Q1 Market Commentary and Looking Forward to the Remainder of 2022
March 11, 2022 | James Sprow | Blue Vault
On Thursday of the Bowman/Blue Vault 2022 Alts Week, our keynote speaker was Anastasia Amoroso, Managing Director, Chief Investment Strategist of iCapital.
Key Takeaways from the Outlook:
• It’s too early to call the bottom of the market. I will take a little longer to have clarity.
• As difficult as the situation in Ukraine is, if you look at our financial linkages to Russia, they are really quite small.
• We may have already priced in the worst-case scenario for commodity prices. We’ve already priced in about 64% of the worst-case scenario for oil. Expect oil to be $100 to $110 for the year.
• Inflation is everywhere and with its demand destruction, we have real potential for a recession.
• The Fed wants to prolong this expansion by adjusting rates just enough, but not to put the economy into recession.
Anastasia first majored in Journalism with a minor in Political Science and then she switched to Finance. “When I think about what’s happening in the global affairs today, it is this cross-section of geopolitics and finance that we just can’t get away from today.”
“When we were thinking about our iCapital 2022 Outlook, we were thinking about higher hurdle rates and lower potential returns. We were always expecting this to be an eventful year. I don’t think we were expecting it to be this eventful in such a short time. We’ve got almost 8% inflation, the highest rate in 40 years. We’ve got the Russian-Ukraine conflict. And finally, the Pandemic is coming to an end in the United States. We have to somehow overcome the 8% inflation rate. I didn’t expect the 60-40 portfolio to be down 7% year-to-date but, once again, here we are.”
Near Term Outlook
“It’s too early to call the bottom. It’s too early to call an all-clear. It’s going to be a little bit longer to have clarity. While we wait, what can we do with the portfolios? I’ll have five or six ideas that you can do with the portfolio to withstand some of this uncertainty.”
“This is a year where little has been working in the market. The only thing that has held up is oil. The NASDAQ is down, the S&P is down. We’ve broken some key trends. What’s happened since the beginning of the year is we’ve broken through the 200-day moving average. Historically, this doesn’t happen often, but once it does, it does take time to find a bottom, it does take time to clear the uncertainty, and it does open up additional potential for a downside. We have to be very mindful of that.”
“There is a huge bull-bear debate in the market. The silver lining is we’ve taken some of the froth out of these valuations. Most people are split 50-50 on any given day. As a result of the pullback we’ve had this year, we’ve taken out a lot of the froth in valuations.”
“As difficult as the situation in Ukraine, if you look at our financial linkages to Russia, they are really quite small. The other thing to look at is the massive rally in commodity prices. We may have already priced in the worst-case scenario.”
“Take a look at the massive rally we’ve seen in commodity prices. The last time that happened was in 2008. We’ve looked at the worst-case scenario for wheat and oil. We may have already priced in the worst-case scenario. We’ve already priced in about 64% of the worst-case scenario for oil.”
“The bearish outlook is as high as it’s been since 2013. Hedge funds have been selling all year.”
“The most important thing that has to happen is to break this feedback loop of negativity. In order for us to call an all-clear on this market.”
“We haven’t priced in the ultimate outcome in Ukraine. We might see more escalation first before we see any sort of constructive negotiations.”
“We have priced in a lot but we may not have priced in all of the downside potential of the situation in Russia and Ukraine. Take a look at the size of Russia compared to the former Soviet Union. If you are Putin, what is the incentive for a de-escalation? The unfortunate most likely scenario is we see more escalation first before we see any kind of constructive negotiations.”
“I don’t think we’ve priced in the duration of the potential disruption. Russia is a significant producer of these commodities. The second-order effects and the unintended consequences of these sanctions are still very much possible and they may result in further supply chain disruption. It’s not just oil, but there are a lot of other commodities provided by Russia.”
“The topic of the day is inflation. Inflation is everywhere. 7.9% food inflation, 25% energy inflation, 41% used car inflation, and 12% airline inflation, it is everywhere, and it is getting broader. More and more consumers are starting to feel it. With inflation as high as it is, if you are a low-income consumer, 90% of your income is spent on food, housing, and gasoline. As you can see, we have a long way to go to bring that inflation down.”
“This is becoming a demand destruction issue, potentially. Real wage growth has slowed to a decade low, at a negative 3% rate. Food prices are projected to be up 14%. Consumer sentiment is at the lowest level in 10 years. This is becoming a real concern for the Fed, for the market. There’s a real potential for a recession.”
“We’ve had a growth slowdown before the situation in Ukraine. This has affected the growth forecasts. Given the sentiment, economists are likely to cut these growth forecasts even more.”
“We are now expecting a negative growth rate in Q1. We have a negative feedback loop we need to break. Let’s take a look at what happened historically after the peak in data. Most equity indices produce negative returns after you see this peak in data. The US stands out. This is a reason why we shouldn’t expect positive real returns.”
