2023 Will Be Different, Speculation Rehab and ESG Fatigue
Dear Clients and Friends,
I hope your 2023 is off to a good start, with some well-lived days in the bank and rich with promise. I will not rehash 2022 at length, enough ink has been spilt on the topic and that feels more like an early January exercise. However, some context of the last two years clarifies the current state of affairs in financial markets and what we might expect going forward, besides the unexpected.
The Crystal Ball: Taking a Look at What’s on the Horizon for Investors in 2023
Last year was entirely predictable in hindsight: Investors do not like inflation, but more importantly, they do not like a Fed hiking rates in response to inflation. That killed the excesses of the pandemic boom in financial assets, which always felt hard to believe, but even harder to resist.
So, what again caused a gravity-defying runup in asset prices in the preceding year? Governments and Central Banks the world over flushed the economy with cash through stimulus spending, and low/zero interest rates, respectively. Cooped up consumers spent it on goods, property, and boredom, yet the supply side of the economy was bottled up and could not meet demand. These collective actions led to a run up in prices of everything: financial assets, real estate, goods and speculative assets; i.e. inflation. Clearly the pendulum swung up too far in 2021, and now the question is whether it has swung down enough to pay for our sins and/or if we need to go through a recession and further price corrections.
Given that context, what can we expect from 2023? You know I will not venture into saying what will happen this year. I’d rather aspire to wisdom than foolishness and heed Bertrand Russell’s words: “The whole problem with the world is that fools and fanatics are always so certain of themselves, and wise people so full of doubts.”
Luckily, in constructing portfolios, you don’t need to know what will happen, just what might happen and what already did. What might happen, is a recession. That certainly is not a newsflash. Since it is not, it is also being factored into asset prices. In other words, selling stocks or buying bonds because you think a recession might happen, is not news to the person or computer algorithm that is on the other side of your trade. Stocks tend to recover from bear markets before recessions end, but not necessarily before they begin. At the same time, no one knows if stocks have dropped far enough to make the actual recession announcement a non-event. I tend to think stocks could drop again when the recession actually happens or is declared after the fact. But, regardless, the passage of time puts us farther away from the beginning of the bear market and eventually time is our friend and bear markets end, absent some catastrophic event.
What also could happen is the Fed sticks the landing. I have seen that phrase several times in the investment newsletters that I have read this month, and I like it. I can’t tell the difference between a triple axel or any other difficult jump in figure skating, but the former is just more exciting to watch, knowing that a crash is likely to occur (no, I don’t want them to fall). In other words, I am rooting for the Fed, but it is going to be a close call. Assuming they stick it, the market could rally further and surprise to the upside.
What I have some confidence in for 2023, is that stock and bond prices won’t move in tandem as they so corrosively did in 2022. A mix of stocks and bonds was supposed to help investors fine tune their risk exposure and smooth out the valleys (and peaks) for investors needing a safer portfolio. Last year that approach was put on its head and investors have been forced to question basic assumptions about portfolio construction. The book-ends of the low risk (100% bond) and high risk (100% stock) index portfolios were close in terms of performance and deep in the red.
This year, however, if we see a recession, it should be supportive of bonds. If we do not see a recession, at least short-term rates are high and compensate for inflation, certainly if that continues to come down.
Markets have been friendly so far this year, for both bond and stock investors, as well as those with money in short term savings vehicles. “The Fed sticks the landing” narrative is in ascendance on good market days, and should it come to pass, Fed Chairman Powell will go down in the history books as the first Fed Chair to land a quad axel in competition. What more can one ask for? “I can think of a thing or two” – you might be tempted to say. Well, ok, the world’s a crazy place, but financially speaking a good start to 2023 goes some way towards putting 2022 and its impact in the rear-view mirror.
Resisting the Temptation of Speculative Investments
I take some pride in having resisted most speculative impulses of the last few years. Not because it confers bragging rights, but because I consider it my duty to protect my clients from impulsive behavior; theirs and mine alike. I have heard investment advisor peers talk about how they offer crypto because their clients want it. Personally, I don’t think an investment advisor’s role is to be the cool kid on the blockchain or the expert of all things new and exciting. Rather, they should admit it, if they don’t have any particular expertise in the fields of AI, Crypto, NFTs, 3D Printing, mRNA, the Metaverse, EVs, Alternative Proteins, Virtual Reality, etc. The best advice might very well be: “I don’t know,” “proceed with caution,” “your guess is as good as mine,” and “don’t bet the farm.” Alas, there is the risk you might come across as a luddite. But if that is your fear, then you have bigger problems.
To be sure, sometimes, the temptation is nearly irresistible. There have been times when I second guessed myself on the hesitation to embrace crypto, for example. All the major investment houses seem to have a crypto offering, trading desk, or research analysts. Was I missing something? Now I feel more secure about my reticence, though I might yet be missing something.
