Thornburg Portfolio Manager and CEO Jason Brady believes the story in financial markets is the return to “normalization,” i.e., the return to long-term averages.
The year 2022 was a wild year in markets, where several events and trends weighed on almost every market and investor. It’s a market truism that everyone loses money in bear markets: Bears, Bulls, everyone. When a bear market in bonds, with one of the fastest and most significant rate rise periods in decades, is a significant headwind for all risk markets, it’s pretty clear that there weren’t a lot of places to hide.
It’s worth unpacking what happened over the year, and why, because what happens in 2022 is the prologue to where we may go in 2023. This past year has been all about inflation and the reaction of global central banks. The seeds of the inflation that we have experienced globally in 2022 were sown over the course of the prior two years. It’s hard to believe that as recently as March 2022 the Fed was still pressing on the gas with zero interest rates and a full-blown quantitative easing program. But as “transitory” became the most over-used word of the year, the Fed and other central banks found themselves far behind the curve and had to work hard to catch up to a galloping set of nominal (vs. real) GDP figures and widespread price spikes.
The chart below shows just how aggressively the Fed has tightened so far in the current cycle. Over the course of nine months through November 2022, the Fed has hiked its policy rate by 375 basis points (bps), while going back to 1975, the Fed’s tightening cycles averaged about 500 bps over 20 months.
Fed’s Current Tightening Cycle Is the Most Aggressive in 40 Years
Sources: St. Louis Fed and Bloomberg
This rapidly changing environment continued to underline the close, and more recently positive, correlation between high quality bonds and risky assets like equities: If you held a 60/40 portfolio, 2022 has been a disaster. Equity multiples declined precipitously, as investors no longer had the TINA (There Is No Alternative) argument to stocks as real rates rose to much more “normal” levels.
As unusual as 2022 has been, it has really been the story of the “normalization” of financial markets, i.e., the return to long-term averages. As a result, high quality bonds may once again play a role in your portfolio in a way that has been denied to you for more than a decade. Credit spreads, while not dramatically interesting in themselves, have returned to long-term averages from very tight levels. Global equities, and in particular growth leadership names, have seen their multiples deflate significantly from historically high levels back towards longer term averages, even while earnings have generally held up relatively well. This environment would be one where the 60/40 portfolio has a strong comeback. In essence, we can think of 2022 as the year where we endured some significant, sharp and perhaps much-needed pain in order to exit from an unsustainable environment of negative real rates and malinvestment: We ripped off the Band-Aid, also known as the Fed “put” (where monetary policymakers will ride to the rescue if risky securities fall).
S&P 500 Price-to-Earnings Ratio Returned to Its 70-year Average
Source: Bloomberg
Now we are in a much better position to weather whatever storms 2023 may bring. Generally rising rate cycles have not ended well. Further, when markets lose confidence in the central bank “put” because inflation has been revived from the dead, it’s likely that we will see further market volatility. While reasonable people can disagree about a global recession in 2023 (I think it will occur, but I’m worried that I have too much company in that prediction), what seems likely in a world where we hang on every economic data point and Fed speech, is that markets will probably price in recessions and booms many times over the course of the coming year.
So again, though it will be stormy, prices have moved significantly to pay investors for that uncertainty. From my seat, much higher yields and much lower equity valuation multiples have given our investment team at Thornburg a lot more to think about and the opportunity to add significant value for our clients. Add that to the fact that our team is built to benefit from the complexity of challenging markets (both from an asset class and a volatility perspective), and I’m very much looking forward to 2023. Because we specialize in an ability to take our fundamental asset-level work and then compare opportunities by looking across silos in markets, we believe we have a sustainable competitive advantage relative to our peers where we choose to compete. This is especially true as markets have both grown larger and more interdependent. Like many other volatile times that I’ve experienced in 16 years at Thornburg (2008, 2012, 2015/6, 2018, 2020, and 2022), I believe that 2023 will be an important time for our strategies. As we often say, we build our reputation in tough times and difficult market environments. I’ve seen our investment philosophy and process succeed most particularly in times like we are now experiencing.
I’m honored to present our 2023 Outlook, which demonstrates Thornburg’s thinking across various asset classes and geographies. I hope you enjoy what follows, and thank you for your time, attention and business.
Jason Brady
CEO, President, and Portfolio Manager
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