2022 was one of the more challenging years in investment history. We said a year ago at this time:
“ We see tough sledding on the horizon for 2022. History has been generally unkind to midterm election-year markets, and the confluence of the election cycle with what is a generally weak third year off a major bottom likely makes for a tough grind in 2022.”
Little did we know how prescient that would turn out, with 2022 being only the fifth year since 1928 in which both stocks and bonds declined. After such a difficult year, Balentine’s 2023 Capital Markets Forecast addresses the path forward, focusing on:
1. how the market got into this position in the first place and how things are likely to be different for investors going forward;
2. why a strategic allocation to the Quality factor may be a strong lever to drive alpha in such a difficult cycle; and
3. how to think about the trade-offs in private capital to help clients reach their goals in a cycle that is likely to be more meager in public markets.
As you delve into our writings, we believe it’s important to remember that the unorthodox monetary policy enacted from 2008 to 2021 is likely over. In the long run, we believe this new regime will bring about a world of higher prospective returns as things normalize from the world of low interest rates and low prospective returns since the Global Financial Crisis. Our writings are geared toward investment policies that we feel are not only relevant, but also likely requirements as the world adapts to a different regime. Like all adjustments, there will be some continued bumpiness on the back of the turbulence experienced in 2022; however, we expect there to be opportunities during the continued tumult and a more favorable investing world on the other side.
Picture it: it’s August 2020, and the S&P 500 has just reached an all-time high. If this had occurred in February 2020, we would have chalked it up to a typical day in the tremendous 2009 bull market as it was approaching its 12th year. However, from where we stand in August, the preceding six months have been quite the roller coaster ride: the pre-pandemic peak occurred in February 2020, then later that month through March, the S&P 500 crashed 34% due to concerns about the possible effects of the COVID-19 pandemic, and now, in August, the market has rebounded to 50% above the pre-pandemic peak.
The story gets even better: by the time the stock market peaks at the end of December 20211, it has experienced the greatest burst off a bottom in post-WWI history with a return of 119%, or 3.8% per month on average. And lest we think the story ends there, household net worth has exploded higher on the back of strong stock market gains, the value of consumer real estate has soared, and bank accounts are flush with cash. In fact, even in the face of the pandemic, the 2020 recession ends up the only recession to date where net worth increased.
Fast forward twelve months, and 2022 could be considered the worst combined year in history for equities and fixed income in capital markets — it is only the fifth time in the last 100 years2 that both equities (as measured by the S&P 500) and fixed income (as measured by 10-year Treasury securities) have exhibited negative total return in the same calendar year, as shown in Figure 1. This has occurred in response to the highest inflation the U.S. has experienced in the last ~40 years. So, how could something so right go so wrong? And what does this mean for the outlook in both the near term and over the next cycle?
Figure 1: Investment Performance is Driven by Economic, Business, and
Figure 1: Same-year declines in both stock prices and bond prices are quite rare
To understand how we arrived at our current uncertain, inflationary environment, we need to go back. Our story begins not with the pandemic in 2020, but with peak interest rates in late 1981-early 1982. Over the last ~40 years, the Federal Reserve (the Fed) has supported asset markets in the quest to stabilize not just asset prices but also the economy, the so-called “Great Moderation.” Falling interest rates were the major market driver during this period; the secular decline of interest rates was an extremely powerful tailwind in creating more value and wealth than there otherwise would have been.
Low interest rates couldn’t last forever. Following many years of strong stock market gains and relatively solid economic growth without inflation, the Fed’s 2020 monetary experiment3 to battle anticipated economic headwinds from the pandemic led to a burst in liquidity and, consequently, consumer demand. This extreme demand, when combined with pandemic supply shocks, led to an explosion in inflation for the first time in decades. Despite the Fed’s assertion that the inflation was likely transitory, by the end
of 2021, it became apparent that this was not the case. As a result, the Fed has implemented policy action and jawboning to normalize price level growth over the longer run and ensure that inflation expectations do not become completely unanchored, sacrificing capital market assets of all kinds in the short term — including but not limited to stock, bond, and housing markets.
Though the target of the Fed’s tightening campaign has been domestic inflation, its actions have had a global impact: the value of the U.S. dollar has surged due to the Fed’s hawkish monetary policy compared to that of other global central banks and international asset prices have struggled as a result. Because the Fed is intent on preventing a stop-and-go monetary policy like that of the early 1970s, it likely will not stop tightening monetary policy until its job is done, regardless of the effect of higher-than-tolerable unemployment or credit stress on capital markets.
1~16 months after reclaiming the pre-COVID highs.
2along with 1931, 1941, 1969, and 2018
3The Fed’s actions were a true experiment — unprecedented in the history of monetary policy.
How will this tightening campaign affect capital markets over the next seven years? Looking in the near term, though equity markets have dropped significantly in the past year, the peak decline so far is commensurate with prior “garden variety” declines. The difference for investors today is the environment surrounding this decline.
