Photo Credit: Fauzan Saari
INVESTMENT ENVIRONMENT
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Source: Orion Advisor Services, AlphaGlider
After a bruising first nine months for global investment markets, investors returned to full risk-on mode during the last quarter of 2022. Global stocks, as measured by the total return our equity benchmark, MSCI ACWI IMI,^d bounced back nearly 10%. Foreign developed markets led the charge, up over 17% as measured by MSCI EAFE.b US stocks lagged, but still performed well in absolute terms — the S&P 500a was up a respectable 7.4%. The bond market was also strong during the quarter with our fixed income benchmark, the Bloomberg US Aggregate,e expanding by 1.9%.
Despite the strong fourth quarter, both global bond and equity markets were hammered over the last 12 months. The total return for global stocks was -18.4%, with foreign emerging markets doing slightly worse (MSCI Emerging Markets was -20.1%), and foreign developed markets doing slightly better (-14.5%). The US equity market, which performed inline with the average of global markets, experienced its seventh worst calendar year in history.
Bonds usually serve as a safe haven when equities fall, but that was not the case in 2022. It was the single worst year for 10-Year Treasuries (-17.8%) as well as for the overall US bond market which was down 13%. A balanced 60/40 US portfolio (i.e. 60% US stocks, 40% US bonds) fell 16.3% in 2022 (before fees), its third worst year in history behind two years during the Great Depression. We’re happy to say that all AlphaGlider strategies, even our most aggressive ones and inclusive of all fees, outperformed the 60/40 US portfolio in 2022 before fees. Still, we’re happy to have 2022 in our rear view mirror.
Runaway inflation, and the aggressive (but late) hiking of interest rates by most of the world’s central banks to combat it, was the trigger for the severe selloff in both bonds and stocks during 2022. As of last month the Consumer Price Index (CPI) was 6.5% higher than a year ago, down from June 2022’s peak of 9.0% (see chart below). However, when excluding volatile food and energy costs (i.e. core inflation), December’s 5.7% reading was little changed from June’s 5.9%, but down somewhat from its 6.6% peak in September. Much of the year-over-year price increases we are currently experiencing are the result of price changes that occurred in the first half of 2022. Bond market participants currently expect inflation to be running less than 3% come the second half of 2023.
Source: The New York Times
The area that most concerns the Federal Reserve (Fed) that inflation may remain persistently above its 2% target is the continued strength of the US labor market. With December’s unemployment rate at 3.5%, its lowest since 1969, there is still significant competition for workers which the Fed fears will keep wage inflation high. Wages were 4.6% higher than a year ago in December. Also of concern to the Fed is the continued strength of consumer spending, particularly for services that were out of reach during the pandemic.
The Fed raised rates by 125 basis points during the fourth quarter, taking its key benchmark borrowing rate to a target range of 4.25%-4.5%. Fed Chair Jerome Powell and many others on the Fed Open Market Committee (FOMC), the body that sets Fed rates, continue to emphasize their determination to squash inflation with a policy of “higher for longer” rates. Bond investors are not buying it though, and are pricing in rates that are 75 basis points below FOMC median rate guidance in one year’s time, and 100 basis points in two year’s time. This is shown on the chart below, with investors’ implied rates in white and FOMC’s median rate guidance in green. Each yellow dot represents the interest rate forecasted by one of the 19 members of the FOMC.
It would appear that bond investors believe the Fed’s high and still rising rates will be successful in pulling inflation down to acceptable levels later this year, allowing the Fed to begin to roll back rates during the second half of 2023 and throughout 2024. They don’t buy the Fed’s “higher for longer” messaging, instead betting that the Fed will be pressured to cut rates when unemployment rises. Equity investors seem to be going along with this general narrative. Gauging by still high earnings estimates and company valuations, a recession is still expected but it will be short and mild.
Shifting overseas, the war between Russia and Ukraine continues with no end in sight. However from an economic and investment standpoint, the European economy has performed better than expected. This is thanks to a warmer than usual winter, allowing the region to use more its scarce energy supplies for industry and transport, and less for heating homes and offices. Flows within the global energy trade have undergone a massive shift since the war in Ukraine broke out last February, with China and India taking on more energy from Russia and less from the Middle East, and Europe bringing in more energy from the Middle East and North America, and less from Russia.
