The Inevitable Resumption of Normal Volatility

The trend shifts we anticipated in 2022 manifested themselves in rather abrupt fashion during the first quarter. After a year of unusually low volatility, the equity markets wasted little time before exacting pressure on their more vulnerable sectors. Even though the S&P 500 experienced its first negative-return quarter in two years, most Hamilton Capital investment strategies fared noticeably better, showing nearly-flat-to-positive performance at quarter’s end.

Advantageous positioning in energy, value, and lower portfolio risk exposure provided a relatively strong outcome. The energy sector delivered a spectacular quarter, as the oil price rallied to well over $100 a barrel due to acute supply-and-demand imbalances. The total return from the energy sector exceeded 39% during the first quarter. The utility sector accompanied energy as the only other positive sector, while all other S&P sectors experienced negative returns for the quarter.

Client portfolios have enjoyed the benefit of healthy exposure to the energy sector throughout the past two years, as depicted by the rolling 2-year percentage change in Chart 1. This graphic is instructive for multiple reasons, but there are two key points: 1) subsequent returns often emanate from allocations made during times of distress (as was the case for energy during much of 2020); and 2) there can be a delay before the market recognizes how impressive the opportunity can become, as the upcycles show varying timeframes and magnitude. The current episode has been most powerful due to the extreme weakness the sector encountered at the trough.

From a portfolio construction perspective, a third point arises: strong performance from an investment with a high allocation can lead to concentration risk. High concentration in an inherently volatile sector has the potential to negatively impact overall portfolio risk and future returns. Consequently, we elected to trim exposure to the energy sector to better align portfolios with their overall risk objectives and to acknowledge that some of the beneficial outperformance has already been realized. Even though some of the best returns may be behind us, we retain a positive outlook on the sector, as the multi-year underinvestment in energy supply and production can’t be corrected by a price spike and a slowdown in the global economy.

Emerging Realities in the Economic Outlook

The tightness in the labor market and supply-and-demand imbalances throughout commodities and the industrial supply chain have given rise to the strongest inflationary trend we have observed in over four decades. The war between Russia and Ukraine has only exacerbated these conditions. We have previously identified these trends as key risks to the outlook for Federal Reserve activity, expecting the Fed to transition from a supportive stance to a more restrictive posture.

The first rate hike is now behind us, but expectations for faster and larger incremental increases have been growing. In addition, market rumblings regarding the Fed balance sheet have turned from ‘tapering’ to ‘run-off’. The notion of ‘tapering’ balance sheet purchases simply suggests a status quo, whereas ‘run-off’ implies an effort to reduce liquidity. These monetary tightening measures are creating a material impact to overall sentiment and expectations for financial markets.

Fixed income managers are now facing a much flatter yield curve, with some timeframes showing slight inversion. Inverted yield curves are not normal and can often be a signal that a recession could be in the offing. A careful study of history reveals that yield curve inversions precede recessions by anywhere from a few months to a couple years, and the economy and financial markets can continue to show positive trends during these periods.

Whether the current inversion leads to a recession is likely to remain unknown for some time. However, it’s unambiguously clear that the probability of a recession occurring within the next 24 months has picked up dramatically. There are numerous models produced by the various Federal Reserve Banks, Wall Street investment banks and many other financial service providers designed to estimate the probability of recession. Goldman Sachs produces a series, which you can see in Chart 2, that is based on the embedded probability of recession implied by what the market is pricing for different assets.

While this shows a 38% chance of recession in the next 24 months, it shows close to no chance of recession in the next 12 months. The low probability of recession in the near term is consistent with many Fed models. Even though many are currently finding a way to discount the near-term odds of recession, the recent inversion of the yield curve certainly highlights this as a possibility which needs to be considered as we invest forward.

For equity investors, the implied risk of recession would indicate that earnings growth could be coming under pressure. In addition, the rising rate environment may produce a contraction in price-to-earnings ratios. We have seen some confirmation of this already in 2022, as the worst-performing segment of the S&P 500 has been high-multiple growth stocks. Our last Capital Markets Review examined the vulnerabilities posed by this group of equities. As a result, we continue to minimize exposure to this area of the market, and this discipline remains a key tenet of our portfolio construction process.

Dynamic Adjustments for the Future

We have already highlighted the reduction in energy exposure that we executed during the first quarter to manage portfolio risk. Heightened market volatility also created a good entry point to purchase additional high-quality stocks. The proceeds from trimming our energy position coupled with modest reductions in other selected holdings were used to make these purchases.  A focus on quality refers to the tendency for stocks with more stable earnings, stronger balance sheets, and higher margins to outperform over a long time horizon. These companies enjoy durable competitive advantages and are well equipped to deal with uncertain and challenging economic environments. Their stocks tend to be more resilient in choppy markets and reduce overall portfolio volatility.

Also, as important as it is to ensure that our portfolios are built to have a reduced volatility signature, it is equally paramount that we make opportunistic allocations when price dislocations occur. In addition to quality equities, we have identified a compelling investment in emerging-market bonds. The onset of war between Russia and Ukraine created the worst performance period for these investments in the last 24 years. Historically, they have offered equity-like returns with lower risk after similar price dislocations, and we believe allocating resources at today’s prices could prove to be an effective enhancement to long-term returns.

As illustrated in Table 1, when the difference in yields between government bonds from emerging economies and the U.S. has reached these levels in the past, emerging bond investors have often realized attractive total returns. Wider spreads essentially mean investors are receiving higher interest for the incremental risk of investing in foreign bonds. Provided these risks are well understood, investors can enjoy higher subsequent returns when prices appreciate to bring the difference in yields to more normal levels. Further, investors collect a healthy interest rate while they’re waiting for this to occur. Currently this is around 5%/year.

The recent drawdown for the prices of EM debt has not been anywhere near as severe as what happened to the energy sector in the wake of the COVID-induced shutdown, but our decision to capitalize on the opportunity is born of the same process.

In closing, volatility like the kind the markets experienced in the first quarter can be unnerving.  However, it can represent opportunity to the experienced investor. Our recent portfolio actions illustrate the advantages of a dynamic process designed to build future returns on past returns. We believe it will continue to be essential as we move through the coming quarters.