Private equity (PE) is a difficult asset class to benchmark, but by every available measurement it has produced excellent returns over long periods of time. The most recently available Cambridge Associates LLC U.S. Private Equity Index as of December 31, 2022 shows a 10-year pooled horizon Net IRR of 17.23% and a 15.29% Net IRR over 20 years. This has significantly outpaced the public market equivalent returns of the various public indexes, for example:

• Beating the Russell 3000 by over 448 basis points over 10 years
• Beating the Russell 3000 by over 550 basis points over 20 years
• Beating the MSCI World by 866 basis points over 10 years
• Beating the MSCI World by 746 basis points over 20 years

The gap between public and private equity performance, as shown in the chart below, may narrow at times such as during the most recent bull market. However, the public markets are rarely able to keep pace for long.

Private equity firms need to maintain this outperformance or else their investor base would soon shift to more liquid, lower cost investment options. The challenge has only increased as more capital has flooded private markets and driven up the price of private companies. But private equity firms have transformed themselves over time to meet this challenge.

Components of PE Performance
At the most basic level there are three ways to increase the value of a portfolio company investment:

1. Use leverage at acquisition and then use free cash flow to pay down debt over time and thereby increase the value of the equity

2. Grow the company’s revenue and earnings

3. Increase the multiple of earnings that the next buyer is willing to pay

Today the old stereotype that PE is just about financial engineering through excessive leverage is mostly a memory. To be sure, leverage is still part of most buyout transactions and PE firms continue to utilize it with varying degrees of prudence. But you can’t outperform in today’s market through financial engineering alone¹. The best performing PE firms focus on #2 and #3.  Achieving multiple expansion is an unpredictable process, but there are certain inflection points where buyers will often pay more.  Successful PE firms find that they can hit these inflection points using a repeatable playbook to grow and scale a company while upgrading its infrastructure and processes.

Today PE succeeds through a combination of financial, governance and operational improvements. On the financial side, this starts with negotiating better terms with lenders and suppliers. But more importantly, PE firms unlock capital investment that a concentrated founder is unable or unwilling to do on their own. This capital makes it possible to accelerate both organic and inorganic growth.

Governance is a key area of professionalization for most portfolio companies. PE firms augment and upgrade management teams, build out an experienced board of directors and establish sophisticated financial reporting systems & processes so that management and the board are governing by data instead of by feel. Establishing an annual budgeting process and monthly key performance indicators increases accountability and allows the board to prioritize value creation projects. Effective governance lets a company make measurable progress towards key priorities and go from one success to another.

For many years PE firms could achieve success with financial and governance transformation alone. But as the market has become more competitive, today it takes more. Operational improvement is the biggest change in the PE world over the past twenty years. PE firms are becoming more specialized with specific end-markets or business models. PE firms today bring significant operational and strategic resources (both internal and external) to bear on their companies, and they get them involved earlier in the process. Where it was once sufficient to buy a company and then take 6 to 12 months taking stock of what they had, today it is a critical to hit the ground running. The integration of operational resources into investment deal teams provides more actionable opportunities for growth.

Financial, governance and operational levers are being used at all levels of private equity, but they are most compelling in the middle market and lower middle market. At Oxford we focus on lower middle market PE firms because there is more opportunity to impact transformational change in these areas at smaller businesses. While no company is completely immune to market headwinds, note that many of these improvements can still be executed despite broader macroeconomic conditions. The long term outperformance of private equity is a result of this systematic business building.

¹Historically so-called “Leveraged” Buyout Transactions were financed with anywhere from 60 to 90 percent debt. As late as 2007, prior to the Global Financial Crisis, the average debt to capitalization ratio for U.S. buyout transactions was 68%. However since that time the ratio has generally been below 60% and in recent years has stayed in the mid-50s. See Kaplan & Stromberg, “Leveraged Buyouts and Private Equity,” Working Paper 14207, National Bureau of Economic Research, July 2008 and McKinsey Global Private Markets Review, 2021 and 2023. 

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. 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-2306-12

**As of 12.1.21
***As of 8.1.22

Read the disclaimer

Recap of March 10

As I am sure all of you are aware at this point, on Friday, March 10, 2023, the California Department of Financial Protection and Innovation (DFPI) took possession of Silicon Valley Bank (SVB), citing inadequate liquidity and insolvency. The DFPI appointed the Federal Deposit Insurance Corporation (FDIC) as receiver of SVB, and the FDIC in turn created the Deposit Insurance National Bank of Santa Clara, which now holds the insured deposits from SVB. Over the course of last weekend regulators moved swiftly and took two major actions to try and contain any potential contagion: (1) they provided a guarantee to cover all deposits at SVB; and Signature Bank and (2) they put in place the Bank Term Funding Program, a generous new short-term lending facility.

