they have stepped in to provide support has given market participants confidence to pay increasingly higher valuations. The Fed has had the flexibility to provide support because inflation, one of its key mandates, has remained tepid. Inflation since 1990 has averaged just 2.5%. That has clearly changed.

There Is No Alternative (TINA)
TINA is an acronym which stands for “There Is No Alternative.” With depressed rates on bonds due to accommodative policy and quantitative easing, investors have been willing to pay a higher price for equities. Some argue a lower discount rate on future cash flows should be used and thus, higher values are warranted; however, skeptics have warned against valuing long-term cash flow streams with lower discount rates as lower interest rates may not be sustainable.

Profit Margins
S&P 500 profit margins, while cyclical, have trended higher over time due to growth in higher-margin sectors such as technology and healthcare. Margin improvement has also been aided by lower interest rates, input costs and modest wage inflation. Post-pandemic profit margins skyrocketed to all-time highs as companies cut costs in anticipation of lower demand only to see sales accelerate in many areas supported by aggressive government stimulus programs.

https://ofgltd.com/wp-content/uploads/2022/06/600-Shiller-ePerspective-Charts-062822-2.jpg

A New Economic Regime
The extraordinary fiscal and monetary response to the global pandemic, combined with supply chain disruptions, resulted in a supply-demand imbalance which is driving inflation to levels not seen in over 40 years. The Russia/Ukraine conflict further exacerbated inflation pressures. Initially viewed as transitory, inflation is proving to be more durable than originally thought.

Stagflation has become a central concern as economic indicators point to rapidly decelerating economic activity with consumer confidence hitting record lows. As stock prices fall, investors are reassessing the value they are willing to pay for equities given the current environment. If inflation remains elevated, history would suggest valuations will come down. In this scenario, the Fed will likely be unable to support the market in a correction and, in fact, may need to continue to tighten policy to reduce demand. Good-bye Fed put. As interest rates rise, there is an increasingly attractive alternative to stocks. So long TINA.

Profit margins are likely to come under pressure as well due to a more cautious consumer, higher commodity prices and increased wage inflation. High debt levels and budget deficits make higher interest rates and tax rates a potentially longer-term headwind as well.

The Voting Machine
As always in market drawdowns, non-fundamental factors influence stock prices as well. The 100%+ gain from pandemic lows fueled investors’ confidence and increased their tolerance for risk. Speculative activity was rampant and margin debt soared. Prices benefited as a result. As markets correct, investors reduce their risk tolerance and margin calls accelerate the decline.

Another important influence on market prices has been the shift in market structure. Passive exposure has increased from less than 1% in the early 90s to nearly half the domestic market today. Passive funds have received the majority of the inflows while active management has declined. One of the more important implications of this change is that the market has become more sensitive to changes in fundamentals. Moves to both the upside and downside have become more extreme. Active managers, in aggregate, are typically sellers as stocks rise above their value and buyers of stocks as they come down. With fewer active managers to step in, market moves have become more exaggerated on both the up and down side. When market corrections occur, the declines tend to happen quickly. Such was the case in 2018, 2020 and this year. In all three instances, we witnessed drawdowns of 20%+ in a matter of weeks.

After a long period of disinflationary growth, a period of stagflation appears to be a higher probability scenario. At Oxford, we strive to construct portfolios that are resilient to a range of economic outcomes. We believe diversifiers and real assets provide portfolio stability in a high-inflation environment, which is a challenging environment for a traditional stock and bond portfolio. While international markets face many of the same economic challenges as the US market, valuations have also discounted these concerns more aggressively. Indiscriminate selling during market corrections drives volatility and dislocations between prices and fair value. For active investors focused on weighing assets but cognizant of the factors driving the pricing machine, these dislocations are opportunities to add value to portfolios.

<em><small>The above commentary represents the opinions of the author as of 6.30.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2206-11</em></small>

Market Commentary

May was a tale of two halves in global markets with early month jitters giving way to late month dip buying as the narrative shifted towards peak inflation and peak Fed hawkishness. The tech-heavy NASDAQ struggled again in May while investors in quality and value oriented market segments saw positive returns.

The unprecedented fiscal support following the COVID-19 crisis is fully in the rearview and monetary policy is now tightening to a degree not seen in generations. The Federal Reserve’s measures to combat inflation are beginning to bite, and investor focus should now shift towards the growth implications of tighter financial conditions. While inflation may well have peaked in recent months, the structural upward pressure on the US dollar, higher credit spreads, elevated commodity prices and a negative wealth effect all serve to further tighten financial conditions likely weighing on near-term growth.

