Second Period: May to August 2022
Dear Clients, Friends and Family:
In my last letter in May, I discussed the challenges and risks that the domestic and international economies were beginning to experience. From inflation and monetary policy to geopolitical changes and conflicts, there was no shortage of topics to be aware of. Unfortunately, over the past four months many of the same challenges we were facing in the spring appear to have grown and continue as we move into the final four months of the year. It is my belief that the United States and many of the other major economies around the world will likely experience a significant slowdown and may be pushed into recession as we, collectively, work to normalize our economies and financial markets. Such an environment is uncomfortable to say the least.
As with anything that provides long-term benefit the pain usually comes before the reward. For example, consistent exercise offers many long-term benefits, but you must endure sore muscles and fatigue before you receive the benefits of being stronger and healthier. The pain of getting long-term results is the cost of those results. The same logic applies to economies and financial markets. In order to have a strong economy prices must be predictable and stable, people must be productively employed, and financial markets must operate efficiently to provide liquidity and adequate returns that are beneficial to both the providers and recipients of capital. When economies become less efficient due to shocks and stimulus a recession is the pain that resets and realigns financial markets and the economy.
In my previous letter I wrote: “the world and its interconnected economy is at a proverbial crossroads in which any direction will have its costs and rewards, either short-term or long-term, and any delay will likely lead to additional consequences that will need to be addressed eventually.” Today, I believe that the monetary authorities have made the correct long-term decision to purposefully address inflation in an aggressive and concerted manner. The costs (or pain) of which will likely lead to continued downward pressures in equity markets in the interim, an increase in unemployment and interest rates, a decline in real estate prices, and may increase bankruptcy filings for those that became too extended. However, the risks of not addressing our inflation issues could lead to even worse outcomes should inflation continue to become embedded in the financial system.
So, what do we do?
We tighten our belts and prepare. Historically, recessions are relatively short-lived when compared to expansionary periods and they typically offer some of the most rewarding times to purchase quality assets. The catch is, you have to be willing to stay the course and not let the fears of a recession or market decline discourage you from proactively pursuing your long-term objectives. One of the great long-term investors of the twentieth century, John Templeton, once said, “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” If you reflect on the year and a half span from spring of 2020 through the end of 2021, one could easily make the argument that we ended 2021 in a state of euphoria. Markets are a cyclical machine, should we enter a period of economic decline pessimism will follow. These are the periods when opportunities are greatest but we will need to endure the bumps along the way to get there.
Why don’t we just move to all-cash and wait it out?
This is a question that is often asked when predictions of market declines are offered. The simple answer is I could be wrong. No one knows what the future holds and furthermore how markets will react to those future events. Holding a larger tactical position in cash is a way to reduce some portfolio volatility and maintain the optionality of redeploying the cash at more advantageous prices, but this is always a short-term, intentional, and measured decision. The risk of being completely out of the market when it begins to expand again is far more costly than staying the course because it requires that you time your reentry point. Trying to determine the ‘best’ entry point to get back into your investments is psychologically challenging. Odds are, the best point to get back in is likely when the newsflow and outlooks are the scariest and you will likely conclude that there will be an ‘even better’ entry point in the future – so you wait. Should the market begin to turn upwards, the internal rationale will be “once it pulls back again I will buy,” but that might not happen as you hope and you risk missing a good part of the new economic expansion. Thus the old motto prevails: to receive the benefits of long-term compounding returns it is time in markets that matters, not timing the market.
How We Are Preparing Our Client’s Portfolios
FIXED INCOME ALLOCATIONS: Within managed client portfolios, we are positioning portfolios more defensively into the final four months of the year. Specifically, we have increased duration and credit quality within fixed income allocations to reduce default risks, minimize volatility as short-end rates increase, and to capture and preserve yield. While fixed income returns will likely continue to experience downward returns pressure in the near-term as the Fed continues to push short-term rates up, we believe the positioning will benefit our clients once rates are allowed to normalize. Should markets continue to decline, clients will receive the benefits of higher yields and the traditional portfolio diversification benefits against equity allocations that have been historically associated with longer-term high quality fixed income allocations.