For 15 years, the Fed employed a policy uber-supportive of asset prices, but in March, it did an about-face and began a rapid tightening campaign, with the rate hikes in May being greater than 25 bps for the first time since 1995. The investment-friendly interest rate and liquidity policies experienced during the “Great Moderation” era and the aftermath of the Global Financial Crisis is likely over; as a result, the tailwind that pulled investors along for the ride is no longer going to be there. Moreover, that tailwind has likely turned into a headwind as money and credit will be in lower supply. With this context in mind, we believe investors will need to reset their perspectives from a mindset of abundance to a mindset of scarcity for the next seven years. Within this scarcity mindset, it becomes important to practice discernment when selecting stocks because there will be more dispersion among their performance.
Having said that, though we can never know for sure what is ahead in the markets, history suggests to us that we can look for patterns to help us make projections — in fact, our datadriven investment model is grounded in this principle. In recent years’ forecasts, we would note that when assets have corrected, it generally leads
to better opportunities looking forward. So, while the reader of our prior forecasts may have expected us to speak more optimistically about future returns given 2022’s declines, our study of the market leads us to believe that this new regime will likely be more modest, though there will be both opportunities and challenges posed by the uncertain environment ahead.
As mentioned earlier, 2022’s declines would seem to suggest that both equities and fixed-income securities are in a better position to generate returns over the long run after declines in 2021.
▶ Equities: On the equity side, valuations as measured by both the cyclically-adjusted P/E (i.e., CAPE) and forward P/E ratios declined by ~25% during 2022, driving equity valuations to their lowest level since 2017 (excluding the ephemeral equity valuations after the pandemic market crash).
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Fixed Income: Securities are yielding more across the entire yield curve, as can be seen in Figure 2. Right now, an investor can earn ~4% per annum without taking any risk in duration or credit. Additionally, there are municipal securities with taxable yield equivalents of 6% that come from cities and counties with solid credit; it has been over 15 years since we saw fixed-income returns that compelling.
However, it could be argued that opportunities in both fixed income and equities look compelling only in comparison with the dreadful opportunities presented to us at the end of 2021. Although the bulk of the equity market declines to date have taken place within longer duration, higher valuation stocks — especially those with little to no earnings — we believe all equities will need to adjust further downward to account for the new environment. For fixed income, a higher inflation environment in tandem with the Fed’s balance sheet runoff will likely hamper bond appreciation moving forward. In addition, further tightening by the Fed would lead to additional declines in fixed income while equity valuations are still elevated compared to valuations at prior equity market bottoms (Figure 3). Put another way, if the Fed keeps up its tightening campaign, then today’s compelling valuations really won’t seem so compelling in hindsight.
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When the Fed raises interest rates, what are the implications on investments? Classic theory suggests higher interest rates, all else equal, means lower stock prices.3 Most of the time, this is true — stock prices decrease because there is competition for capital, and all else equal, investors are less likely to choose stocks if risk-free interest rates are higher unless they are getting compensated for the risk in the form of higher risk premia. Generally, this occurs during periods of rising rates accompanied by sharp inflation. As a result, equity valuations will structurally decline, which generally manifest themselves in the form of lower valuations. In Figure 4, we can see how the valuation of stocks declined in the 1970s, as inflation became structural and embedded.
However, stock prices sometimes increase within higher interest rates. If rates are rising because the economy is improving and, as a result, demand for capital is driving up the price of capital via higher interest rates, then stocks will likely view the rising rates as a positive and will likely rise as a result. This happened, for example, in the 1950s and 1960s after WWII finally pulled the economy out of the grips of the aftermath of the Great Depression several decades earlier, as shown in Figure 5.
Overall, the impact of interest rates on stock prices is mitigated by the rate of inflation. In the 1970s, rising rates accompanied sharp inflation and led to decreased stock prices. In the 1950s and 1960s, rising rates accompanied low inflation and led to increased stock prices.
3The value of a financial asset is measured by discounting future cash flows back to the present value. Increased interest rates create a higher overall discount rate — and the financial asset value therefore decreases.
Figure 5: Rising rates, in themselves, do not necessitate equity weakness
S&P 500 Performance When the 10-Year Treasury Rises by at least 1%
Starting Date Ending Date Starting Yield Ending Yield Return 1/1950 6/1953 2.3% 3.1% 80.9% 7/1954 10/1957 2.3% 4.0% 60.7% 4/1958 1/1960 2.9% 4.7% 40.4% 5/1961 9/1966 3.7% 5.2% 70.8% 3/1967 5/1970 4.5% 7.9% (1.9%) 11/1971 9/1975 5.8% 8.4% 2.8% 12/1976 3/1980 6.9% 12.8% 18.4% 6/1980 9/1981 9.8% 15.3% 11.4% 5/1983 6/1984 10.4% 13.6% (1.5%) 1/1987 10/1987 7.1% 9.5% 6.7% 10/1993 11/1994 5.3% 8.0% 2.2% 10/1998 1/2000 4.5% 6.7% 39.5% 6/2003 5/2006 3.3% 5.1% 39.1% 7/2012 10/2018 1.5% 3.2% 127.2%
Source: FactSet and Balentine
In past cycles, the Fed’s monetary policy, both loosening and tightening, has focused on setting interest rate levels, which tend to affect businesses and economic growth directly and Wall Street indirectly. However, given the extreme conditions in 2008 that were not responding to the usual policy of lowering short-term interest rates, the Fed took the unprecedented step to purchase assets. These actions to ease monetary policy beyond the ability of merely lowering interest rates was dubbed “Quantitative Easing” (i.e., QE). Because of this, the Fed’s tightening campaign this time around is also focused on decreasing the assets on the central bank balance sheet and the amount of money in the economy, or Quantitative Tightening (i.e., QT), in addition to standard interest rate hikes. Decreasing its balance sheet will serve to reduce the monetary excesses assumed over the last 14 years. While interest rate hikes tend to affect the economy more than capital markets, balance sheet reduction will have a more direct effect on capital markets than on the economy (though both will be affected to a degree) via removal of liquidity in the system. Balance sheet growth was a big reason asset prices rose so sharply over recent years in the absence of huge productivity gains in the economy, a dynamic that is likely now to run in reverse.