Slowing economic growth paired with persistent inflation is generally a challenging combination for passive exposures to financial assets such as the traditional 60/40 stock/bond portfolio. Using the 10- year Treasury and Shiller S&P 500 earnings yields as proxies, the US 60/40 portfolio has a negative real expected return with inflation running anywhere north of roughly 3%.

Diversification into things like real assets, uncorrelated active strategies and businesses with positive cash flow and pricing power has never been more necessary for families looking to preserve and compound real wealth. Financial asset strategies that perform best in the “goldilocks” disinflationary growth environment that characterized the past few decades may struggle in a world of shifting growth and inflation dynamics. Our investment team strives to design balanced asset allocations capable of compounding wealth in a more macro-agnostic manner relative to traditional 60/40.

While the macro backdrop appears mixed, we can take solace in a number of items:

• Firstly, our client’s portfolios include strategies capable of performing in various market environments.
• Additionally, some supply chain disruptions appear to be ebbing as China reopens from lockdown and the world gradually adjusts to the new normal.
• Asset valuations appear more reasonable after a horrid start to 2022 as the market discounts the known challenges noted above.
• The opportunity set for non-traditional areas of client portfolios, such as Real Assets and Diversifier Strategies, appear historically attractive.
• The longer-term prospects for properly diversified portfolios are stronger now than they were 6 months ago despite the uncertain macro environment.

Creaks in Credit: A Look at Corporate Credit Conditions

A favorite saying of market prognosticators is that the Fed “hikes rates until something breaks.” That ‘something’ generally surfaces in the credit markets with illiquidity causing spreads to widen and thus bond prices to fall. In extreme scenarios, a credit market seizure may preclude borrowers from rolling over maturing debts causing an abrupt spike in bankruptcies. Stocks seem to grab a disproportionate share of investors’ attention, but the credit markets are the foundation of the financial system. The access to and price of credit have major implications in a leveraged economy. As such, changes in borrowing rates and “spreads” are bellwether indicators of financial conditions, and sharp rises in borrowing costs can be a harbinger of economic problems.

Despite the recent challenge for stock prices, the credit markets have been surprisingly sanguine year to date. That is until a confluence of challenges have tightened financial conditions for corporate borrowers in recent weeks. Consumer sentiment continues to decline foreshadowing reduced spending, inflationary cost pressures are adversely impacting corporate profit margins and the rapid rise in Treasury rates has increased debt service costs further reducing creditworthiness of borrowers. All told, investment grade total borrowing costs have nearly doubled in recent quarters, and high-yield spreads are approaching 4Q18 levels that precipitated the “Powell Pivot” to more dovish monetary policy.

The recent creaks in credit could very well prove to be a short-lived overreaction, but equity investors are right to consider the potential implications of higher corporate borrowing costs. Specifically, higher debt service costs weigh on profitability, further compounding credit concerns. Tighter borrowing conditions may curtail or eliminate companies’ ability and willingness to execute share buyback programs; something that has been a major tailwind for stocks in recent years. Lastly, the combination of lower equity valuations and higher debt service costs could force management teams to eschew capex spending in favor of debt repayment in what is often called a “balance sheet recession.” All else equal, these factors left unchecked could weigh on near-term economic growth. Corporate credit conditions remain historically favorable despite the recent spread widening, but further percolations in the credit markets are something we are watching closely.

The above commentary represents the opinions of the author as of 6.3.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2206-1

Market Commentary

April proved challenging yet again for investors with the traditional 60/40 stock/bond portfolio falling 6.9%; its worst month since March of 2020. The tech-heavy NASDAQ index experienced its single worst month since 2008, dropping 13.3% as financial gravity seems to have found the previously untouchable growth stocks.

Thus far 2022 has been one of the most difficult investing environments on record as numerous macro factors have conspired to depress growth and risk appetites. The record fiscal stimulus following the COVID crisis has ended and it’s knock-on simulative effects likely fully digested by now. On the monetary side, the Federal Reserve appears committed to tightening policy through all available means; balance sheet run-off/quantitative tightening and well-telegraphed interest rate hikes. Lastly, structural upward pressure on the US Dollar, higher credit spreads, elevated commodity prices and a negative wealth effect all serve to further tighten financial conditions likely weighing on near term growth.