Weakness in other regional banks

Although these actions certainly provided confidence to the system heading into Monday morning, March 13, investor fears the latter half of the week caused weakness in other regional banks. First Republic lost a fifth of its market share after S&P Global Ratings downgraded its credit rating to “junk.” It subsequently took a $30 billion investment from a syndicate of eleven major banks, including JPMorgan Chase, Bank of America, Wells Fargo, Citigroup and Truist. Given the difference in balance sheets between SVB and First Republic, this shows just how fragile the banking system can be when it comes to issues of consumer confidence.

We saw more action in the banking world this past weekend with the announcement that UBS would purchase Credit Suisse for $3.2 billion. This came at the urging of regulators and required the Swiss government to provide more than $9 billion to backstop losses that UBS may incur in taking over Credit Suisse. The Swiss National Bank is providing more than $100 billion of liquidity to UBS to help facilitate the transaction.

What questions does all of this have us asking?

After the precipitous demise of SVB and Signature Bank over the weekend followed by the swift action of regulators to try and stem the tide of contagion, we are left with a number of questions about what the knock on effects might be.

I. Has the Fed done enough to stem the tide of contagion?
The Fed has taken two major policy actions: (1) A guarantee covering all deposits of SVB and Signature Bank; and (2) put in place the Bank Term Funding Program, a generous new short-term lending facility. Although there was some positive market response with regional bank stocks market value improving early in the week, in situations like these it is never quite clear whether enough has been done. This became clear as the market value of many of the regional banks rode a roller coaster the rest of the week with First Republic even taking a $30 billion investment from eleven major banks. The collapse of SVB and Signature Bank caused a stunning shift in market expectations around Fed policy towards interest rates, but a strong core CPI reading for February this week was a reminder that the inflation issue remains front and center. Either way, it appears as though risks to increasing US interest rates have shifted to the downside.

II. What is the magnitude of unrealized losses on banks’ balance sheets throughout the system?
Higher interest rates caused a loss in value of SVB’s securities portfolio, which is a headwind faced by all banks. 450 basis points of rate hikes in a 12-month period drove $620 billion of unrealized losses on US bank balance sheets at the end of 2022. We have already seen a small erosion of core capital ratios due to unrealized losses on available for sale securities accumulated during the past year. Looking at the ~60 largest banks, we see that the CET1 capital ratio fell from 13.4% to 12.9% of risk weighted assets over the course of 2022. This seemingly still leaves banks a decent enough capital buffer to withstand further falls in value. However, what happens if the emergency liquidity facility provided by central banks proves to be insufficient and banks need to realize losses on their held to maturity securities in order to make good on their liabilities? This would compound losses and bring banks’ solvency into question.

III. What is the risk of contagion to other domestic banks or other economies?
The main channel of contagion to both US banks and other economies is a loss of confidence in the system as a whole. It is difficult to predict if and when this will happen. There are a few items that give us some comfort that we might avoid it. First, the collapses of SVB and Signature Bank were due to seemingly idiosyncratic issues, large unhedged interest rate risk and large exposures to cryptocurrency, respectively. Other major banks and large regionals have a lower level of balance sheet exposure.

Source:  BCA Research

Second, SVB was not subject to the Fed’s stress tests, which might have clamped down on its behaviors (maybe). Our hesitation on this point stems from the fact that the Fed had spotted issues at SVB, noting that it was using an incorrect model to evaluate interest rate risk and keeping it under supervisory review for much of 2022. In the Eurozone, the European Banking Authority takes a more expansive approach, conducting stress tests on 70 European banks covering 70% of EU banking assets. The question is whether or not the regulators would be able to do anything to correct bad behavior before markets identify it and react.

Third, and likely most important, central banks have several tools to manage contagion risks caused by problems on the liability side of banks’ balance sheets. That is, bank runs or a freezing within funding markets. We saw two of these tools employed in this scenario: (1) the expansion of deposit insurance; and (2) the extension of lending windows. This is notably different from situations involving a crisis driven by an increase in credit risk (e.g., the collapse of Lehman Brothers).

Nevertheless, there is the very real possibility that given how interconnected our financial system is, other follow-on issues will emerge that are not front and center today. Also, given how dependent our banking system is on consumer confidence, any serious degradation in consumers’ confidence that banks can meet deposit demands will have swift, negative consequences for banks (e.g., First Republic) and will likely ripple through the rest of the US and potentially, the global economy.