These opportunities and challenges could cumulatively impact the market in a few ways over the next 7–10 years:
Bifurcation in Economy and Asset Prices. Asset markets can deviate from the real economy; in fact, capital markets tend to lead the economy. However, there is another possibility that demonstrates an even more extreme dynamic between the markets and the economy than mere time lag: it is not far-fetched that we will see a larger bifurcation in magnitude or even the economy and asset prices move in disparate directions. This dynamic, similar to what was experienced in the 1970s (as shown in Figure 6) and a reversal of the 2009–2021 market dynamic, could mean that while the economy experiences decent nominal growth, stocks may struggle — sometimes the stock market rises faster than growth in both GDP and earnings per share, which is a function of multiple expansion5. This is often a function of increased liquidity in the system burning a hole in investors’ pockets as they watch markets rise, thereby begetting even further buying.
Recession. Of course, excess liquidity in the market could also induce a bear market, as it is slowly expunged from the system, perhaps accompanied only by a mild economic or consumer recession. Markets move towards equilibrium, and a bear market is needed to remove the liquidity added to the system in early 2020 to stave off the possibility of a pandemic-induced depression (Figure 7). Recall that during the QE era over the last 14 years, QE was perhaps the primary mechanism to stimulate investment and hiring. Consequently, markets spurred by larger-than-normal multiple expansion, rose robustly, and it is likely the same will be true in reverse during QT. The economy and hiring may eventually slow through reduced corporate investment as the cost of capital rises, but this is by no means a given, just like robust expansion was not a given during QE. Under such a scenario, a more substantial decline in asset prices may be needed to generate a demand slowdown.
Figure 7:
There is still a large amount of liquidity in the monetary system remaining from the Fed’s pandemic-induced injections
With the decline we have seen to date in 2022, many pundits continue to suggest that markets are falling due to recession fears, but if the aforementioned 2010–2019 liquidity feedback loop merely reverses itself, it will not be necessary for the economy to slow very much, if at all, for capital markets to stagnate or even fall. This would be at odds with recent history, where investors have seen demand-driven downturns associated with recessions in, for example, 2001 and 2008. In fact, we see many similarities in the present downturn to that of the 1970s. Recall what we showed in Figure 6, that GDP and earnings per share grew robustly for the most part in the 1970s, but equity markets went nowhere, point to point.
In the next 7–10 years, we posit that a similar environment to the 1970s, one in which the slowdown is not demand-driven, could take hold for the following reasons:
▶ Strong Consumer Health. Even with the Federal Reserve tightening, consumer health could remain relatively strong given:
1) low leverage on consumer balance sheets and many mortgages locked in at very low fixed rates and 2) strong employment markets.
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Consistent
Government demand will likely not diminish substantively via fiscal austerity. If anything, deficits may rise as treasury yields rise and transfer payments increase to offset the pain of inflation, which ironically will perpetuate inflation by lessening any decline in demand. Under such a scenario, the demand decline would come from stultifying corporate investment, which would be the only remaining lever outside of consumer and government spending.
▶ Government Deficits. As government deficits rise to pay for transfer payments in an environment where the Fed is no longer buying —and may even be selling — bonds, a failure to reduce government deficits in proportion with the Fed balance sheet runoff may have a crowding-out effect on liquidity in addition to the direct liquidity pressure coming from the Fed shrinking its balance sheet.
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Corporate investment decline would eventually filter to the top lines of corporate revenues (on cuts in capital expenditures) and the top lines of consumers (on cuts in the labor force).
As we have said, we do not expect this to be an exact repeat of the 1970s, but we do expect there to be certain similarities:
Vacillating Capital Markets. The most important similarity between the potential environment ahead and the 1970s is that, as inflation vacillates and figures out its new range, capital markets are likely to do the same. This is precisely what occurred in the 1968–1982 bear market; when the stock market eventually bottomed in 1982, stock valuations roughly matched the 1968 peak. In other words, for 14 years, stocks experienced many ups and downs as circumstances and levels of certainty changed and evolved; however, the net result was stocks ultimately ended up at the same valuation where they started (Figure 8). If today’s market rose and fell by the same percentages as it did in this period, the S&P 500 would vacillate widely, starting at 4766, hitting a relative minimum at 2795 and a relative maximum at 6180 before settling at 4710 (Figure 9). If the market follows this pattern, it would create opportunities for some trades over cycles but does not present a secular growth opportunity like we saw during the almost 14 years between March 2009 and December 2021. We don’t expect this level of volatility, but we do expect directionally this to be more the case than what we have seen over the last 40 years where there have been more sharply defined bull markets and bear markets.
