Strange Predictions 2023

Strange Predictions

Happy new year everyone… I think most investors will be pleased to see the end of 2022…

We’re satisfied with Aviator’s performance during 2022. The REIT portfolio has performed well considering the change in interest rates and delivered good returns due to strong leasing activity.

In respect to the capital markets portfolios, it wasn’t a year to be a hero – capital preservation was the priority. We’re satisfied with the results we produced. With the benefit of hindsight, there’s always a few things you could have done better but we’re comfortable with our performance.

Being more specific on what we could have done better, we anticipated a volatile market and understand what this means – strong moves both up and down. What we could have done better is to be a bit more “active” – locking in profits when you have them. That’s something we will be more mindful of this year given an anticipation that the market environment will likely be much the same. Capital preservation might well be the key this year also – whilst volatility presents opportunities, it’s still no time to be a hero.

A year like no other…

2022 goes down in history as one of the worst ever. You might find this confusing – equity markets didn’t have a “terrible” year, especially Aussie shares. But for the global bond markets, it was a year with few precedents.

The interest rate rises experienced during 2022 burst the bond bubble.

Although not so much of a thing in Australia, there’s the concept of a traditional “60/40 portfolio”. 60% equities and 40% bonds. The general logic to this “balanced” portfolio is that it stands to deliver very acceptable returns over time whilst greatly reducing risk when compared to a higher equity allocation. The lower risk aspect is due to the fact that bonds generally perform fairly well when share markets don’t.

Sadly, 2022 wasn’t kind to the traditional balanced portfolio. Analysts have figured that, for U.S. investors, this portfolio had its worst year in about 140 years!

In the face of the bond market, I need to admit that I’m surprised by how resilient the share
markets have been.

Reflect back a couple of years ago… a big driver of markets was central bank easy money policies. Interest rates were near-zero and the Fed (amongst other global central banks) continued on their ridiculous “quantitative easing” regime.

A risk-free “hurdle rate” near zero combined with extreme liquidity were powerful drivers. Bonds were priced to provide very little return, reflective of official interest rates. TINA (there is no alternative) and FOMO (fear of missing out) were the order of the day… for a decade…

Remember those infamous “taper tantrums”? Previously, mere talk by the Fed about easing up on the quantitative easing sent markets into convulsions.

Things have changed. In case you haven’t looked, you can actually get a kinda respectable
risk-free return again. Cash is no longer trash.

Now sure, the markets have had a rough year… a lot of that is the result of rapidly rising interest rates and the end of quantitative easing. But to be honest, I would have thought the interest rate rises – some of the swiftest in history – would be a bit more meaningful in terms of “repricing” risk assets of all kinds.

As we roll into 2023, inflation and interest rates are undoubtedly two of the biggest themes.

The last two months have brought some positive news on inflation – at least in the U.S. For what it’s worth, I do think there’s a decent chance that inflation has peaked. But this really isn’t the important thing.

Here’s a fun chart courtesy of Bianco Research. What this does is tracks how analyst inflation expectations have changed over time. Notice that at every point in time (including today), no matter how high inflation is today, analysts have forecasted that inflation will be back to a nice, comfortable 2% within 6 or 12 months. Of course, this has been diabolically wrong for the last 18 months, but as we head into 2023 it remains the consensus expectation that inflation will fall consistently and precipitously over the next 12 months.

But what if it doesn’t?

Again, I’m certainly not suggesting there’s worse inflation to come. But what if, instead of falling nicely back into the (recent) historical range of 1 to 2%, what if inflation remains sticky for a while at, let’s say 5%?

I think this is a real possibility. Many of the drivers of the low inflation world aren’t there. “Globalisation” is beginning to reverse as nations and companies begin to feel there might be other considerations beyond simply where we can get products made as cheaply as possible.

Labour is getting scarcer (and more expensive). Raw materials are getting scarcer (and more expensive). Companies of all kinds are desperate to raise prices – that’s inflation right there.

If inflation sticks for a while at 5%, that’s too uncomfortable for the Fed. Rates stay higher for longer – just like the Fed themselves are saying we should envisage.

Of course, a nasty recession might help with lowering inflation.

Strange Predictions

Most sell-side analysts are obliged to make predictions on what the year ahead brings. Unsurprisingly, aggregators of these predictions report that the average analyst expects a roughly 10% rise for the U.S. markets in 2023 –price targets currently sit around 4300-ish for the S&P500.

Concurrent with this, most economists expect a recession in the U.S. in the coming 12
months.

As a similar anecdote, I saw a commentator report recently that he attended a small U.S. conference for funds managers and high-net-worth clients – “smart money”, in other words. The moderator conducted an informal poll among the couple of hundred attendees.

“Who thinks there will be a recession in the coming 12 months?”

100% said yes there will be.

“Who thinks the market will be lower in 12 months’ time?”

Zero.

This is quite astonishing. Recessions are bad for corporate profits and bad for share markets. If you think the economy is going to take a tumble, you should also feel the markets will take a tumble.

Piecing these factors together, we arrive at the general consensus narrative moving into 2023:

Inflation has peaked and is set to fall back towards the Fed’s comfort range of <2%, likely assisted by a weakening economy. This will enable the Fed to embark on a rate-cutting cycle which will reflate the economy and push share markets back into a glorious new bull market.

