The Manley Macro Memo

Market Review and Outlook:   

Historically, the 60/40 blend of stocks and bonds (our benchmark) has reduced portfolio risk and maintained most of the stock market's reward because stocks and bonds have a low correlation. Importantly, during periods of recession or financial stress, bonds act as a safe haven and typically appreciate when stocks fall. In fact, since 1928, there were only five years when both stocks and bonds declined (see table below).

Unfortunately, the 60/40 blend is having its worst year since 1931, when the U.S. was in the Great Depression. While stocks are in a "normal" bear market, the bond market is having its worst year in a century (see table below).

Source: Compound@CharlieBiello

The financial markets are performing terribly this year because of the Federal Reserve's reckless monetary policy since the Pandemic. To stabilize the economy during the Pandemic, the Fed employed emergency measures – it cut interest rates to 0.0% and printed approximately $4.8 trillion to buy bonds and fund the government's massive spending programs. The Fed failed to reduce or remove its emergency measures when the economy recovered. In fact, the Fed waited until this March to raise interest rates to 0.25% and terminate its $120 billion per month bond-buying program – unfortunately, inflation was already 8.6%, which was a 40-year high (see chart below).



The Fed's first monetary mistake led to asset bubbles (after the pandemic low, the S&P 500 surged by 119% in 21 months and was valued at a record level relative to GDP) and drove inflation to a 40-year high. The Fed was slow to act because it believed that inflation was "transitory," and when it was clear its analysis was wrong, the Fed panicked and raised short-term rates in an unprecedented manner. The Fed's aggressive tightening of financial conditions drove the bond market down more than 16% (its worst performance in over a century). Also, because interest rates are the primary driver of stock valuations, sharply higher interest rates led to a 27.5% decline in the S&P 500.

The Fed's reckless monetary policy led to the worst possible economic environment for financial assets – stagflation. All asset classes have performed poorly this year except for the U.S. dollar (which benefits from rising relative interest rates) and energy, which benefited from years of underinvestment, onerous Federal regulations, and the war in Ukraine.

Recently, the Fed signaled that its tightening cycle is coming to an end, which is good news for financial markets. Unfortunately, the unintended consequences of the Fed's aggressive actions will not impact the economy until next year. The cost of capital (interest rates) has risen sharply due to the Fed's tightening cycle, and its impact on the economy is uncertain. While most leading indicators forecast a recession next year, the magnitude and duration are unknowable at this time.

Sharply higher interest rates will likely lead to a recession next year. The magnitude and duration are uncertain.

High-interest rates have an adverse impact on the economy. First, debt-financed businesses (housing, automobiles, and durable goods) slow as their product becomes more expensive to own. Recently, the National Association of Realtors calculated the adverse impact a 7% mortgage rate will have on housing affordability, "On a $300,000 loan, that translates to a typical monthly mortgage payment of nearly $2,000, compared to $1,265 just one year ago." Also, as interest expense rises, consumers and businesses reduce spending to pay higher interest expenses. Finally, high-interest rates reduce the value of stocks, bonds, and other assets, which creates a negative wealth effect that curtails spending.

In our view, the stagflationary environment is ending, which is good news for financial assets. Significantly higher interest rates are slowing the economy, and inflation has likely peaked. The Fed indicated that it would moderate the pace and magnitude of its rate hikes, allowing the bond market to stabilize.

The transition from stagflation to recession should provide a positive environment for stocks. Once the Fed moves to the sidelines, bad economic news (disappointing growth) will be good news, which will drive stocks higher on the expectation the Fed will soon start cutting interest rates and orchestrate an economic soft landing.

Unfortunately, history shows that soft landings are rare, and recessions had always occurred when inflation breached 5%. Also, quick pivots are rare; typically, the Fed waits about eight months after its last hike to start cutting interest rates. Usually, by the time the Fed starts cutting interest rates, bad economic news is bad news, and the economy is in recession – not a good environment for stocks.

Stocks and bonds rarely decline in the same year – it's only happened five times in nearly 100 years. The Fed's monetary mistakes led to the worst investing environment since the Great Depression. We believe that sharply higher interest rates will lead to a recession next year, and regrettably, many jobs will be lost. While recessions are terrible since many people lose their jobs, periods of high inflation have a worse impact on most households. Additionally, while most assets lose value during periods of stagflation, U.S. Treasury bonds, gold, and the defensive sectors of the stock market typically perform well during recessions. Also, investors can earn more than 4% per annum in risk-free short-term U.S. Treasuries.

We are positioned to perform well in a recessionary environment. We are underweight stocks relative to our benchmark and are invested in the market's defensive (not economically sensitive) sectors. Additionally, we are invested in safe havens and are in the process of building a bond ladder that will "lock in" a government bond rate of more than 4% for the next five years. In 2022, there was no place to hide – stocks and bonds were overvalued, and cash yielded 0.0%. Looking forward, we see many opportunities to generate positive returns in a problematic recessionary economic environment.

Financial Market Review

Our Model Portfolio: 

The benchmark for our model portfolio is the Traditional Blend — 60% equity and 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, to manage risk, we volatility-weight our positions and set a volatility target equal to our benchmark's historic risk level. When volatility increases, our asset allocation dynamically reduces our equity risk exposure.

Our Model Portfolio performed well in September relative to our 60/40 benchmark because of our defensive investment posture, which was underweight stocks and invested in the market's defensive sectors (healthcare, consumer staples, utilities) and the safe havens (gold and U.S. Treasury bonds). Year-to-date, we are performing very well on a relative basis, but our absolute return is approaching our (10.0%) threshold.

Instead of protecting our portfolio during the market decline, the safe havens (gold and U.S. long-term treasury bonds) have performed poorly due to rising real rates. We believe that the tightening cycle is almost over, and real rates have peaked, leading to better performance for the safe havens.

We are well-positioned for the transition from stagflation to a recessionary economic environment. We expect favorable seasonality, passive 401k inflows, and corporate buybacks to fuel a decent year-end rally. Additionally, stocks usually perform well after the mid-term election. Although stocks will remain volatile, we expect to perform well in the year-end rally and mitigate some of our losses.

Current Risk-Weighted Model Portfolio:

Our portfolio's risk level (annualized volatility) is 11.8%, which is significantly less than our benchmark's risk level of 24.8%.

In Summary:  

• The Fed's reckless policies created the worst investment year since the Great Depression. This year, sharply higher interest rates drove the stock and bond markets down more than 25% and 16%, respectively. Higher interest rates negatively impacted financial markets this year, and we believe it will cause a recession next year.

• The first leg of the bear market was due to rising interest rates and declining valuation – the Shiller CAPE fell by 24% (37x to 28x). The next leg lower for stocks will be driven by declining earnings expectations. According to S&P Global, Wall Street expects corporate profits to grow by 14% next year, which seems unrealistic, especially since earnings usually decline by 17% during recessions.

• We believe the economy is transitioning from stagflation to a recessionary environment. In this recessionary environment (declining growth and inflation), we believe the market's defensive sectors (healthcare, staples, utilities, and value) will outperform since the economy has less impact on their businesses. Also, as investors shift their focus from inflationary to recessionary fears, we expect long-term treasury bonds and gold to help hedge the portfolio's equity exposure.

• In this high-risk environment, we remain focused on preserving capital until market volatility wanes, the economy stabilizes, and stocks offer favorable risk-reward.

Disclaimer: The material in this newsletter is for educational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. All investments contain risk.