“Consensus earnings estimates for the S&P 500 give you roughly 4,300. That doesn’t give us a lot of potential upside. Maybe it’s not a 19X multiple for S&P earnings. You could potentially have another 10% downside for the S&P. The math does not support a whole lot of upside for the S&P. We could have a positive resolution in Russia and the Ukraine, but that is not the base case, and we’d rather have a certainty first that it does happen rather than say we’ve seen the worst and reached the bottom.”
“We’re going to see more negative earnings revisions and you’re going to have to see these negative revisions bottom out before we call the all-clear on this market. The only sectors where we’ve seen
positive earnings revisions are in energy, real estate, and info tech. The sectors where we’re seeing downside earnings revisions are the cyclicals. The last time we looked at these charts three weeks ago the consumer discretionaries didn’t have the number of downside revisions that they have today.”
“These are times when you want to buy into the market with a 12-month time horizon in mind. Of course, patience will be required.”
“Once the Fed hikes and it’s been 12 months since the first rate hike we do see positive returns, as the market adjusts to the Fed’s more cautious approach. The Fed wants to prolong this expansion by adjusting rates just enough, but not too much to put the economy into recession.”
“Real rates are deeply negative today and they’re still going to be below zero even if the Fed hikes rates 200 bps. By 2023, The Fed is not going to hike into a tight monetary policy, it’s still going to be below zero.”
“Once we price in more of the recession probability, and once we do that, we’ll see an amazing buying opportunity in this market, we’re just not there yet.”
Six ideas for a portfolio in this situation
“What do you do in clients’ portfolios to position for this uncertainty now and more clarity later?”
“We need to get something in the portfolio that can deliver hyper-growth when the S&P is not performing, and two, it’s a set of inflation and rate shock absorber ideas that are clearly needed today.”
“This has been a very challenging backdrop for fixed income investing. There’s one silver lining for this.”
“One of our ideas is to look at the private credit market where most of the securities are floating rate, and they offer a yield that is almost double what the publicly-traded leveraged loan market is giving you. Private credit that gives you close to an 8% yield.”
“The second idea is commercial real estate. This is a $31 trillion market globally. If you look at the performance of real estate inflation going back to 2000, you see NOI growth that outpaces inflation.”
“Industrial/warehouse vacancies are extremely low. Multifamily RE is one of the better opportunities in real estate right now.”
“The median home price rose by more than $100K over the last year. And you have mortgage rates topping 4%. The affordability of housing relative to housing units is now beginning to deteriorate. Now you’re not better off to be buying a house than renting. Real estate rent growth has been close to 11%, over and above inflation. The supply-demand dynamics and higher replacement costs should provide some capital appreciation for rental real estate.”
“Does real estate do well in a rising rate environment? Today we have strengthening fundamentals of CRE. The spread of cap rates over the Treasury is right at the historical average, but it’s not at the low that we’ve seen prior time periods. I would definitely put real estate as one of the top opportunities right now.”
Another idea is to monetize volatility through options. We are right now in the 97th percentile with regard to volatility. One of the ways to take advantage of this volatility is to potentially buy the security and write a call option on it. Given this volatility backdrop, you’re going to collect these very generous premiums for selling the option which can either enhance the return if the security rallies or it could reduce the loss if the stock goes the other way.”
“What might you add to the equity side of the portfolio?”
“Venture capital. Venture capital has had a 600 bps return above the public market equivalent. They are not subject to day-to-day market-to-market volatility. VC funds are investing in innovation. For example, there are 58 times more private companies available that are pursuing AI than in the public markets.”
“The last thing I’ll say is cryptocurrencies.”
“Crypto: When you can’t trust the central authority to maintain the value of your currency or trust them to allow you to transfer your money because of the government, that’s where a decentralized blockchain or cryptocurrency might be very helpful. Last year was a record year for venture capital funding different crypto applications. Can we create a more secure and more private and more decentralized web than the social media models we have today? Can we reduce the cost by having decentralized technologies and eliminate intermediaries and eliminate an unneeded layer of cost?”
“That is where we are today, where we have a higher hurdle rate with high inflation, and we have the lower expected returns in the public markets, and that is why we’re looking for these alternatives to add to the allocation.”
“Alternatives have been a mainstay for many years. And if you’re an endowment you’re probably allocating 43% to alternatives and real estate. If you’re an HNW individual you’re probably allocating 14% to real estate. Regardless of their asset level, most of them intend to increase their allocations to alternatives.”
“Alternatives are not just a “nice-to-have” but they are becoming a “must-to-have.”
“Where nothing is working in the markets, where 60-40 is not working? There are things we can do, we just have to expand the universe in which we look.”
Today is the final day of Alts Week 2022 but there are still several sessions to gain valuable insight from.