EQUITY ALLOCATIONS: Equity allocations were trimmed during the July and early August bear market rally with some of the proceeds moving to a tactical cash position. An intentional reduction to international equity allocations – particularly within Europe – will be maintained until it becomes more clear on how the continent’s inflation and energy issues can be resolved. As of this writing, many countries within Europe are experiencing high degrees of uncertainty surrounding their energy resources for the upcoming winter, increasing inflationary pressures, pockets of civil unrest due to energy and climate change policies, and it is expected that monetary authorities within the region will continue to implement restrictive monetary policies for the foreseeable future.
DRY POWDER: Over the last two months a larger than typical cash position was tactically accumulated within discretionary portfolios. Given our outlook we believe having some available cash can be advantageous in the event that markets continue to sell-off in the historically more volatile third period of the year. Given the increase in short-term rates, the interest earned while parking cash is significantly more than it has been in recent history. As mentioned above, this position is expected to be short-term and intentional. The cash will be redeployed as opportunities present themselves.
Looking Forward: September to December 2022 and Beyond
Moving forward into the remainder of 2022 and the first half of 2023 our base case is that the Federal Reserve will continue to make good on its promise to “keep it up until the job is done” as Federal Reserve Chairman Jerome Powell succinctly closed his recent Jackson Hole remarks with. Meaning the Fed will continue to raise and hold short-term interest rates at an elevated level for the next several months while reducing its balance sheet until there is convincing evidence that core inflation is on a sustainable path down to its 2 percent target.
The direct and indirect impacts of these actions, and the similar actions that other monetary authorities are taking, will likely push many of the world’s major economies into slowdowns or recessions – including the United States. Should this scenario materialize, we will continue to see equity markets decline, commodity prices continue to be volatile until demand destruction becomes material, debt laden companies and those with high fixed costs will become strained and some will likely fail, and employment rates will likely rise as companies layoff to save expense during the period of financial stress increasing the rate of unemployment.
Additionally, we expect that there will continue to be an elevated risk of geopolitical and international trade tensions especially between G7 countries and the BRICS+ coalition led by China. Such tensions could lead to less international trade, increased risk of conflicts and war, natural resource hoarding or price gouging, onshoring, and increased protectionism of sensitive and critical industries and technologies. The resulting effects will undoubtedly increase costs, limit availability, and reduce productivity. In sum, without diplomacy and constructive intervention the global economy could continue to splinter into regional and/or ideological factions reducing the vast economies of scale that we collectively benefited from in the past. Translating these macroeconomic outcomes into financial market terms will likely result in an increase in asset risk premiums and reduced liquidity over time – both of which have negative impacts to asset prices and access to capital.
As I mentioned above, with risk comes the potential for reward. In the instances of general market declines we will be actively looking to reduce or minimize taxable capital gains while redeploying capital into areas that we believe exhibit quality and value over the long-run. Perspective matters in investing – you have the option of thinking about your investments in days or decades. The former is usually subject to the headlines and sentiment of the day, whereas the latter is subject to the long-term growth of the economy and benefits from compounding returns. Over the long-term you will need to endure many economic cycles to attain your objectives. From that perspective, this contraction is just one of many that will need to be endured but offers the most reward.
Your partner in Bear Markets and Bull Markets.
On the behalf of Canyon Creek Investment Advisors, thank you for your trust and support. It is our mission to help each of our clients achieve their long-term objectives through proactive engagement and disciplined implementation of their investment strategy. My top priority is always to help my clients make sense of the current climate, whether that be in the world, the economy, or the financial markets. It’s what I’m here for. Our promise is to help our clients stay on track with their goals despite any turbulence they may encounter along the way. If you or anyone you know could use a partner to help manage your finances and investments, please don’t hesitate to reach out. We are ever grateful for your support! Thank you!
Principal & Founder
Canyon Creek Investment Advisors, Ltd.