Figure 8: While the 1968-1982 market did not rise point-to-point, there were pockets of opportunity in a volatile path
9: If today’s market rose and fell by the same percentages it did from 1968–1982, it could create trading opportunities. 4766 3198
5192 2795
6180 4710 2200
S&P 500 1968–1982 (Left Axis) S&P 500 Projection (Right Axis)
Source: FactSet and Balentine
Falling Asset Price Multiples. In a higher inflationary environment, asset price multiples typically fall, as investor confidence in the sustainability of earnings is lowered, which may lead to investors’ reduced willingness to pay for those earnings streams. However, investors over the past 40 years or so have been investing in an environment with low inflation and low cost of capital — generated by a savings glut creating excess capital. Early indicators signal we have transitioned into the opposite environment post-pandemic: higher inflation and an increasing scarcity of capital, driving yields higher and stock multiples lower in a secular bear market that lasts 10–15 years, à la 1968–1982. And we stress again, a secularly stagnant stock market, albeit with cyclical bulls and bears, can happen independently of the state of the economy (as measured by GDP) or earnings (as measured by index earnings per share), especially when multiples and interest rates have yet to fully adjust after an era of tremendous monetary and fiscal excesses. Of course, we cannot say for sure this will be the case, but the ingredients are there, especially with current multiples well above historical lows (as we saw in Figure 4) and with rates still closer to the lower end of the historical range, as we see in Figure 10.
During the last 40 years, bonds provided the necessary offset to equities as their prices rose (i.e., yields fell) while stocks declined, and we do not believe they will be as reliable for investors during this inflationary adjustment period. If you look at the total returns from bonds in the 1970s, the numbers look good on the surface. However, upon deeper inspection, we see that the total return was driven by strong starting yields, which was offset by capital depreciation as interest rates rose. We expect similar price action from bonds now, but the important difference is that starting yields today are much lower. So, although investors lost some principal value as rates rose in the 1970s, they were compensated enough in the elevated starting yields. This is not the case now — 2022, which started from near-zero yields, was the worst year for bonds on record.
Bond prices did not provide the desired volatility buffer during the stock declines in the 1970s. So, while starting yields helped to offset declines in the portfolio, bond prices did not. With the 10-year yield now between 3.5%–4.0%, we are at a point where starting yields are beginning to be attractive enough to dampen portfolio volatility, but unfortunately not likely high enough yet to provide the necessary volatility smoothing for an investor without even higher starting yields.
That is not to say that bonds will underperform stocks; quite the opposite actually — bonds are still likely to outperform stocks. However, outperforming with positive correlation (i.e., going down by less rather than going up) will likely not provide the diversification necessary to smooth the portfolio volatility to the desired level. So, during the time, the role of fixed income in portfolios may now be less about smoothing the volatility of the portfolios and more about receiving yield on the investment while investors look for other ways to smooth volatility.
So, how does one to invest in such an environment? We think there are three points to guide investing during this time, which are already integrated into our investment process:
1. There will be opportunities. During the 13.5 year period between December 1968 and August 1982, the S&P index went down 36%, up 74%, down 48%, up 127%, and finally down 28%, for a total return of -6%. So even though the market was essentially flat over the period, there were certainly opportunities to generate return, both absolute and relative. This is where our Stocks vs. Bonds process should allow us to take advantage of cyclical upswings within the potential for a structurally stagnant period.
2. Old playbooks are not likely to be relevant; in fact, it is more than likely that they will be counterproductive, giving a false sense of confidence. Investors will need to think differently. This idea of trying to buy the dip in technology stocks is not going to get it done in an inflationary environment. It will take looking for new ideas, as history suggests that new leadership emerges in new bull cycles:
▶ Technology peaked in 2000, bottomed in 2002, but didn’t begin to outperform the rest of the index until 2006.
▶ Financials peaked in 2006, bottomed in 2009, but didn’t begin to outperform the rest of the index until 2020.
▶ Energy peaked in 2008, but it didn’t bottom or begin to outperform the rest of the index until 2020.
This is where our Equity momentum models should allow us to take advantage of the cycles in new leadership while giving us the ability to quantify when those relationships are no longer poised to outperform.
3. The market will experience a paradigm shift. Fixed income will likely be more about generating true income and less about lessening portfolio volatility. In a stressed liquidity and likely inflationary environment, it will take owning equity securities with high enough dividend and/or buyback yields that they offset the downdraft of multiples and can be reinvested/compounded, such as, for example, equities of the highest quality factor (which we will flesh out further later in this Capital Markets Forecast). We expect this to be the case even if QT does not bring about a significant credit event like the failure of Lehman Brothers in the U.S.6. It is our more recent approaches such as implementing specific U.S. sectors and positioning aspects of certain portfolios toward a more quality bias that should allow us to take advantage of these more granular aspects to this period.
Keeping these three tenets as the core of our playbook should allow our portfolios to weather the tough secular stretch and come out well on the other side while we actively plan for the next secular cycle.
6We would note that we will likely continue to see failures such as what almost occurred in British pension plans and what did, in fact, occur with FTX. However, we do not expect anything akin to the 2008 episode, at least here in the U.S. As central banks continue their quest to defeat inflation, would not yet preclude such an occurrence in other areas where there may be risk in, for example, floating rate mortgages, areas with more extreme real estate bubbles, and the old wounds of the fixed currency Eurozone.
