Client Letter 4Q 2022
We have finally come to the end of a tough year. This was a year in which there were few, if any, places to hide from the carnage. Stocks tumbled as much as 25% before bouncing in the fourth quarter to end down 19.4% for the year. Normally bonds provide at least a cushion to soften the blow, but the numerous hikes in interest rates by the Federal Reserve meant that, while bond yields (the interest rate you can earn on a bond over its life) rose dramatically, the price of bonds fell dramatically. This means if you held a bond mutual fund at the start of the year, it likely fell around 12.9% for the year. And the operative watchword for the year was “inflation”.
The inflation rate peaked at 9.06% in June before starting to slowly retreat. However, by the end of November, it was still at 7.11% - well above the 2% - 3% range the Federal Reserve is targeting. This has led the Fed to hike interest rates from a range of 0% - 0.25% at the start of the year to 4.25% - 4.50% by December. We are likely to see a couple of additional rate hikes in 2023 with the expectation being a Fed funds rate of around 5% before interest rate hikes pause.
Inflation is expected to continue to trend down over the next year, but we are not likely to be back at the Fed’s stated goal of 2 – 3% soon. This will mean that interest rates will be “higher for longer”. In other words, welcome to the 2000’s. Interest rates on Treasury bonds are essentially back to the levels prior to the Great Recession. The International Monetary Fund (IMF) has estimated that global inflation will decline to around 6.5% for 2023 and to 4.1% by 2024. This argues that interest rates are going to stay elevated through all of 2023 and well into 2024 before there is any chance for relief. I fully expect the Fed to hike interest rates at their next meeting at the end of January with possibly the last raise coming in March. If that happens, you will see us start to gradually shift our current bond fund mix from funds that are focused on very short-term, interest rate sensitive bond funds to ones that can “lock in” those higher interest rates for the long term.
In addition to higher interest rates, which are typically a drag on stock returns, we are beginning to see companies laying off workers. The majority of these layoffs are in the companies that were beneficiaries of the pandemic and the “work from home” trends of the past two years such as DoorDash, Amazon and Peloton. While some of the numbers sound scary, we need to keep things in perspective. News media will try to spin things to sound sensational. Amazon is laying off 18,000 workers. This is only about 1.1% of their total workforce, though. DoorDash is laying off 6% of their workforce which totals about 500 people. Facebook parent Meta is laying off 13% of their workforce or about 9,300 people which is about half of the number they hired during 2021.
These layoffs are certainly something to take note of when it comes to business and the economy. Many companies overstaffed in the face of boom times during and just after the pandemic. As I write this letter, the December jobs report has just been released showing continued strength in our economy. The unemployment rate ticked down slightly to around 3.5% while wages ticked up 0.3% for December. Wage inflation is a problem that can throw a monkey wrench in what the Fed is trying to accomplish. In addition, there are still about 10.5 million job openings in the U.S. currently.
Many of the people being laid off from these companies will be able to find other work, though it may not necessarily be at the same pay scale or in the same field. And there will be some skill mismatch – engineers not wanting to move to retail sales, for example – but all indications are that the Federal Reserve is going to be able to engineer what economists call a “soft landing”. What the Fed wants is for the economy to slow down to rein in inflation. This is usually caused by a recession. In a “soft landing” situation, the economy manages to avoid a deep or long recession. I would submit that, given the labor shortage we currently are experiencing, any recession we have will not be your father’s recession. Unemployment is not likely to rise much above the 4% range – well below the 6% - 8% range for most of the past recessions.
So what worked this past year and what did not work? The one thing that did work was oil and gas. Between inflation, a relative return to a normal world and the Russian invasion of Ukraine, oil spiked from around $75 per barrel at the start of the year to as much as $120 per barrel by June before returning at year-end to about where it started. Oil stocks were all the rage. In fact, if you look at the best performing stocks in the S&P 500 Index for the year, oil stocks were nine of the top ten and 14 of the top 17 performing stocks before you start to get to a more diversified list of companies. Very little else worked as the only other sector to have a positive return for the year were the utility companies and only by DA1.65% for the year.
The three sectors that were off the most were communication services (Google parent company Alphabet, Facebook parent company Meta, Disney and Netflix, for example) which was down almost 41% for the year, consumer cyclical stocks such as Amazon, car dealers and travel and leisure companies with this sector off about 35% and technology stocks which tumbled 31.55% for the year. All of these sectors and most of these stocks fell into what advisors often call “growth” stocks. Growth stocks benefit when interest rates are low. The fact that these sectors fell as much as they did should not be a surprise in light of the interest rate situation. We managed to avoid individual stocks in these sectors during the year. The only exposure we had was through some of the mutual funds we held. We did cut most of our holdings in these funds throughout the year, but our one regret was not eliminating them all earlier in the year.
More important than what did or didn’t work this past year is what will or won’t work for the next year or two. Much depends upon how the economy shapes up, of course, but we have some clues based on history. As Mark Twain once said, “history doesn’t repeat but it often rhymes.” We have been going back through history to find time periods that were similar, though, in many ways, this time really is different. Structurally, the U.S. is in a different place now than it ever has been in history. That aside, there will be parts of the economy that “rhyme” with the past giving us clues as to what may and may not work.
As for client accounts, we avoided a lot of trading in the fourth quarter. The biggest moves we made involved the reallocation of fixed income holdings. We have finally settled on four different funds to use for exposure to fixed income (bonds). With rising interest rates during the year, this has been a tough sector to find what works. The four funds we are using include two that take advantage of rising rates by investing in bonds or loans that have adjustable interest rates. As interest rates increase, the income from these bonds or loans increases, leading to higher income to us as shareholders and a bit more stable price.
The two funds that benefit from rising interest rates are the Janus Henderson AAA CLO fund (ticker: JAAA) and the Wisdom Tree Floating Rate Treasury fund (ticker: USFR). Both funds ended up for the year with JAAA gaining 0.53% and USFR up 1.98% for the year. In addition to these two funds, we added two new funds to the mix. One is a nontraditional, “go anywhere” bond fund from T. Rowe Price. It is the Global Dynamic Bond fund (ticker: RPIEX) and this fund was up 3.6% for the year. The last fund we are using in our fixed income mix is not exactly what most investors would think of when it comes to “fixed income”.
When it comes to investing in fixed income securities, the idea is to earn a reasonable rate of interest that compensates for the risk over the time period you are holding the investment. If you buy a three-year CD, for example, you will want to earn a higher rate of interest per year than if you bought a one-year CD. The same should hold if you bought a bond that matures in five years. You would likely ask for a higher interest rate than for the 3-year CD or bond.
The fund we are using is the First Trust Vivaldi Merger Arbitrage fund (ticker: MARB). This fund invests in merger deals. These are deals where one company makes an offer to buy another company. When this happens, the price of the stock of the company being acquired will usually jump but there will still be a difference between the current stock price and the ultimate purchase price. As you get closer to the time when the deal will close, this gap narrows. Buying shares of the company to be acquired is a lower risk way to hopefully earn a fixed return. This return is usually related to prevailing interest rates rather than stock market performance. These types of investments have a low correlation to how the stock market performs and generally much less risk during down markets. In fact, this particular fund was up 3.89% for the year.
The only other significant trade we made was eliminating our holding in Ingles Markets (ticker: IMKTA), a regional grocery chain. We sold out of that near the end of November for about a 57% profit in a little more than the year we held the stock. It’s not that the company was doing anything wrong, but the price was getting well above what we calculated as its fair value. If things change, we will consider re-entering the position.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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