Anyone who grew up in California may remember the grocery store chain called Alpha Beta. Alpha Beta was known for organizing their groceries in alphabetical order. Shopping there as a kid was always fun, because you could easily just head to the “C” aisle and quickly load up on candy and chocolate and off you would go about your day. They were also famous for their tagline, “Tell A Friend” and ended every commercial advertisement with that not-so-subliminal message. Sadly, Alpha Beta was sold off to other grocery operators in the mid 90’s and no longer exists. What does Alpha Beta have to do with today’s capital markets and our slowing economy? As a grocery store absolutely nothing…but in the context of the terms Alpha and Beta, absolutely everything.
From a finance perspective, Alpha is generally defined as excess return on an investment above a benchmark. Typically, active managers try to generate Alpha through security selection and asset allocation, attempting to diversify away broad market risk. On the other hand, Beta is a measure of return that can be expected from incurring market risk. Passive investing is a form of Beta because indexes simply provide market returns.
In times of easy financial conditions, it can be difficult to discern Alpha from Beta. A simpler way to think about it is when the tide comes in, everything rises such as prices, values, and investment returns. And when the tide goes out…well the optimist would say, “at least it becomes easier to identify Alpha.”
Regardless of the analogy used to describe the first half of 2022, the selloff has been brutal. The abrupt fall in prices of seemingly every asset class is truly of historic proportions, with stocks and bonds gripped in a drawdown not seen since the Great Depression.
Figure 1: Worst Six-Month Period Return since 1932
It is not news to any reader that the markets have been a bit manic over the last quarter with virtually all asset classes posting negative returns. More challenging have been the intra-quarter returns with many asset classes leading one month only to do an about-face the next. Even vaunted hedge fund managers who can trade hundreds of asset classes daily have struggled with some of the most iconic hedge funds posting spectacularly negative returns this past quarter. Indeed, traders are struggling to price in how much central bank tightening it is going to take to put the inflation genie back in the bottle.
Figure 2: Nothing Worked in Q2
Adding onto humanity’s bizarre odyssey over the last three years, Russia’s continuing invasion of Ukraine and The Neverending (Global Covid) Story contributed to a cacophony of factors that provided an energy shock just when the world needed it least and forced the Fed into much more aggressive action than many had envisioned. When the Fed steps the brakes, it’s best to be wearing seatbelts. And as the FOMC continues to press on those brakes harder and harder, we can only hope that Chair Powell has an anti-lock braking system installed.
Figure 3: Record Tightening of Conditions
We have written many times that the economy moves in a cycle of Growth to Peak to Contraction to Trough to Growth. It’s clear we are in a contractionary phase and the natural question is, “when will we reach the Trough?” Fortunately, we have a fairly accurate playbook to help us understand where we are in the cycle and what we can expect in the months ahead – it is called the HOPE model and is authored by our research partners at Piper Sandler. We have already seen Housing and Order growth slow materially. As earnings season kicks off, we expect Profit growth to slow materially with many companies missing targets. Earnings estimates look to be too high to us and we suspect corporate CFOs will use this opportunity to get as much of their bad news out as they can, allowing their stock prices to take the near term hit so they can base before finding support to move higher again.
Figure 4: Where Are We in the Contraction?
After slowing Profits comes weakening Employment and we are just now starting to see cracks form in the once white-hot labor market. While headline unemployment is still currently low, closer inspection reveals payroll growth is slowing, job postings at bellwethers such as Apple, Microsoft and others are being withdrawn and layoffs are starting to percolate. Recall the Fed has a dual mandate of 1) price stability (i.e. controlling inflation) and 2) maximum employment. After two years of labor shortages, declines in labor force participation rates and concerns about inflationary wage spirals, we suspect the Fed is willing to let unemployment rise significantly higher in order to accomplish job number 1.
Figure 5: Weaker Employment Ahead
There is much discussion as to whether there will be a global and/or US recession or not. Smart people make some very logical and strong arguments on both sides of the coin. In the end, we don’t think it really matters if we go into a technical recession or not as the journey is going to be very volatile and at times uncomfortable along the way. Fortunately, this time around does not appear to be a systemic issue, such as the Global Financial Crisis of 2008; banks are well reserved, consumers are generally less levered and savings rates are materially higher, which will afford some support over the next few quarters as the economy seeks to find its trough. That said, we expect declining economic measures well into 2023, rising unemployment and though inflation should start to ebb, it will remain structurally higher for a longer period. Midterm elections will also add to short term volatility and historically, have led to cyclical rallies in equity markets.
Figure 6: History Argues for Bear Market Rallies
Our investment team has made significant changes to portfolios over the past quarter and has materially shifted exposures to a much more defensive profile. As previously written, we have shortened duration across all asset classes and while we cannot control the tides, that activity has helped to protect portfolio values over the past quarter. While it appears that longer-term interest rates have likely topped out, we are expecting lower lows in the equity markets before they find a bottom. Remember, bottoming is a process, not an event and we expect a few head fakes along the way.
As we embark into a new era of higher short-term interest rates and a higher structural level of inflation, we believe it is the prime environment to include Private Capital into traditional portfolios. Not only can Private Capital help diversify traditional public investments, but certain vehicles and structures can also benefit from rising rates and inflationary pressures.
Figure 7: Private Capital as a Source of Returns AND Diversification
In the Private Capital space, manager selection is paramount. While dispersion of returns amongst managers is fairly low in the public markets, dispersion of returns in the private markets is significantly higher. We believe in this shifting and volatile environment, public market returns will be dominated by Beta, however prudent allocation and thoughtful access to private markets will be a durable source of Alpha. At Capital Planning Advisors, we are pleased to have built some excellent relationships with world-class institutional managers to bring highly differentiated solutions to our clients and help them meet their goals. Tell a friend.
Figure 8: Private Capital as a Source of Alpha
Reiterating what we wrote last quarter, navigating this environment has been challenging and we know this recent correction and ongoing volatility has been uncomfortable for many of you. Long-term horizons can suddenly seemingly get very short in market conditions like these, and we encourage you to speak with your Relationship Manager if you have thoughts or concerns about the markets. We are here for you.
Our Capital Insights readership continues to grow substantially and now encompasses clients, prospective clients, strategic partners, as well as friends of our firm. To our clients, we deeply appreciate your business and trust in your Capital Planning Advisors team. If you are not a client and are contemplating initiating a relationship with us, either directly with your personal or business assets, or by referring someone you think could benefit from our services and approach, we would be delighted to speak with you.