2022 Signaled the Dawn of a New Era
Global capital markets experienced a tumultuous ride throughout 2022 that proved to be quite challenging for most investors. While it was a historically bad year for both stocks and bonds, that was not the case for the investment portfolios managed by Hamilton Capital. Our dynamic process identified pockets of opportunity and avoided areas of speculative excess. As a result, our portfolios generally outperformed financial markets by wide margins. Several key investment positions drove our results:
- Energy Appreciated by more than 65% for the year
- US Large Cap Value Outperformed large-cap growth by more than 20%
- US Large Cap Quality DGRW allocation outperformed the S&P 500 by over 12%
- Cash and T-Bills Positive return versus -13% for the Bloomberg Barclays Agg
While these effective portfolio allocations contributed to strong relative investment performance comparisons, we believe the asset classes and sectors that we intentionally avoided enabled our portfolios to preserve far more capital than most portfolio managers, an essential attribute of our dynamic process.
Throughout 2022, our portfolios maintained a meaningful underweight stance versus equities. That proved quite prescient, as the S&P fell by over 19% for the year, as detailed in the graphic above. The primary component of the equity underweight was the tactical decision to avoid exposure to the overvalued large-cap-growth asset class, which declined by 27%. Even more disconcerting for many investors was the abysmal performance of the six largest mega-cap tech stocks contained in this class, which are commonly held across most investment portfolios. As the chart shows, they fell 39% on average.
The ‘Era of Free Money’ Has Run Its Course (At Least for Now)
2022 marked a new era for the equity and bond markets that we highlighted as ‘Shifting Trends’ in our year-end Capital Markets Review last January. We explained that the tightness in the labor market was contributing to higher-than-desired inflation and that we were expecting a change in Fed policy from a supportive stance to a more restrictive posture.
Indeed, after a decade where the Fed Funds rates hovered near zero and the Fed balance sheet grew more than ten-fold, the Fed embarked on a historic rate-hiking cycle and started the process of shrinking its balance sheet. In fact, it has been the swiftest increase in interest rates in modern history, as you’ll see in Chart 2 below. To date, the Fed has aggressively hiked rates by 425 basis points in only 10 months. And while the pace of increases is expected to slow, further rate hikes appear likely.
Most importantly, these shifts in Fed policy from a stimulative to restrictive stance marked a significant change impacting the economy and the fundamental underpinnings of financial assets. Economic activity has adjusted to a slower pace, profitability has taken a step backwards, and higher rates have compressed valuations. As the Fed seeks to choke inflation, the prospect of recession has increased. We do not believe asset prices reflect this possibility since the risk of a significant decline in earnings has not been factored into market assumptions. So, more downside could lie ahead.
Potential Impact on Financial Assets in the New Era in Front of Us
Over the course of the next several years, we would expect the United States economy and capital markets to look very different than they have since the financial crisis. We are likely to witness many, if not all, of the following changes:
- Far less monetary support from the Fed and less fiscal stimulus
- A higher resting level for inflation and higher interest rates
- Weaker corporate earnings and lower valuations
- More cyclicality and associated higher levels of volatility
- More labor market tightness due to demographics (aging society)
- Reversing trends in globalization
In a broad sense, each of these factors portends a lower-return environment for financial assets. Yet, against this environment, there will still be pockets of opportunity. Some will come from discounted valuations that emerge from increased volatility. Others may be industries that come into favor, like energy stocks over the last couple of years. The point is, to be successful we believe one will need to choose investment exposures with great care.
Summary and Closing Comments
In this environment, we believe asset allocation will need to be driven by more than buying and holding a diversified portfolio of assets, which is the prescription of many advisors. While returns can be favorable during stimulative periods where all boats are rising, we believe being highly selective is the recipe for success.
To us, asset allocation should always be a continuous series of dynamic, forward-looking choices about portfolio holdings. The goal should always be to seize great opportunities when presented and to steer away from unproductive assets. This is the core of what we do, and its merits were on full display last year in what was a very difficult market.
As we look forward, we continue to search for attractive entry points to add to risk assets with a high margin of safety. Some opportunities may come sooner; others will be deferred until markets bottom. Equally important is the protection of capital. Therefore, we continue to be patient, but always vigilant.
We thank you for the privilege of allowing us to guide your assets forward. Should you have any questions or observations, please don’t hesitate to connect with us.