Investing in the market can sometimes feel like riding a roller coaster: sudden peaks and drops in a volatile environment may inspire excitement — and fear — for roller coaster passengers and investors. Unlike roller coasters, which have wooden supports that create a fixed path regardless of the feelings of passengers, economic and business cycles can shift unexpectedly, catching investors by surprise, and those “surprises” can cause a wild swing of asset prices in the market.
To understand how investor sentiment affects asset prices, we first need to understand the way the economic and business cycles shape the markets. On the highest level, the economic cycle and macro environments can influence monetary
policies, which directly impact credit conditions that alternate between irrationally generous and unfairly restrictive. These economic and credit conditions lead to a business cycle marked by rising and falling sales and profits. In turn, the intrinsic value of the financial assets associated with sales and profits rises and falls. In Figure 1, you can see this concept illustrated visually. The green line represents secular cycles, which last for 10-30 years. Within that cycle, many business cycles, represented by the blue line, occur. These can last from 1-10 years each, evident here by the peaks and troughs. Additionally, the stock market, represented by the black line, fluctuates up and down within the context of the secular and business cycles.
Investor psychology also comes into play at the financial market level. During enriched investment cycles with ample low-cost capital, investors are more likely to take outsized risks and tolerate hefty valuations just to gain the “last mile” of return. Since the economy and, in aggregate, businesses, can be cyclical and the market tends to revert to the mean over time, when business and investment environments come down from their high points, they expose poor investments that cause outsized losses. Investor greed turns
to fear as they sell the perceived risky assets to embrace safety, which causes valuations for financial assets to drop below their intrinsic value — imagine individual slats of the roller coaster track collapsing.
These swings between greed and fear create a more volatile market cycle that fluctuates greater than “fundamental” economic and business cycles, causing asset market value disconnected from fair value, thus creating investment opportunities.
Belief # 1 Investors rarely go directly from feeling Fear to Optimism
Belief # 2 Market behavior tells us how investors feel
At Balentine, our data-driven investment process analyzes these cycles and looks for patterns to maximize the possibility of clients achieving longterm investment goals. As we look ahead and anticipate the conditions of the capital market over the next five to seven years, we see changes on the horizon: higher market volatility and limited valuation expansion due to high inflationary pressure, higher interest rates, uneven global
economic recovery, and geopolitical unrest. These conditions signal to us that investors should focus on optimizing portfolio construction and asset selection to weather these tough times — and for strategies that allocate a passive beta-like core, we believe implementing quality as a core will enable the strategy to capture the potential alpha in the new paradigm more effectively.
For the past decade, a low-rate environment drove down return on investment at the safe end of the risk curve and provided the fuel for investors to take outsize risk. Financial innovations have often taken place when people with abundant cheap capital chase the desire to get rich quickly; bearing higher risk generally produces higher returns. Unfortunately, this risk means that the promises that entice investors to commit don’t always come to fruition. In fact, there are ample examples throughout financial history:
1960s–early 1970s: With “Nifty Fifty Investing,” demand for growth and popular stocks was high, pushing the valuation to an unreasonable level in the early 1970s and precipitating the subsequent market crash.
1980s: Financial innovations like portfolio insurance led investors to believe they could enjoy the appreciation potential that comes with large commitments to equities with less risk. It took the stock market crash to expose the true nature of such innovation.
1990s: High-flying dot-com, e-retailer, and media aggregation stocks brewed the so-called tech bubble. Between March 2000 and October 2002, the NASDAQ fell from 5,048 to 1,139, erasing nearly all its gains during the dot-com bubble. By the end of 2001, most publicly traded dot-com companies had failed.
2000s: Subprime mortgages were granted without background checks, packaged in structured products so complex no one understood who assumed the risks, creating The Financial Crisis concurrent with a 50 percent peak-to-trough drop in stock prices between October 2007 to March 2009.
Similarly, in the past few years, investors believed digital tokens and pandemic stocks would be successful forever and invested heavily. As the Fed shifts monetary policy from accommodative to restrictive, capital markets shift from an environment of low inflation, low rates, and elevated valuations to an environment of higher trend inflation, higher rates, and modest valuation. In turn, many poor investments have crashed and started to file for bankruptcy. This new regime calls for a strategic shift in portfolio positioning.
Quality-based investment strategies aim to capture the excess return of high-quality stocks over low-quality stocks. They focus on quality factors, strong business fundamentals typically associated with profitable companies with low leverage and stable earnings. We believe there are three key benefits for quality-based
As the capital market transitions to a new regime with the greater unknown, asset durability will be tested. A quality-focused core may allow investors to be more tactical with other risky assets, thus generating a different kind of alpha than previous decades.
We believe introducing quality-based investments as the core of one’s investment strategy will expand the ability to capture tactical opportunities within this new market environment.