IV. How will other central banks respond?
For the time being it is likely that central banks will continue on their independent hiking paths as they continue to fight inflation. The European Central Bank (ECB) went ahead with its pre-announced intention and increased the deposit rate by 50 basis points last week. The Bank of England is set to raise the Bank Rate by 25 basis points this coming week.

We only need to look back to the 1999/2000 dotcom crash as a reminder that other central banks do not have to follow the Fed in lockstep when the severity of a crisis differs from country to country. During that time, while all major central banks cut interest rates, the 475 basis point cut in the US dwarfed the 150 basis point cut in the Eurozone and the 200 basis point cut in the United Kingdom.

Although it is likely (and reasonable) that the various central banks will continue down independent paths with regard to interest rate policy and inflation battles, we have started to see coordinated central bank action on the liquidity front in order to ease strains in global funding markets and dampen the effects on the supply of credit to households and businesses. Over the weekend, The Bank of Canada, the Bank of England, the Bank of Japan, the ECB, the Federal Reserve and the Swiss National Bank announced a coordinated action to enhance the provision of liquidity via the standing US dollar liquidity swap line arrangements. According to a press release by the Board of Governors of the Federal Reserve System, “To improve the swap lines’ effectiveness in providing U.S. dollar funding, the central banks currently offering U.S. dollar operations have agreed to increase the frequency of 7-day maturity operations from weekly to daily.” 

The worst case scenario is that the problems are not confined to the US banking system and are more widespread through the broader US or global economy. This more widespread scenario could be because of similar problems to SVB or, more likely, because SVB, Signature Bank, First Republic and Credit Suisse are an early indication of other unknown vulnerabilities hiding in the financial sector.

Conclusion

The specific issues leading to the collapse of SVB and Signature Bank appear to be more acute at those institutions. However, if depositors started to fear the certainty of their deposits, as they did with SVB, policymakers would likely need to take quick action to insure those deposits, stem the outflow of capital and prevent more banks from selling assets and realizing losses. While the most likely scenario is probably something between the problems being confined to a sub segment of the US banking system on the one hand and the broader US economy on the other, there is a tail risk scenario where the collapse of SVB marks the start of a broader global financial crisis. Said more simply, the US economy is likely to feel some lasting effects, which will affect the path of US monetary policy with a left-tail possibility that the knock-on impact is not contained to the United States and will be felt more broadly throughout the global financial system.

^​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 3.20.23 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. 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. Read the disclaimers. OFG-2303-09

As I am sure all of you are aware at this point, on Friday, March 10, 2023, the California Department of Financial Protection and Innovation took possession of Silicon Valley Bank, citing inadequate liquidity and insolvency. The Department of Financial Protection and Innovation appointed the Federal Deposit Insurance Corporation as receiver of Silicon Valley Bank, and the Federal Deposit Insurance Corporation in turn created the Deposit Insurance National Bank of Santa Clara, which now holds the insured deposits from Silicon Valley Bank. Given Silicon Valley Bank’s prominent position in the technology ecosystem, this began causing ripples throughout the industry.

Over the weekend regulators moved swiftly to try and contain any potential contagion. According to the Federal Deposit Insurance Corporation, insured Silicon Valley Bank depositors had access to their funds Monday morning. In a joint statement from Treasury Secretary Janet Yellen, Federal Reserve Chair Jerome Powell and Federal Deposit Insurance Corporation Chair Martin Gruenberg, federal regulators announced they would roll out emergency measures to backstop all depositors. The Federal Reserve has gone one step further and stated under a new “Bank Term Funding Program” that it is making additional funding available to banks (beyond Silicon Valley Bank) to ensure they have the ability to meet the needs of all depositors. This program will offer loans of up to one year to banks that pledge US Treasury, mortgage-backed securities and other collateral.

For perspective, Silicon Valley Bank is the sixteenth largest bank in the United States and the second largest to ever fail. Its ~$210B in assets are roughly two-thirds of Washington Mutual (not adjusting for inflation,) which failed in 2008 and is the largest bank to fail in the United States.

Similar to a hypothetical story that is used to explain exponential thinking (or threats) involving lily pads covering a pond, the pace and timing of Silicon Valley Bank’s failure can be best described as gradual then sudden. It was over the course of several years that Silicon Valley Bank’s financial position deteriorated, but just two days elapsed between its March 8 announcement that it was seeking to raise $2.5B of new capital to shore up its balance sheet and the March 10 declaration by regulators that it had failed and was being placed in receivership.