Perhaps the most important development overseas during the fourth quarter was China’s abrupt abandonment of its strict zero-Covid policies. In the short term this could cause further supply chain disruptions around the world as a wave of infections ripples through the relatively vulnerable Chinese population. But as we have seen when other regions of the world come out of Covid lockdowns, consumption, economic growth, and inflation picks up soon thereafter.
PERFORMANCE DISCUSSION
Fourth Quarter
All AlphaGlider strategies beat their respective benchmarks during the fourth quarter, aided by the strong showing from our large overweight positions in developed foreign market equities. MSCI EAFE, the standard equity index for this region, outperformed the US’s S&P 500 by approximately 10 percentage points during this period. Our strategies held approximately 50% more of these developed foreign equities than their respective benchmarks throughout the quarter. While US equities lagged their international peers during the quarter, our somewhat limited US equity exposure performed strongly due to its heavy mix of value and quality companies.
Our new fund position in emerging market bonds did extremely well versus our bond benchmark, the Bloomberg US Aggregate, beating it by over six percentage points. Much of this outperformance was due to the weakness in the US dollar which we thought looked extremely overvalued when we bought into these bonds in the third quarter. Also benefitting from the weak US dollar was our position in physical gold.
The largest detractor to our strategies during the fourth quarter was their overexposure to US government bonds. As investors rushed back into risk assets during the quarter, US government bonds were relatively flat.
The following are individual funds that particularly helped, and hurt, our strategies’ performance during the quarter relative to our equity and bond index benchmarks (MSCI ACWI IMI +9.8% & Bloomberg US Aggregate Bond +1.9%):
Significant 4Q22 Benefactors:
+15.9% SPDR Portfolio Developed World ex-US, SPDW
+14.5% Vanguard Value, VTV
+14.2% Vanguard ESG International Stock, VSGX
+13.8% Vanguard FTSE Pacific, VPL
+13.3% Nuveen ESG Large-Cap Value, NULV
+13.0% Vanguard Dividend Appreciation, VIG
+11.1% iShares MSCI Singapore Capped, EWS
+9.7% SPDR Gold MiniShares, GLDM
+8.0% Vanguard Emerging Markets Gov’t Bond, VWOB
+3.9% Vanguard Market Neutral, VMNFX
Significant 4Q22 Detractors:
+0.8% Vanguard Short-Term Treasury, VGSH
+1.3% Vanguard ST Inflation-Protected Securities, VTIP
+4.2% iShares Global Clean Energy, ICLN
+4.2% Fidelity MSCI Information Tech, FTEC
Last 12 Months
As in the fourth quarter, all AlphaGlider strategies beat their respective benchmarks during the last year. Much of this outperformance came from our conservative positioning going into 2022, particularly within our bond allocations which were short in duration and heavy in safer government bonds relative to our fixed income benchmark, the Bloomberg US Aggregate Index. We were also helped by the conservative footing within our US equity exposure via value, quality, and consumer staples stocks.
AlphaGlider strategies also benefited from having some investments in the alternatives space, such as physical gold and a market neutral equity fund that generally goes long value stocks and short highly valued growth stocks. This latter fund outperformed the S&P 500 by 32 percentage points and the Bloomberg US Aggregate Index by 26 percentage points.
The largest detractors to our strategies’ relative performance over the last year came from overseas equities, particularly from emerging markets and real estate. An unexpected land war in Europe will do that to you.
The following are individual funds that particularly helped, and hurt, our strategies’ performance during the last 12 months (LTM) relative to our equity and bond index benchmarks (MSCI ACWI IMI -18.4% & Bloomberg US Aggregate Bond -13.0%):
Significant LTM Benefactors:
+13.5% Vanguard Market Neutral, VMNFX
-0.5% SPDR Gold MiniShares, GLDM
-1.7% Fidelity MSCI Consumer Staples, FSTA
-2.1% Vanguard Value, VTV
-2.8% Vanguard ST Inflation-Protected Securities, VTIP
-3.8% Vanguard Short-Term Treasury, VGSH
-5.6% Vanguard Short-Term Corporate Bond, VCSH
-5.7% iShares ESG 1-5 Yr Corporate Bond, SUSB
-9.8% iShares MSCI Singapore Capped, EWS
-9.8% Vanguard Dividend Appreciation, VIG
-10.1% Nuveen ESG Large-Cap Value, NULV
Significant LTM Detractors:
-29.6% Fidelity MSCI Information Tech, FTEC
-22.8% Vanguard Global Ex-US Real Estate, VNQI
-22.4% iShares ESG Aware MSCI EM, ESGE
OUTLOOK & STRATEGY POSITIONING
I’m going to do something a bit different this quarter for this section and talk about something outside of my lane — residential real estate. I will be the first to admit that my wife’s and my track record of buying and selling homes has been a bit hit and miss, but as one’s single largest investment, I feel we should all have an opinion on this important asset class. Home purchases can be tricky as most of us don’t have much control over their timing, location, and qualities, particularly early in our careers. But with age and accrued wealth, we gain more control over these factors. Giving some thought to their valuations and risk/reward tradeoffs can help make big profits or avoid big mistakes, particularly in times of valuation extremes. I think we’re living in period of one of these extremes at the moment. The steep run-up in house prices since the pandemic started, combined with the recent spike in mortgage rates, has me worried that we could see a substantial multi-year decline in house prices, perhaps of the same magnitude that we experienced in the aftermath of the Global Financial Crisis (GFC).