The tragic events in Ukraine viewed from a financial perspective will have a similar effect as COVID in accelerating a number of trends that were already well underway. Countries must now reconsider their food and energy security. Companies will need to further shift their supply chain priorities from “just in time” to “just in case”. This shift will likely involve reshoring production to higher cost domiciles, and holding higher inventories than previously considered necessary. The deflationary forces of globalization are abating as the world becomes more polarized and volatile. Deglobalization will mean higher input costs, product availability disruptions and more persistent inflation.

Higher costs and tightening conditions applies to all financial asset classes concurrently, causing correlations between stocks and bonds to increase sharply. With bonds failing to play defense in a tightening environment the overall risk of traditional portfolios increases leaving investors doubly exposed in a stagflation scenario where stocks and bonds fall together. This all-too-common blind spot in traditional portfolios to the scenario of rising inflation and falling growth is a major reason why Oxford believes in further diversification beyond traditional stocks and bonds.

Investors have been well rewarded in 2022 for diversifying portfolios into real assets and certain active strategies such as trend following and global macro. Prudent allocations to these areas has provided much needed ballast to portfolios, and provides a ready source of liquidity to rebalance into depressed financial assets, further improving long term returns. In periods where mentalities shift from “nominal” to “real”, investors remember the importance of holding non-financial assets and active strategies capable of profiting from volatility and downtrends.

While the macro backdrop appears challenging, we can take solace in a number of items. Firstly, while inflation is likely to remain elevated, the absolute level of CPI probably peaked in April as base effects from COVID begin to roll off and commodity prices come under some short term pressure. Additionally, asset valuations appear much more reasonable after a horrid start to 2022 as the market discounts the known challenges noted above. Much of the obvious froth in technology names has subsided, and both stocks and bonds valuations appear slightly more reasonable at current levels. The longer term prospects for diversified portfolios are stronger now than they were 6 months ago despite the challenging macro environment.

Squaring Strong Labor Market with Poor Consumer Sentiment

Headlines continue to tout tightness in the labor market and the apparent newfound bargaining power of workers. Overall nominal wages increased 5.5% year-over-year through the end of March; well above long-term trends.

Concurrently, consumer sentiment measures are low and trending negatively. The University of Michigan Consumer Sentiment Index is currently below 60; numbers not seen since the 2008 Global Financial Crisis. Employed workers are earning more than ever before, but consumers are increasingly dour? What gives?

While nominal wages have been increasing at 5.5%, headline CPI for the same period was 8.5%. Compounding the issue, prices of food, energy and rent, which comprise the majority of spending for lower wage cohorts, have all been increasing well above headline numbers. With inflation running this hot workers are earning less in “real” (inflation-adjusted) terms despite the above trend growth in nominal wages. Negative real wage growth means workers take home pay buys fewer goods and services thus reducing standards of living. Persistently high inflation is making Americans poorer and likely explains why consumer sentiment is low and trending negatively.

​​​​​Yield Curve Inversion

The yield curve inverting is arguably the most famous recession indicator amongst professional investors. As such, inversions garner headlines when they infrequently occur. However, yield curve inversions tend to be a noisy and nuanced signal of impending recession.

What is a yield curve inversion?

An inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit quality (e.g. 2-Year yields exceeding 10-Year yields).

What does an inverted curve mean?

Curve inversions represent a strong market signal that bond investors believe higher short term rates will dampen economic growth and inflation resulting in lower interest rates in the future, and increasing the attractiveness of longer duration bonds. If the bond market is correct in this view, the economy is headed for disinflation, contracting economic growth and potentially a deflationary recession.

The nuance?

Recessions have historically occurred only after the majority of the yield curve inverts. Additionally, recessions typically coincide with the yield curve re-steepening as monetary policy maker’s sharply pivot towards looser policies, interest rates are cut and investors rush to the safety of cash and money markets.

The Federal Reserve claims to have the tools necessary to tame inflation without hurting employment or economic growth. The bond market doesn’t seem to be buying that narrative, but history suggests “don’t fight the Fed”. We are keeping a particularly close eye on the bond market for further signals.

The above commentary represents the opinions of the author as of 5.22.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2205-22.

“The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them.  Where this propensity can go wrong is when it increases our impression of understanding.” Nassim Taleb (The Black Swan)

In the complex world of finance, there is a strong human desire to create narratives that somehow make sense of it all. By assigning a logical and sequential story to explain markets, we unknowingly build an often misguided confidence in our ability to understand changes in equities, interest rates, oil prices and inflation, to name a few.