To illustrate the point, imagine a large pond that is completely empty except for a single lily pad. Assume that the lily pad will grow exponentially covering the entire pond in three years. In other words, after one month there will two lily pads, after two months there will be four, etc. The pond is covered in 36 months. When asked when the pond would be half filled with lily pads, the normal temptation (and knee jerk response) would be to say 18 months or half of the 36 months. On the contrary, in fact, the correct answer is 35 months. Merely one month (or compounding time period) before the pond is filled, it’s only half filled. This is because it doubles the next month. Although the correct answer is relatively straightforward to understand, our brains tend to work more linearly than exponentially. It is not necessarily obvious before knowing the answer that the pond is 1/64 full in month 30, only six months before it is completely full.

What Happened?

The short answer is, an old-fashioned run on the bank. The much wordier answer is that Silicon Valley Bank carved out a distinct but riskier niche than many of its competitors, which set it up for large potential capital shortfalls in a rising interest rate environment, deposit outflows and forced asset sales.

Silicon Valley Bank is known as a bank for start-ups. It would open up accounts and start a relationship with these young companies often before larger lenders would consider it. It also lent to them, something other banks are reluctant to do, and used this product as a way to get the whole banking relationship with these young companies. That is, it was not uncommon for Silicon Valley Bank to require all banking business be conducted with it in order for the company to secure a line of credit. Silicon Valley Bank had an unusually high reliance on corporate venture capital deposits. Of Silicon Valley Bank’s ~$173B of customer deposits, $~150B were uninsured (i.e., over the $250,000 Federal Deposit Insurance Corporation insurance limit) and only ~$5B were fully insured.

Between the last quarter in 2019 and the first quarter of 2022, deposits at US banks rose precipitously (by $5.4T, yes trillion with a “T”) but because of weak loan demand only 15% was lent out as traditional commercial loans. The rest was invested in securities portfolios, primarily US Treasuries and mortgage-backed securities. Silicon Valley Bank experienced this to an even greater extent. As the venture community boomed over the last handful of years so did Silicon Valley Bank’s deposit accounts, as its clients were flush with cash and needed somewhere to put it. Silicon Valley Bank’s deposits grew more than 4x from $44B at the end of 2017 to $189B at the end of 2021; however, its loan book only grew from $23B to $66B. Since the bank model is predicated on making money on the spread between the interest rate paid on deposits and the rate paid by borrowers, having a deposit base that is outsized versus a loan book causes issues. This drove Silicon Valley Bank to acquire other interest-bearing assets, or more specifically $128B worth of mortgage-backed securities and US Treasury by the end of 2021.

Banks can either designate these securities as being “available-for-sale” or “hold-to-maturity” portfolios. The primary difference being that available-for-sale portfolios are regularly marked to market and hold-to-maturity portfolios are only marked to market when a sale occurs. However, if even a portion of the hold-to-maturity portfolio is sold then the entire portfolio must be marked to market. This makes selling hold-to-maturity securities complicated because it results in larger portions of the portfolio being suddenly marked to market, which can then result in the need to raise capital. Silicon Valley Bank was one of the banks that relied heavily on hold-to-maturity treatment for its growing securities portfolio. From 2019 to the end of 2022, Silicon Valley Bank grew its available-for-sale book from $14B to $27B but grew its hold-to-maturity book from $14B to $99B.

Given its need to sell securities and what interest rates did during 2022, you can imagine what that mark to market looked like on Silicon Valley Bank’s books. At the same time, those same soaring interest rates slowed the boom in the venture capital community. This left Silicon Valley Bank uniquely exposed. Its deposits had grown significantly when interest rates were low and its clients had plenty of cash. Since the bank also made investments during this time, it purchased bonds at their peak price and lowest rates. As venture-capital fundraising dried up, Silicon Valley Bank’s clients drew down their deposits to fund operations. Deposits fell from $189B at the end of 2021 to $173B at the end of 2022. Silicon Valley Bank was forced to sell off its liquid bond portfolio at substantially lower prices than it paid. The $1.8B in losses it took on these sales left a hole and hence the need to raise $2.5B of equity capital to plug a hole in its balance sheet. When it went under on Friday, the bank held $91B of investments, valued at their cost at the end of last year.

Once word of the needed capital raise became public, depositors across the venture capital ecosystem descended upon Silicon Valley Bank like the townspeople of Bedford Falls on George Bailey’s Building and Loan. A classic run on the bank.

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. 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 3.14.23 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-2303-9
**As of 12.1.21
***As of 8.1.22
Read the disclaimers

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.

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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>