Source: St. Louis Fed, AlphaGlider
The chart to the right shows the progression of US home prices over the last 20 years, capturing the frenetic gains in the lead-up to the last housing bubble, its bursting, the steady recovery, and then the even more frenetic gains made during the pandemic. The home prices are as measured by the S&P Case-Shiller US National Home Price Index, a representative sampling of prices for single-family homes around the US. up about one-eighth of the fund, will benefit from the 20% decline in their operating currency, the won. Despite liquidating the Europe equity fund, we still maintain a small overweight position in European equities via our foreign developed markets fund.
Source: New York Fed
There were numerous reasons for the spike in prices during the last housing bubble, but the one most often blamed was the significant expansion of loans to buyers with lower incomes and savings (i.e. subprime mortgages). The chart to the left shows that about one-half of all mortgages were issued to home buyers with a credit score below 720. With the supply of homes stable but demand up due to the entry of this new class of buyer, prices shot up 30% over a two and a half year period (11.5% annualized).
We recently experienced another massive spike in housing demand, this time not from credit-challenged buyers armed with subprime mortgages, but rather from buyers qualifying for low interest rate (less than 3%) mortgages (see chart below; mortgage rates in blue and home prices in red). These were better off households who wanted a larger place from which to work and go to school from home, as well as well-financed institutional investors. As you can see on the first chart in this section, the price spike from this surge in new demand was even higher than in the lead up to the GFC, up 45% over a similar two and a half year period (17.1% annualized).
Source: St. Louis Fed, AlphaGlider
Source: Longtermtrends
Just because the price of an asset goes up rapidly doesn’t necessarily mean that the asset is an investment bubble or that it’s even overvalued. However, investment metrics and ratios can be helpful in spotting bubbles. In the case of housing prices, affordability ratios such as home value to income level are logical ones. The chart on the right shows the ratio of the median home price to the median household income in the US. After running between 4 and 5x throughout the 1960, ‘70s, ‘80s, and ‘90s, it spiked to just above 7x in the lead up to the GFC before dipping back down again below 5x in 2011. This past summer, this ratio peaked at 7.75x.
But the affordability of a house is more complicated than just the price of the house and one’s income. It also includes the cost of borrowing (i.e. mortgage rates), insurance, and property taxes. That’s where the Federal Reserve Bank of Atlanta’s Home Ownership Affordability Monitor (HOAM) comes in. At a level of 100, the median income family buying a median priced home today would spend 30% of their income on these housing costs — the maximum level that many economists determine is “affordable.” Scores below 100 indicate the degree to which 30% of the median family income comes up short in covering the costs of the median home.
Source: Atlanta Fed, AlphaGlider
As of October 2022, the HOAM sat at a dismal 64.7. This translates into a whopping 46.4% of the median family’s income going to the cost of owning the median home purchased at that time. At the peak of the previous housing bubble, the HOAM bottomed out at 71.5 (42.0% of their income going to covering home costs). It’s no surprise that the pace of existing home sales has fallen 30% from this time last year and is now at similar levels to what we saw after the popping of the last housing bubble. As these last two charts demonstrate, homes are extremely unaffordable at the moment for many Americans. However, the invisible hand of our free markets has recently started to make some progress in restoring affordability to the market.
There are three primary drivers of home affordability for the average American home buyer: the buyer’s income, the price of the home, and the rate of the mortgage used to finance it. So let’s look at each of them.
