April 2023
Both the stock and bond markets finished the first quarter with single digit gains. The stock returns listed in the table below average 4.8% and the bonds 2.8%. The previous quarter the averages were 9.6% and 2.8%. The last six months have been a welcome turn around from the previous nine from January-September 2022, when stock averaged –8.8% and bonds –4.1%. Over the last twelve months, both averages are still negative, but the three-year stock average is a robust 15.1%. Even the small-cap tech-heavy Brown Capital fund, which in late December had a three-year average return of –5.5%, now is at a positive 3.6%.
Foreign stock funds had a better quarter than the domestics, and they are also ahead by double digits at the three-year mark. The five-year return of the foreign funds of just 2.9% indicates how they have struggled since the 2008 financial crisis. In 2017 the ten-year average return of Vanguard’s Total International Index Fund was 1%. Wow, ten years! There has been some improvement. Currently, its ten-year and fifteen-year averages are 4.6%, and 2.4%. Generally, CIM doesn’t recommend index funds. Imagine if you had taken the advice of index proponents like Vanguard, who recommend keeping 40% of your stock allocation in a foreign index fund. Vanguard advocates strict adherence to index investing, so if 40% of global GNP (gross national product) is foreign, they suggest you invest 40% in foreign. The argument is you shouldn’t try to out-guess the market. A counter-argument is that indexing eliminates any form of discretion. If investing in the BRIC countries (Brazil, Russia, India, and China) doesn’t call for discretion, what does?
Bonds were due for a breakout from their years-long doldrums, and they finally got it in January. But it didn’t last. February was a setback, and March saw bonds struggle just to get back to the January numbers. Newer issued bonds carry higher interest rates than they have in years, so it is just a matter of time for a turnaround. The yield on intermediate corporate bonds are at just under 5%. That’s a good sign and quite a turnaround for bonds that lost 5% of their value over the last twelve months. We are patiently awaiting the benefits of our allocation in Treasury Inflation-Protected Bonds. To date, the super quick acceleration of interest rates has been winning the tug of war with the TIP protection features. Average inflation from 1997 to before the current run-up was 2.2%. The historic rate usually quoted is 3.5%, but that includes an average rate of 9% for the ten years ending in 1982.
The path to recovery from 2022 has not been smooth, and the outlook for the next nine months to a year remains uncertain. Goldman Sachs titled a recent publication: Caution: Heavy Fog Ahead. We are familiar with high inflation and rapidly rising interest rates. Then in the last days of the quarter, the economy was suddenly presented with two of the biggest bank failures in US history. There was and still is the possibility that those failures will carry over to other institutions, especially smaller regional banks that don’t have the resources of the bigger banks and financial companies. Also, we now have a credit crunch. Borrowing money had been easy and cheap since the crisis of 2008. Now it’s expensive. For some companies with lower credit ratings, funding may simply not be available. Over a year ago, the allocation to Hi Yield bonds in CIM client portfolios was reduced in anticipation of the cutback in massive government supports extended to weaker companies at the start of the Covid pandemic. The Federal Reserve recognized that the weaker companies would be the ones most in jeopardy from disruption of the Covid pandemic.
Zombie companies are those that earn just enough money to continue operating and service their debt. They manage to meet wages, rent, and interest payments but have no reserves to deal with emergencies, let alone invest to spur growth. They may be just one event - a market disruption or a poor quarter performance - away from insolvency. They are especially dependent on lending facilities for financial life support. Estimates of publicly listed companies that are zombies run as high as 15%. Before Covid, it was 6%. Zombie companies include AMC, Chewy, GameStop, Shake Shack, and Uber.
Predictions for the near term are for the economy and the markets to continue to struggle. No question there has been progress on the war against inflation. However, many of the intended and unintended consequences of the measures have not yet filtered through the economy. With higher rates and tighter credit, lower corporate profits are a sure bet. The question is how much lower and for how long. A recession is in the works, although it should be modest.
The potential in the next few months for default by the US on its debt would undoubtedly be extremely disruptive. It probably won’t happen because of the major negative political consequences to a government shutdown and/or a reduction in the quality ratings of US debt. On the other hand, you can expect market volatility to reflect the inevitable political rhetoric. The president says he won’t negotiate the creditworthiness of the US. House Republicans want spending cuts to reduce debt by $1.5 trillion. In fact, addressing the nation’s debt will require big and politically painful changes. The sooner we get started, the better.
There will always be times when investment returns will not be great. That is the very nature of capital markets. Company profits are the ultimate driver of stock prices. The markets are buffeted by projections that generally look forward maybe six months to a year. Maybe two years if they have to, as they did when Covid hit. Right now, some markets are optimistically pricing in a reduction of interest rates as early as the end of 2023. The Federal Reserve is adamant that its decisions will be based on incoming data, that is, consumer spending, the job market, inflation, and any surprises, for example, maybe a bank failure. If the Feds don’t know what they are going to do, how can anybody else know?