Q2 Letter - 2022
“The erosion of our confidence in the future is threatening the social fabric of America” – The Malaise Speech, Jimmy Carter, 1979.
Alexander the Great’s undermanned defeat over Persian King Darius III at the battle of Gaugamela is considered one of the greatest turning points in human history. Persia was a 200-year-old empire that had modernized communication, agriculture, and societal structure. Alexander rallied the Macedonians and Greeks around nationalism. Around this time, Persia was seen to be in decline. Having been recently embarrassed on the battlefield, slowing economic growth and a cultural civil war, Persia was receding on the world stage. Over the course of a decade, Alexander the Great was able to usurp the Persian Empire and finally take over at the battle of Gaugamela. (Please read to end for relevance).
Mirador Capital Partners' core strategy, MLS, was down just over 1/2 of the S&P500 and 1/3 of the NASDAQ Composite.
Risk assets continue to decline. The crypto markets have experienced a historic meltdown with Bitcoin falling below $20,000. The moves in Ethereum tokens and the collapse in “stable-coins” has wiped out 2/3 of what was once a $3T market. Perhaps the demand of a cartoon ape JPEG priced 108x the average U.S. income was a clear signal that financial conditions were too easy.
In the equities markets, multiple compression continues. Mirador expects valuations to continue declining mainly driven by an aggressive central bank tightening cycle which includes a terminal Fed Funds rate of 3.5% and trillions of dollars taken out of the economy. We have strong conviction that this is not currently fully baked into equity prices. Although equities saw a notable uptick in inflows at the end of the second quarter, fundraising in both public and private markets has slowed dramatically. We remain cautious of prices and skeptical of Wall Street’s overzealous earnings expectations. In the first half of 2022, the S&P500 index has declined roughly 20% but the aggregate earnings estimates of its constituents has increased 8%. A strong dollar, margin pressure, and slowing demand is going to put downward pressure on earnings. When the dust settles and earnings revise downward, we can take a more holistic approach in understanding price to value and adopt a more offensive posture. For now, equity risk premiums sit below 20-year historical averages – which as history implies, indicates below 20-year historical returns.
The U.S. Treasury term structure has remained mostly inverted with the short term of the curve steepening (then subsequently flattening). Recall that yield curve inversion is our most historically accurate indicator of a recession. When the payout of a 1-year government bond is higher than holding a 10-year government bond, something is broken. Inflation breakevens largely ignored this move and have declined 54 bps giving everyone in “camp transitory” a relishing relief. Although, the moves in treasury and treasury derivatives markets do not reflect a natural shift as the Fed has synthetically kept treasury yields down with their Open Market Operation actions.
The Consumer Price Index (CPI) is anticipated to stay in the high single digits through 2022. Historically, when the CPI print has gotten above 4%, two things have always been true: 1. Inflation rates did not normalize unless the Fed took the Fed Funds rate above the inflation rate, and 2. There has always been a recession. Because of the structural damage it would cause, the former is not likely. However, all signs in the market point to the latter coming to fruition. There has never been more of a divergence in the history of the U.S. financial system between risk-free rates and inflation rates. Then again, we have never in the history of the U.S. financial system had a decade of negative-yielding real risk-free rates. The pundits of Modern Monetary Theory (infinite money printing without consequence) are somewhere between weighing the risks of having a Japan-like “lost decade” and continuing to subsidize demand. Washington is still enamored by MMT and continues to propose subsidizing demand to “fight inflation”. Commodities markets are showing signs of easing, but analysts predict there is still room higher (particularly in food and energy). A natural gas refinery in Texas, which accounts for 25% of U.S. Natural Gas exports recently blew up. The European Union is slowly cutting themselves off of the Russian Natural Gas supply to put the cherry on top of their sanction cake. The Biden administration has shifted the blame of their own early energy policy overreach from large oil companies to mom-and-pop gas station operators. Bloomberg reporter Tom Keene equated the administration’s energy response with “central planning”.
As a result of current and expected policy actions against inflation we expect the real economy to feel some real pain. As quantitative tightening wanes money supply and the prices of goods and services continue increasing, household savings have dropped near pre-pandemic levels and consumer credit has spiked 20%. Consumer and investor sentiment has hit all-time lows in almost every category measured. The most impactful has been the 30-year mortgage rate, the rate at which most Americans finance their home. This coupled with the elevated cost of housing has increased the cost of a mortgage two-fold in the past two years. In contrast, retail housing activity is starting to fall which could have a significant effect on GDP. Oddly enough, consumers are doing reportedly well and the U.S. has historically low unemployment.
CEO of J.P. Morgan, Jamie Dimon, summarized the economy in their Q2’2022 earnings call best: “The U.S. economy continues to grow and both the job market and consumer spending, and their ability to spend, remain healthy.” Followed by, “But geopolitical tension, high inflation, waning consumer confidence, the uncertainty about how high rates have to go, and the never-before-seen quantitative tightening and their effects on global liquidity are very likely to have negative consequences on the global economy sometime down the road.”
Since ancient Persia, economic cyclicality has been amplified by future sentiment, but we cannot forget about long-term cyclicality. Much like President Carter inferred in 1979 the dismal outlook continues to weigh down on consumer and investor psychology, which is a vicious cycle. Whether the Fed manufactures a hard landing and rips off the proverbial “band-aid” by aggressive rate hikes to control inflation or we experience a longer period of elevated inflation and slowing economic growth we must take this downturn for what it is…cyclicality.
The story of Persia sounds eerily synonymous with what Ray Dalio calls the “changing world order” but Earth’s civilizations are no longer zero-sum. Advances in technology have enabled us to grow prosperity within our empires without having to take from one another. Regardless of what transpires in the short-term of this economic cycle, we are very optimistic about the long-term future. The quality of life, breakthroughs in AI and Biology, and the most global peace relative to historical measures have proved that there is no better time to be living in the United States and be invested in its future.
Information presented reflects the personal opinions, viewpoints and analyses of the employees of Mirador Capital Partners, LP, an SEC-registered Investment Adviser. The views reflected in the commentary are subject to change at any time without notice. Nothing herein constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Mirador Capital Partners, LP manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Visit us at miradorcp.com for more information.