And it’s no wonder. We are hit on all sides with market “stories.” If you regularly watch financial news networks or visit their websites, you’ve noticed that each and every day the closing value of a market is followed by commentary on WHY it went up or down. Equity markets rise on strong retail sales. The most amusing days contain a very rationale headline explaining why the market opened higher (easing fears of COVID, as an example), only to see it reverse and close lower for a different reason (high oil prices).

Consensus narratives can be the most dangerous for investors. They are widely accepted and very likely backed by recent trends, creating a feedback loop to investors that supports the thesis. But what happens when current prices fully reflect the consensus narrative? It can be lonely and painful at times to lean against a consensus view, but it can also be a profitable one.

In October 2020, CNBC perpetuated a frenzied narrative on so-called COVID stocks. In one segment of a popular show, the network highlighted specific companies that were obvious beneficiaries of our economic lockdown period. To add a little sizzle to the show, they were even grouped together and named the “Magnificent Seven.”  Sounds like the 2020 version of the “Nifty Fifty.” Here is the list: Peloton, Netflix, Zoom, PayPal, Roku, Tesla and Square. The Magnificent Seven had an equal-weight return of 210% in the previous seven months compared to a paltry 28% for the S&P 500. It was an easy story to tell. Demand for services/products of these companies were boosted by a work-from-home economy. And look at the returns! On occasion you would even hear the argument that traditional valuation techniques don’t apply. The feedback loop continued. . .

Here is the problem. The median price-to-sales ratio was a magnificent 12x. This was a five-time premium over the broad US market, which frankly, was not historically all that cheap in its own right. Not every stock that trades at that level is doomed to fall, but the bar was set unbelievably high for these businesses to sustain their growth and justify their multiples.

Sales growth has actually been very strong for these companies since that time, but even so, the stock prices have fallen under the weight of those massive growth expectations. Since October 2020, the Magnificent Seven group has declined by 49% compared to a 27% gain for the S&P 500. This occurred as the group generated average sales growth of 27% in 2021, higher than the S&P 500 growth rate of 16%.

Around that same time, another popular narrative was impacting a different sector – and this one was quite the horror story. The combined energy and metals sectors’ weights in the S&P 500 had declined to less than 3% shortly after the COVID lockdown. For context, several individual tech companies in the index had larger market capitalizations.

The excitement surrounding electric vehicle (EV) adoption and the prospect of growth in renewable energy eventually minimizing the need for fossil fuels was causing many investors to nearly abandon the sector altogether, pushing valuations to extremely low levels. According to GMO, at one point in mid-2020, the valuation of the MSCI ACWI Commodity Producers Index approached a 70% discount to the broad MSCI ACWI Index. Disappointing recent returns supported and reinforced this view and sentiment.

Regardless of different views on a realistic mix of energy sources or the role of fossil fuels in the future, the important point is the popular narrative was so extreme it ignored current key facts. First, even assuming optimistic expansion of renewable energy, we are still years away from peak demand in fossil fuels according to the International Energy Agency (IEA). Second, the call on natural resources – such as copper, lithium, cobalt and nickel – necessary to sustain a growing fleet of EVs will support demand for these metals for years to come.

In short, the renewable energy transition will occur over years and decades and impact producers differently. It is certainly more nuanced than – sell them all. Yet valuations applied to energy/industrial metals commodity producers seemed to imply their imminent demise.

What happened next? From October 2020 to April 2022, the S&P North American Natural Resources Index returned 103%. While it’s true the Russian invasion of Ukraine amplified the impact on commodity prices via a supply side disruption, the majority of the gain occurred prior to the invasion – a 53% spread over the S&P 500 from October 2020 to February 2022.

It is important to remember capital markets are extremely complex and shouldn’t be distilled down or woven into a neat story. The attraction of the Magnificent Seven and the negative sentiment towards energy and metals were near a peak in October 2020. And yet, from that point forward, the performance spread has been +152% in favor of the iShares North American Natural Resources ETF.

Valuations matter. Eventually. Be wary of widely held views and compelling narratives that attempt to explain and justify what seems to be unreasonable. These can be sources of opportunity and risk as shown above. As we say within our Oxford investment team, “the most dangerous view is the one shared by all.”

The above commentary represents the opinions of the author as of 5.4.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2204-5