Q3 Letter - 2022
“The only defense against the world is a thorough knowledge of it.”
― John Locke
U.S. equities remained relatively flat this quarter as the bear market rally, fueled by cooling inflation expectations, succumbed to hotter than expected August CPI data. Downward pressure on stocks continued from the Fed as this quarter saw two 75 bp rate hikes, taking the effective Fed Funds rate to 3.0-3.25%. The probability of another 75 bp hike at the November FOMC is 96%, as support for continued tightening is becoming the consensus amongst even the most dovish Fed Presidents.
Here are a few recent highlights from the Fed:
Inflation is well above the Committee’s 2% objective and is showing little signs of abating
A period of below-trend real GDP growth would help reduce inflationary pressures and set the stage for the sustained achievement of the Committee’s objectives
It would be appropriate for the committee to consider sales of agency mortgage backed securities
As short-term rates increase, yields have become more attractive. The average yield on corporate high-yield and investment-grade bonds rose to 9.5% and 6.1%, respectively. The appetite for U.S. issued “risk-free” securities has driven the price of the U.S. dollar up astronomically relative to other G10 countries. Global demand for the dollar has driven foreign institutions to de-leverage on dollar-denominated commodities such as oil, driving down the price of financial futures contracts. The institutional selling of commodities has slowed the steam on the oil trade and increased dollar strength. As a result, real wages in the U.S. have increased, giving the consumer more buying power, which continues to make the Fed’s job increasingly difficult.
The U.S. energy policy and influence on global pricing remains concerning. The social narrative around oil is starting to shift as the economic impact of Environmental, Social, and Governance (ESG) policies and trade sanctions related to Russia/Ukraine have many from the left and right questioning mainstream narratives. In recent weeks, the world’s largest asset manager, BlackRock, has seen large outflows as Louisiana, South Carolina, Utah, and Arkansas have joined Texas in uniting against BlackRock’s “anti-oil” policy – which is directly tied to its ESG goals.
The CEO and founder of the largest electric vehicle company, Tesla, recently opined on oil and gas:
“At this point in time, we need more oil and gas, not less. These [fossil fuels] are necessary right now if civilization is going to function.” - Elon Musk at the Offshore Northern Seas conference in Norway on August 28th, 2022.
The energy sector has been and is expected to be the largest contributor to earnings growth in 2022. Energy companies, which represent around 4% of the S&P 500, have seen earnings growth of around 300% y/y. The S&P500 earnings growth projections for 2022 are 8.9%...but only 2.4% when you exclude energy. Our view remains that the companies in the S&P500 not involved in the energy sector are likely to see material EPS downgrades over the next three quarters. Lack of liquidity, declining household balance sheets, and China’s zero-covid policy are three factors that may lead the S&P500 downward.
On the other side of the monetary equation, the Fed is doing its first-ever major quantitative tightening (QT) program. Starting with $9 trillion in assets on the central bank’s balance sheet in 2021, the Fed is selling treasuries and mortgage-backed securities to constrict money supply. Major central banks are following suit and global money supply is going negative on a y/y basis after a record amount of liquidity was pumped into the world during the pandemic. At the current rate of global QT ($750 billion), even the most liquid markets are experiencing record illiquidity and more downside in equities is implied.
Household balance sheet quality is declining as savings are being depleted and consumer credit levels are rising. The 30-year mortgage rate has gone from 3.00% at the beginning of the year to 6.50% today. The monthly payment on a $450,000 home with a 30-year mortgage was $1,900 at the beginning of the year (28% of the median income). Today, that same payment could only afford a $350,000 home. Housing prices would have to decline 30% to come to par with cash flow cost. Housing prices are still holding up and are unlikely to drop 30% because of the supply imbalance.
One interesting note is that the percent of variable-rate mortgages has risen to pre-Global Financial Crisis levels.
In China, Xi Jinping, is running for a historic third term, which, if successful, would cement his place as the country's most powerful leader since Mao Zedong. The Chinese Communist Party is continuing to double-down on its zero-covid policy, which has had detrimental impact to the Chinese economy and continues to constrain global supply-side issues. Slowing economic growth and high unemployment amongst young people in China has factored into the disruption of global supply chains. The institute of Supply Chain Management’s September 2022 report noted, “The New Export Orders Index contracted in September... …weakness in European economies and China’s economic sluggishness continue to constrain new export orders and are having a negative influence on new order rates.”
Positioning in our portfolios is usually based on a top-down approach that starts with a world view and ends with asset selection. The unpredictability and randomness of the world today indicates record levels of uncertainty. Whether this is true or not, we believe the best offense is a good defense. We are finding yield in short term bonds and will continue to position defensively in equities.
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.