Standard factors such as Growth, Value, Momentum, and Size; as well as some strategies, such as those with leverage, were able to produce strong returns by taking extra risks when the market was in a favorable condition. Still, taking on extra risk can be a double-edged sword and accelerate loss during a restrictive and stressed market environment where investors seek stability the most. One of the key benefits of qualityfocused investments is downside protection. Historical data shows quality factors’ ability to produce excess return beyond systematic risk during severe economic and market downturns — a characteristic vital to survival. Consider Figure 4: We aggregated all the relative return
and performance volatility data for various factors between 1994 to 2022 when the equity benchmark MSCI ACWI Index had a negative monthly return. Within that period, the quality factor, represented by MSCI USA Quality, had the best relative return against MSCI ACWI Index with the lowest return volatility among other common factors such as value, growth, and momentum. An investor who had systematically overweighted the basket of quality-focused investments over this period would have earned a substantial premium. Please note: the characteristics measured below are only present in months where our benchmark, MSCI ACWI Index, had negative returns.
Figure 4: Relative return and volatility during negative market return environment (1994–2022)
7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 7.5% 8.0% 8.5% 9.0%
MSCI USA Quality 6.0%
Relative Return to MSCI ACWI 9.5%
Russell V, 4.5%
MSCI USA Momentum, 3.6%
MSCI ACWI, 0.0%
Return Volatility
Source: Bloomberg, Balentine
Russell G, 0.5%
10.0% 10.5% 11.0%
How are these quality-focused investments selected? In essence, companies with high profitability, lower financial leverage, and consistent earnings power are likely to withstand adverse economic and business conditions better than the broader equity market. Figure 5 illustrates the key business metrics between the top 20% of companies with high quality score vs. the bottom 20%. Strong business foundations also lead to tangible shareholder returns enhanced by dividends and dividend growth.
Figure 5:
40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0%
Years
Profitability Comparison
In addition, high-quality companies also tend to deliver strong shareholder returns in terms of dividends and dividend growth. Based on assessment of available historical and consensus estimated dividend data from Bloomberg, the U.S. Quality Factor Index has a projected average dividend growth rate of 10.4% a year, higher than both U.S. large cap (S&P 500 Index) and Global large and mid-cap (MSCI ACWI Index), which had 7.4% and 4.6% respectively (see Figure 6). Despite a tough economic and financial market in 2022, the consensus still estimates a 22.3% dividend growth for the U.S. Quality Factor Index for the current year. Higher dividend growth rate above expected inflation can serve as an ideal inflation hedge for dividend income.
Though quality is present in every asset, quality investments in fixed income means treasuries and investment-grade bonds.
Investment-grade and high-yield credit markets are on pace for their worst year on record as 2022 was defined by a surprisingly hawkish monetary policy and sticky inflation with resilient growth. However, the treasury market could react differently when a true economic crisis presents itself – proving itself as an effective hedge against credit risk.
Treasuries are a reliable “flight to quality” asset — as the debt obligations are issued by the Government and secured by the full faith and credit of the country, they have essentially no credit risk. The longer-dated treasuries might be sensitive to interest rate risk, but their long duration effectively reduces re-investment risks when the near-term capital market condition is highly volatile. In addition, central banks are more
likely to provide accommodative monetary policy by cutting interest rates to stabilize and stimulate the economy to provide a tailwind for the assets.
Consider the past 35 years, the 10-year treasury began recessions about 1% above the trend from 1986, rallying eventually to 1% below the trend, usually reaching a trough after each slump. Although the multi-decade downtrend has broken, a 2% drop in 10-year yields is still a likely path over the course of the next cycle. Investors will likely stay invested in long-dated treasuries as a hedge against recession risk and for a potential tailwind for price appreciation, as they are likely seeking some safety amidst economic challenges and await the full effect of the most intense Fed monetary rate hike in recent history. Figure 7 demonstrates the long-held Treasury yield path during true economic stress. Here, you can see recessions shaded in light green.
Source: Bloomberg, Balentine
Federal Funds Target Rate Mid Point of Range - Last Price
- Last Price
If you look outside of the recession and severe market correction periods to consider long-term benefits of the Quality factor, you will notice its superior risk-adjusted return that can be implemented on a standalone basis and serves as a diversifier.
The quality factor produces one of the highest average returns for the past 15 years (2007–2021) with one of the lowest return variations or volatility when compared to other identified factors. Figure 8 illustrates this point by showing different factors in a calendar year for the past 10 years with a 15-year average return ranked from the highest to the lowest. It also ranks the performance volatility from the lowest to highest as preferred side by side to see the most desirable outcome — superior risk-adjusted return.
Figure 8: The quality factor produces one of the highest average returns for the past 15 years with one of the lowest return variations or volatility when compared to other identified factors
Source: Bloomberg, Balentine
Since there is no single identifiable metric that can consistently explain quality’s unique return superiority, there is no consistent definition for it. The most common metrics used to measure quality are profitability, earnings stability, capital structure, and return on investments. Through research findings, the correlations of returns among those individual metrics reveal a lack of similarity, indicating they are not proxies for a common factor, but rather a collection of heterogeneous attributes linked by the theme of financial and return quality. Therefore, quality is more appropriately interpreted as multi-factor portfolios which can invest on a standalone basis or implemented as a diversifier with other factors.
The other key test for quality as a core is its pervasiveness — its time and geography. Quality investment is hardly a regional phenomenon. When measured by a 15-year information ratio, which measures risk-adjusted returns above the returns of a benchmark to the volatility of those returns, quality leads each region compared to enhanced value, momentum, and low volatility factors (Figure 9).