The way I protect myself from speculative impulses is by contemplating what could go wrong. Have you ever asked yourself “how did I get into this mess?” Usually, the real problem you are trying to solve for is “how do I get out of this mess?” After all, when you got in, it probably didn’t seem that messy. So I try to always do a post mortem before an investment is even born in my portfolios and ask myself “how do I get out and will I know when to get out?” While not fail-proof, it has saved me from pursuing many of the temptations served up during the speculative mania of recent times.
Buying International Stocks and Selling Private Real Estate Funds
You probably have heard me say this before, but you do not have to know the future to be a successful investor, you just have to know yourself. Knowing myself informs me mostly of what not to invest in, but more interestingly perhaps is what I am investing in. On the low risk side, I have been buying Treasury bonds with short maturities. These look pretty good to me. If inflation does continue downward, these 4%+ yields are attractive and if inflation surprises to the upside, you are somewhat protected due to limited interest rate risk in shorter maturity bonds. If more than a mild recession occurs, it would be better to be in longer-dated Treasuries so you can get a bump in price, from lower interest rates. But I don’t buy low risk assets in hopes of a bump and prefer that my stocks do the bumping.
On the stock side, I think international markets look interesting. I have been wrong on this one before, but in 2022 and so far in 2023 international stocks have outperformed the US market. If there is a reversal in fortunes of the long-morose international equity asset class, now would only be the early days of such a reversal. In much the same way, the value vs growth performance reversal is only in early innings and something I feel has a high likelihood of persisting for some time.
Another investment view I hold is that private assets are overpriced relative to traded assets. Specifically, if you look at Real Estate Investment Trusts (REITs), which are traded in the market, they were down 26% in 2022. By contracts, private real estate investment vehicles – at least the ones I am familiar with – have not marked down the value of their assets. Much like homeowners have not mentally marked down the value of their homes, irrespective of what higher interest rates might suggest. So I have been selling some private real estate exposure and buying some public exposure in REITs. For many clients this is not applicable, as they don’t own private real estate funds, and for good reason. Traditionally, these private funds have been rich in fees that accrue to management, and they fail the “how do I get out of this mess?” question, due to their illiquidity. Of course, nothing is ever that black & white and I have found some private vehicles that looked interesting from time to time.
Going Beyond Wall Street: Is There Value In Pursuing An ESG Investment Strategy?
And now for something completely different: investing with your values by pursuing an ESG investment strategy is not popular at all, as far as I can tell, despite Wall Street’s infatuation with it and incessant marketing of it. Since I play in that sandbox I thought it would be a good idea to broach the topic. To refresh, ESG investing is the inclusion of Environmental, Social, and Governance criteria in selecting portfolio companies. It’s politically very polarizing, as are many things in a polarized society. Those who identify with today’s version of conservatism think that corporate America has some left-leaning political agenda it has decided to embark on and that ESG is just an expression thereof. Progressive voices think ESG is green-washing and that it is just Wall Street’s attempt to fight fee compression and to capture the assets that transfer from baby boomers to Millennials (apparently Gen X gets nothing, or at least it is never mentioned). Individual investors sometimes think it sounds good, but often scratch their heads when they look at the holdings and see mostly the same companies they would otherwise see in a non-ESG fund.
So, do I believe in it? I think the narratives around ESG are poisoned and I am liking the term less and less. The record can be set straight, by taking a more narrow view of what it actually is, or ought to be. I believe it is a risk framework. Investors have always incorporated risk when assessing potential investments. ESG just brings a distinct set of risks to the table that may have received less attention in the past. In 1969, when the Cuyahoga River caught on fire due to industrial pollution, it (sadly) wasn’t a material financial risk to the industrial companies that caused it. Today it would be. A jewelry retailer 20 years ago could probably get away with supply chain issues and blood diamonds. Today it would not be helpful to the brand. 15 years ago, a utility could build cheap coal plants and externalize the cost of pollution. Today a utility stock would be a less risky investment if it had a low carbon footprint relative to its competitors. So ESG, properly understood, is just risk management. Now, if you want to bring your values to bear on your portfolio, you might find ESG lacking. Then, it might be more useful to target specific companies for exclusion, based on the specific values and priorities you wish to express in your portfolio. If you are worried that ESG is some virtue signaling, subpar investment approach, then do not worry. At the very core of ESG strategies lies the premise that you can have your cake and eat it too, i.e. no concessionary returns. And as to a political agenda embedded in ESG, rest assured (or don’t get your hopes up), it is Wall Street.
I often find myself writing these letters on a Friday and the weekend beckons. Specifically, the mountains beckon. With age and a milder climate, I have grown more fair weathery so I might sit this one out with highs around 10F on Mount Hood. Besides, if you are trying to get a 4-yr old into skiing, it is best to skip the cold days. Stay warm wherever you are!
Jan Schalkwijk, CFA
JPS Global Investments