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

“There are decades where nothing happens; and there are weeks where decades happen.” — Vladimir Ilyich Lenin

The latter half of this quote seems to be an accurate depiction of this past week. Despite Putin’s apparent façade of cooperation, Russia has launched a lethal, multi-front invasion of Ukraine.

Russia embarking on one of Europe’s largest military offensives since the Second World War raises troubling questions for investors and policymakers to consider.

• Does a passive US Administration increase the risk of further geopolitical tensions?
• Does the limited global response to the Ukraine invasion embolden Chinese aggression toward Taiwan?
• Are we witnessing the point where American hegemony dissolves into a fully “G-Zero” world order?
• What are the supply chain and energy implications of deteriorating relations with a major commodity exporter?

Not surprisingly, markets have been volatile as these geopolitical considerations are discounted into asset prices. Global equities are lower across the board as the uncertainty of war demands a premium and corporate borrowing costs have risen. Commodity prices, oil prices in particular, have been aggressively bid up in expectation of supply disruptions. US Treasuries have caught their usual flight-to-safety bid and expectations for upcoming Federal Reserve rate hikes have collapsed. (See chart below.) All else equal, lower rates and a flatter treasury yield curve should be a net positive for risk assets, but whether that discounting effect is enough to offset the aforementioned “war premium” remains to be seen.

Uncertainty abounds, but some of the medium-term consequences of recent developments are fairly straightforward. A world of heightened geopolitical tension, commodity price pressures, supply chain disruptions and historically-rich asset prices warrant investors to dust off their “stagflationary” playbook.

• Persistent inflation paired with low interest rates renders high-quality fixed income securities a “melting ice cube” in real terms. Futures markets imply that this dynamic is unlikely to change anytime soon. Financial repression is here and seems unlikely to abate.
• Above-average valuations and unclear growth prospects widen the dispersion of outcomes across equities. An environment characterized by large dispersion may warrant inclusion of active managers to augment cost-effective passive exposures. Additionally, risk-adjusted performance should be enhanced by tilting portfolios in favor of value, quality and defensive businesses, as well as active strategies capable of using short positions to reduce overall market sensitivity.
• After a dozen years dominated by the passive 60% stock/40% bond allocation, history suggests certain diversifying alternative strategies may be a bright spot going forward. Strategies such as managed futures and global macro should see increased opportunities for profit with high volatility in growth and inflation. Including these types of strategies is the most capital-efficient way to reduce overall portfolio risk through the power of diversification.

The range of potential outcomes in Ukraine is enormous and impossible to handicap. In these times of peak uncertainty and stress, the best response is to remain unemotional and objective when evaluating investment decisions. To that end, Oxford continues to rely on a balanced, long-term approach supplemented by systematic tilts toward areas likely to improve wealth compounding.

The Caproasia list of top 10 largest multi-family offices in the world is based on assets as reported in the Form ADV as of December 31, 2019. This list excludes multi-family offices that are operated within banking groups or a subsidiary of banking groups. The Financial Planning magazine lists of the 2020 Top 15 Firms and the 2013-2017 Top 150 RIA Firms are based on assets under management as reported in the Form ADV. The lists contain independent fee-only planning firms. Broker-dealers, insurance company affiliations and firms with substantial outside ownership stakes held by private equity firms and some outside investors are excluded. The lists do not include roll-ups, aggregators or turnkey asset management programs. To capture firms that provide true, holistic financial advice to individuals, only firms with more than 50% individual clients, as can be determined through Form ADVs, are included. The rating may not be representative of a client’s experience and is not indicative of future performance. Oxford did not pay a fee for inclusion in the rankings, but may purchase reprints. 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 2.25.22 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-2202-6