Figure 9: When measured by 15Yr information ratio, quality leads each region compared to enhanced value, momentum, and low volatility factors
1.00 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40
Source: S&P GlobalEnhanced Value Global U.S. Europe Asia Quality Momentum Low Volatility
After 10-plus years of easy money, loose credit policy and consistent economic growth, macro conditions have started to quickly deteriorate in the U.S. and globally. As we look ahead and anticipate slowing economic growth, a sharp increase in short-term interest rates, and tightening credit and liquidity conditions, the path to normalization will be highly dependent on how long it takes for inflation to get back to normal. This could take a while, for reasons we mention in the first article.
In these uncertain times, before the next secular trend emerges, there is potential for alpha. In loose monetary policy times, capital is devoted to innovative investments, many of which fail the test of time. In times of crisis, finding alpha is vital to survival so that investors may achieve financial goals over the long run. We believe investors should practice discipline and focus on the durability of investment assets when the capital market environment calls for extra caution, and we believe emphasizing quality as a core can be a strategy to satisfy this need. Incorporating the stable and durable core expands the strategy’s ability to capture tactical investment opportunities, which may lead to a more predictable and repeatable investment experience.
Life is full of trade-offs — and investing is no different. Balentine navigates these trade-offs for our clients in multiple ways, and accessing private capital is one of them. When considering private capital investments, which are the equity and debt of private companies and real assets, Balentine acknowledges the following three trade-offs: diversification, access, and fees.
Diversification in private capital is advantageous in tightening the cone of outcomes. Consider venture capital. According to a 2012 Harvard Business School study, 75% of venture companies fail. This begs the question: Why would anyone invest? The answer is the benefit received from the 25% of venture companies that do succeed typically outweighs the losses from the 75% that fail. Investors need to consider this asymmetry of outcomes when approaching the asset class. Would they prefer rolling the dice on one venture company, or would it be prudent to invest in 20 or even 100 of these companies to make the outcome non-binary?
As for access, success begets success. Private capital managers who have long track records of performing well are often brought the best deals and their funds are often closed to new investors. It is not a coincidence that the general partners who helped grow companies like Apple, eBay, and Facebook are still relevant and performing well today. It is also not a coincidence that there is not a “Click Here To Invest” button for the general public on their websites.
This leads to another parallel truth: There is no such thing as a free lunch. Investors who seek diversification and access will have to pay for it with an additional layer of fees. These trade-offs are evident when one considers the four main ways to access private capital, ordered from lowest diversification and fees to highest diversification and fees in Figure 1.
a. For an additional layer of fees, investors can commit to a fund manager who then turns around and commits to a number of other fund managers. This creates diversification as it would take multiple funds failing for the investor to lose money.
b. Ideally, the fund of funds manager has access to the best fund managers who typically are capacity constrained and not easily accessed by the average investor.
c. The goal is that the top-level access and diversification are worth the trade-off of paying higher fees.
a. Investors can forgo the additional layer of fees, diversification, and access fund of funds provide by investing directly into one fund. A certain level of diversification still exists as a fund will typically invest in 10–20 assets.
b. The goal here is that individual fund managers can outperform the fund of funds through fewer fees and a more concentrated approach. The downside is that the investor can be exposed to negative outcomes in the case that one manager fails to perform.
a. Moving beyond funds, investors can invest in deals alongside the fund managers who have additional capacity for companies or assets. This occurs when managers are at the end of the investment period and lack the dry powder to invest fully, or if the check they need to write is oversized for their fund.
b. Often in private equity (less so in venture), these deals can exclude management and performance fees, which represent an advantageous way for investors to dial up their private exposure.
c. The other advantage is the company or asset is fully managed by the general partner of the investment, who is typically well-aligned to deliver a good outcome.
a. Direct deals are one-off investments that are typically sourced from an investor’s network or family or are presented to Balentine by so-called “fundless sponsors,” knowledgeable individuals looking for opportunities who do not have a committed fund. On the surface, they look like co-investments, but require two additional considerations:
i. Who is managing the asset? General partners will typically take board seats or have control of the asset in fund investments. If an investor is passive in the company or asset, they are relying heavily on the management team of the asset to execute.
ii. Why is this deal being shown? There could be a reason no fund manager wanted to do the deal or buy the asset. It is crucial to understand why — and how — the deal has made it into the investor’s view.
Both co-investment and direct deals land on the far end of the spectrum of diversification. While fees may be low, diversification is non-existent. A failure of the company or asset represents 100% failure in the investment.
Figure 1: Accessing private capital is a trade-off between diversification and fees
Trading off fees for diversification and access.
Forgoing a layer of fees for less diversification. Important to ensure the investor has access to superior funds.
Forgoing all fees for no diversification. Protection in the form of GP managing the deal.
Forgoing all fees for no diversification. Beware of lack of professional management.
When considering private investments for clients, Balentine seeks a balance in these trade-offs. To gain broad access to an asset class, we will use the fund of funds model. This allows one check from an investor to be diversified across multiple sub-asset classes, vintages, and stages of funds. This tends to be an investor’s first, and sometimes only, investment. This increases the chance the cone of outcomes is narrow and the extra layer of fees is worth the diversification.