Some of this certainly does have solid backing in terms of historical precedent. Markets do generally bottom in rate-cutting cycles and a shift in the economy from contraction to expansion is generally accompanied by durable share market strength. But there’s a couple of major issues with this narrative.

Investors seem fixated on this “Fed pivot” – a shift to rate cuts – will be the catalyst for market gains. The problem is that, historically, the worst of the market falls have generally happened after the pivot! This makes sense – the pivot occurs because something just broke!

The other issue relates to valuations. “Useful” valuation metrics – not your Wall St nonsense “the market is trading on XYZ-times our estimated 2023 earnings of $ABC which is historically reasonable”.

John Hussman is one of a few historically-informed, data-driven commentators good enough to share their valuable research with the world. Sure, we could re-create then slightly tweak his models before passing them off as our own, but we’re not ashamed to credit his efforts.

John and his team have built and tested all sorts of valuation models over the years. The testing involves comparing them to actual subsequent returns – how well did they predict future returns?

Importantly, valuations tell you little about short-term returns. Indeed, Hussman’s work shows a good model will have its most powerful predictive capabilities looking out about 10 to 12 years.

Here’s where one of their most useful models currently sits in the context of the last 100 or so years:

The valuations witnessed in 2021 were never seen before. The falls of 2022 have been sufficient to unwind the frothiest bit of the bubble. Valuations remain about as expensive as they have ever been except for 2021.

So what does this mean?

It means that U.S. share markets are incredibly richly valued and priced to deliver poor returns looking out on a medium/long-term horizon. Said slightly differently, investors should not expect to generate anywhere near a “historically-average” annual rate of return over the coming decade from this point.

But what about the short-term? Markets could absolutely move higher, right?

Absolutely. Reliable valuation models tell us what we can expect to have unfolded over the next decade or so – they tell us little about the short-term. There’s no reason why markets can’t become even more richly-valued in years to come. Indeed, the only reason why valuations could get as stretched as they did in 2021 was because they breezed through already historically-extreme valuation levels.

But financial history shows a high propensity for things to “revert to mean”. Maybe not today. Maybe not tomorrow. But assuming that any financial metric like valuations or profit margins have forever shifted to a permanently high plateau is not a smart bet.

Similarly, believing that a new bull market will begin from some of the highest valuation levels
in history is not a smart bet.

As I’ve mentioned multiple times over the past year, its uncomfortable to even talk about what “historically-normal” valuation means in relation to the current market. Maybe 1800 for the S&P500. As in more than 50% lower. Absurd, right?

That’s just “historically-normal”. If the market was to reach “undervalued” such as 1974 or 1982… well, that’s simply too absurd to even discuss.

To emphasise, there’s no predictions being made here – these are simply observations.

In summary…

We enter 2023 with the U.S. equity markets – the most important and influential in the world – being as nearly richly-valued as they have ever been.

The economy is clearly weakening – most people expect a recession to materialise.

Recessions are bad for corporate earnings and profits.

U.S. profit margins are well beyond historical norms, largely impacted by massive deficit spending by governments during Covid as well as a decade of relatively low wages growth – both these are reversing and will drag profits regardless of economic conditions.

This is a bad combination.

And yet…

Investors are practically cheering on a recession – convinced that this will result in collapsing inflation, the Fed cutting rates back to zero, maybe a restart of quantitative easing and a return to the “TINA”, “FOMO” environment that’s ruled for years.

In our view…

We feel no pressure to offer up any specific targets or outlooks for the year to come. As described above, we see the markets in a difficult position. A global recession does seem very possible. How bad? Who knows.

Absent a significant recession there’s a real possibility inflation might be stickier than most expect. If that plays out, its logical some of the “hope” surrounding rate cuts comes out.

Buckle up – it might be another volatile year.

Meanwhile in Australia…

I’m not ashamed to say that I have little opinion on the investment landscape in Australia right now. The key reason is because we’re extremely susceptible to external forces.

If the U.S. share markets drop 30%, our market is going down. Maybe we out-perform by only going down 20%.

If the Chinese economy continues to melt down, this would be bad for us. Will this happen? Certainly possible although I don’t have strong opinions on this. As I’ve discussed in detail in the past, they have an economic model that’s well past its “best before date” and has yielded a dangerously unbalanced economy. But is it going to collapse?

China – like Australia – seem to relentlessly chug along. Nothing much seems to bother us. Nothing much seems to really matter down here. You might sense a hint of sarcasm and cynicism within this – you would be right.

I am interested in whether the table below ends up mattering:

This is a list of the nations with the highest levels of household debt. There’s us, right near
the top – go Australia!

We’re also a nation of floating rate debt. Whilst in some other nations, “fixed” rates are more prevalent, variable interest rates rule down under.

Here’s a snapshot of average mortgage rates in Australia:

Highest they have been in about a decade…That’s surely taking a toll on our economy. But probably nothing to worry about, right? Nothing really matters down here…

I probably should finish these rather pessimistic comments by saying we’re very excited and optimistic about the year ahead. It will surely be a year filled with opportunities. However, for investors, it probably won’t be as simple as buying some shares then sitting back and watching your portfolio balloon in value – you’re going to have to work for returns a bit harder this year.