Incomes have been rising over the last couple of years (most recently, +4.6% year-on-year in December), but unfortunately not as fast as overall inflation of goods and services, and definitely not as fast as housing. We expect both unemployment to rise and wage growth to slow going forward as the Fed’s high interest rates continue to bite. So while we still expect incomes to rise and thus improve home affordability, the benefit will likely be minor and of a much smaller magnitude than the impacts from changes in mortgage rates and home prices.
On the other hand, changes in mortgage rates can be the most volatile driver of home affordability — as was the case in 2022 when 30-year fixed mortgage rates spiked from a little over 3% entering the year, to just over 7% in late October. As inflation expectations began to fall in the fourth quarter, mortgage rates dropped to approximately 6.3% exiting the year. Predicting how mortgage rates progress is always difficult, but especially so now with the Fed aggressively battling high inflation. Our current thinking is that mortgage rates may decline slowly over the coming years but would be surprised if they dipped below 5% exiting 2024 given the Fed’s “higher for longer” guidance on its own rates. At 5% and above, homes would continue to be unaffordable at today’s home prices. There’s also the real chance that inflation proves to be harder to eradicate than the markets believe, causing the Fed and mortgage rates to surprise to the upside — worsening home affordability.
Home prices are the last primary driver of home affordability, and they recently started to fall according to the Case-Shiller Index. After peaking in June, prices fell 3% over the following four months to October, the most recent month for which there is data. Home price movements to the downside are usually slow as sellers tend to pull out of the market instead of taking a price cut, especially if it they would have to buy a new home with a mortgage rate double that of the one they are selling, as is presently the case for many.
As was the case in the deflating of the last housing bubble, we suspect that this time house affordability will eventually return — reversion to the mean is a powerful force. We believe that it will be mostly driven by a combination of a decline in home prices and in mortgage rates, as was the case after the last housing bubble. Between 2006 and 2009, we saw the median US home price fall 18% (from $231k to $188k) and 30-year fixed mortgage rates decline 200 basis points (from 6.8% to 4.8%), taking the HAOM from 71.5 to 100, the point at which the median income family buying the median priced home would commit 30% of their income to housing. But as we mentioned before, the median home price didn’t bottom out until three years later, down another 4% to $182k, while mortgage rates fell another 90 basis points to 3.9%. Incomes only grew a paltry 4.6% cumulatively (not annually) over this 2006-2012 period of falling home prices and mortgage rates.
The key take-home point for me after doing this exercise is that one should think carefully about expanding one’s exposure to housing at the moment. Now is probably not a good time to buy your first home, upgrade your primary home, to buy that second/vacation home you’ve always wanted, or to buy an investment home to rent out. With home affordability just as bad or worse than at the peak of the 2006 housing bubble, you are likely better off waiting on the sidelines for more favorable entry price levels and mortgage rates. Gauging the bottom of the market is difficult, but know that it can take many years for it to occur after a peak — six years in the case of the last housing bubble. We are now only six months past what is likely to be the peak of the current housing cycle. Be patient if you can. Just like with stocks, the objective is to buy low and sell high. Right now it looks like we’re still much closer to the high than to the low in the US housing market.
**NOTES & DISCLOSURES**
1This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete, and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
2Mutual funds, exchange-traded funds and exchange-traded notes are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
3Alternative investments, including hedge funds, commodities and managed futures involve a high degree of risk, often engage in leveraging and other speculative investments practices that may increase risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. The performance of alternative investments including hedge funds and managed futures can be volatile. Often, hedge funds or managed futures account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, including hedge funds and managed futures and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products including hedge funds and managed futures often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in the US markets. Additionally, alternative investments including hedge funds and managed futures often entail commodity trading which can involve substantial risk of loss.
4Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.
^Indices are unmanaged and investors cannot invest directly in an index. The performance of indices do not account for any fees, commissions or other expenses that would be incurred.
aThe Standard & Poor's 500 (S&P 500) Index is a free float-adjusted market capitalization weighted index that is designed to measure large cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization in the US equity markets.
bMSCI Europe, Australasia and Far East (EAFE) Index is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of developed market equities outside of the US.
cMSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure large and mid-cap equity market performance in the global Emerging Markets.
dMSCI All-Country World (ACWI) Investable Market Index (IMI) is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of global equity markets.
eThe Bloomberg Barclays US Aggregate Bond Index is a market capitalization weighted index that is designed to track most investment grade bonds traded in the United States. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the United States. Municipal bonds and Treasury Inflation-Protected Securities (TIPS) are excluded due to tax treatment issues.
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