Another area where we use the fund of funds model is in venture capital. With many of the top quartile managers closed to new investors, the fund of funds model is our attempt to gain access to the next wave of world-changing companies.
Once an investor has a solid and diversified core, Balentine then employs direct funds to sharpen access to private equity, real assets, and debt. We look for managers who are investing on one of our four intergenerational themes1 and have a material track record of doing so. We lean on our experience and process to mitigate the risk of higher concentration as well as our long-standing relationships in the market to gain access to high-performing managers.
In an attempt to deliver even further concentration and return, Balentine will seek to co-invest with our managers in the deals in which they have capacity. This brings down the overall fee of the full investment and gears clients’ portfolios toward the potential high-return companies or assets. We prefer this method over direct investments, as we can lean on the general partner’s expertise and alignment to move the company or asset along its needed path. This is not to say we will not recommend direct investments that are not co-investments, but the bar will be high.
In search of optimizing these trade-offs, Balentine creates investment structures that allow our clients to receive the best of diversification, access, and fees. This structure allows us to invest capital across multiple funds and co-investments without the additional management fees that fund of funds charge. This will also broaden the landscape of funds available to our clients as some hard-to-access managers require high minimums to invest. Our most recent fund was created to access the decarbonization of our energy stack theme. In 2023, we will launch another structure to take advantage of the opportunities we see in the credit markets.
Navigating the trade-offs that exist in the private capital markets can be the difference between a favorable and unfavorable outcome. Balentine’s experience allows us to understand when to ask clients to pay for diversification and access as well as when to accept concentration and risk. We appreciate he trust our clients place in our judgment as we seek to be discerning in a world of scarcity.
1See Capital Markets Forecast 2022 for more detail.
Future market returns — specifically, projected income and projected adjustments to valuation — are a function of starting point. Therefore, we provide an annual update to our forecast of capital market returns. The goal for this strategic forecast is to update our outlook to account for year-over-year changes to the starting point of the new seven-year cycle. These forecasts offer a little insight into the tactical outlook over the next year or so, but rather a more strategic outlook over the next seven years.
A year ago, Value stocks were in a much stronger position to deliver superior returns, owing mostly to superior starting valuation and dividend yield. While the disparity between Growth and Value valuations narrowed during 2022, a disparity remains. As a result, the valuations in U.S. Large Cap Growth continue to contemplate earnings growth that, if history is any guide, is likely to overstate what will actually come to pass.
Based on our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, better meet our clients’ objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2023 and beyond.
Our update includes answers to the following questions:
What public market returns are realistic during the market cycle?
What risks may have to be assumed to capture those returns?
What opportunities do investments in private markets have to offer?
Yield
Cash 3.8%
YTM Duration
Bloomberg Barclays US Aggregate 4.3% 6.2
Bloomberg Barclays US Treasury 3.8% 6.1
Bloomberg Barclays US (7Yr–10Yr) 3.7% 7.7
Bloomberg Barclays Municipal Bond 3.6% 6.1
Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade 5.1% 7.2
Bloomberg Barclays US Aggregate Credit - Corporate - High Yield 8.5% 3.9
Bloomberg Barclays US Treasury Inflation Protected Notes (TIPS) 4.0% 5.2
Bloomberg Barclays Global Aggregate 3.5% 6.7
JP Morgan EMBI Global Diversified 8.2% 7.4
MSCI All Country World (Global equities)
3.2%–8.1% 16.5%
Russell 1000 (U.S. Large Cap) 2.0%–8.3% 14.5%
Russell 1000 Growth (U.S. Large Cap Growth) 1.4%–7.7% 16.0%
Russell 1000 Value (U.S. Large Cap Value) 2.6%–9.0% 13.0%
Russell 2000 (U.S. Small Cap) 3.4%–9.8% 19.2%
MSCI EAFE (International Developed) 4.6%–11.0% 17.0%
MSCI EAFE Small Cap (International Developed Small Cap) 5.2%–11.7% 19.7%
MSCI Europe 3.4%–9.8% 17.0%
MSCI Emerging Markets 7.3%–9.5% 23.5%
Return Risk
Cambridge PE
Source: Balentine
8.2%–13.1% 9.5%
2022 was a pivotal year for the capital markets. The key takeaway from our experience and research is that while things are likely to be more challenging going forward, there will be opportunities for investors. However, unlike the years after the Global Financial Crisis (GFC) where the idea was to ride the overall market with some ancillary tactical implementations, the last 2–3 years have shown that practicing discernment will likely be required, as the post-GFC playbooks will likely be less relevant. Steps taken to recalibrate our portfolios include, but are not limited to, gearing our strategic allocation toward the Quality factor, higher risk budgeting to the more tactical portion of the public portfolio, continuing to implement strong private capital portfolios, and not succumbing to the temptation of alternatives, which, despite this year’s significant drawdown in equity markets, have not offered enough downside protection in down years to compensate for their underperformance in up years. Additional steps are likely to follow in the coming years as the investment environment sorts itself out, and we are optimistic that these additional steps will be accretive in such an environment, as they were in 2022.
The opinions expressed are those of Balentine. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Balentine or any non-investment related services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Past performance may not be indicative of future results. This information should not be considered
a recommendation to purchase or sell any particular security. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.
Balentine is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services can be found in its Form ADV Part 2, which is available upon request.
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