In this webcast recording, KAR CIO Doug Foreman presents a late year 2022 update on the economic environment and financial markets and shares KAR’s outlook for 2023. Recorded December 8, 2022. (32:19)
STEVE RIGALI: Good afternoon, everyone, and thank you for joining us for today’s Kayne Anderson Rudnick webinar. I’m Steve Rigali, Executive Managing Director at the firm. Joining me today is Doug Foreman, Chief Investment Officer. For today’s webinar, Doug will provide his views on both the current economic environment and global capital markets, and he will also provide his outlook for 2023. I’ll now turn it over to Doug for his presentation. Doug?
DOUG FOREMAN: Thank you, Steve, and thank you all for joining us this afternoon. Well, it’s been an interesting and difficult year in terms of managing money for clients, such as yourselves, all year long and hopefully I’ll have some explanations for what this year has brought and why what has happened has happened and a little bit about the outlook as we move forward into 2023.
I think there are some key issues for the market overall that we need to get right and talk about today. #1, have long-term interest rates already peaked out for this cycle? We saw rates reach a high in June and again in September and the 10-year and 30-year bond rates have actually been falling recently. The reason this is important is that stocks, particularly growth stocks, are priced off of long-term interest rates, not so much short-term rates. The Fed controls short-term rates and obviously short-term rates can have an impact on the health of the economy and investors’ perceptions of the health of the economy. But growth stocks particularly and stocks in general are long-duration assets like the 10- and the 30-year bond. So, having that not be going up every day is really important as we move forward.
And then, this has been a tough year – as I mentioned earlier, the S&P peak to trough has been down about 25%, 26%, 27%, so that’s pretty much typical what you get in a mild to shallow recession, and we’ll talk about that and whether or not that’s already signaled a recession that may be coming.
And we’re going to take a poll here briefly. Just out of curiosity, I’d like to figure out how many of you out there actually believe we’re going to go into recession over the next year or so, over 2023. So just take a quick poll and vote yes or no whether you think we’re likely to go into recession.
We think a shallow recession is already priced by the stock market, and I’ll show you some data as to why we think that. We think the key going forward is going to be improved earnings growth. We’re in a slow-growth environment – if not heading into a recession, at least a slow-growth environment – and if that’s the case, then it’s going to be really important that businesses can show some sort of earnings growth in that environment, and it will be tougher and tougher for many businesses to do that.
So, we at Kayne here are laser-focused on finding businesses that have something unique and special and can grow, even in a difficult economic environment, which we’re likely to be in over the next year or so.
And high quality, of course, helps us a lot because high-quality businesses have more pricing power and are able to offset some of the inflationary spiral costs that many businesses have been absorbing over the last couple years due to the rise in inflation that we’ve seen that’s caused all the chaos in the markets.
So, let’s take a look at the poll results… 70% of you think yes and 30% think no. What’s interesting about this, I think, last week we had a live event and about 90% of the clients in the room raised their hand, and my point in taking this poll and trying to gauge people’s points of view, it’s probably the most anticipated recession in the history of mankind and certainly the most anticipated recession since I’ve been in the business over the last 30-plus years. And this is interesting because if we took the same poll in 2000 or 2007, just before some really meaningful downdrafts in the economy and recessions, I think the answer here would have been the exact opposite where 10% or less would have expected a recession, including professional investors.
So, the fact that so many people are anticipating bad news is actually a positive for assets as we move forward because businesses aren’t out there building inventory, hiring people, exceptionally bullish about the outlook for demand. It’s quite the opposite – consumers are quite cautious and actually quite negative about the outlook. I’ll show you some charts on that later… And businesses themselves are very cautious as well. So, this can help mitigate the downturn that we may be experiencing here and not turn into something more systematic like we saw in 2000 and 2008.
So, let’s talk a little about what’s actually happened over the last year. What you see year to date is the one place to be has been energy. Energy has really outperformed dramatically the rest of the market as energy prices soared during the course of the year. This area has slowed down a lot over the last 3-6 months, really since June, when prices peaked. The price of the commodity, the price of oil, at about $110 [a barrel], it’s down now in the $70’s, so this has slowed down but clearly in the first half of the year this was the place to be. The other thing to notice about the market behavior is all the groups that did well this year – energy, consumer staples, utilities, and health care – these are areas that even in a recession demand holds up relatively well.
In consumer staples, people are still going to eat when times are tough, you’re still going to pay your light bill and heat your house no matter what’s going on, and healthcare, you’re still going to take the medicines that you need and go to the doctor’s when you’re sick. These are the areas that tend to hold up really well in a recession. My point is that the market has already played out a recession that this may or may not be happening over the next year.
The areas that did really poorly, these are all the economically sensitive areas. Technology, of course, has been hurt the most and this is communications services, which is also another technology arena, these are the areas that have really been hurt from both a slowdown in the economy, the slowdown in the growth rates of the tech spending sector, and also the big rise in interest rates, which hurt some of these companies in technology that don’t make money short term even though some of them have pretty good long-term outlooks.
The other interesting thing about the market this past year is that large stocks have done better than small stocks. No big surprise… In a difficult market, that’s what usually happens, large stocks outperform small stocks. People hang onto their Apples, and they get rid of their lesser-known technology names, and we’ve certain seen that this last year, and value has certainly done a lot better than growth because the growth benchmarks tend to have a lot of technology in them. Value has a lot less technology in their benchmark and so value has hung in there much better than growth this year.
The other interesting thing about the chart is almost regardless of the index or area of the market, what you see is the average stock and the median stock have performed way worse than the index and so it’s been tough as a stockpicker because anything out of index has really been slammed in the marketplace and you really see the difference between how small stocks have not held up versus large stocks overall. A couple points off the index difference isn’t that much but if you look at the average stock pick, it’s much more meaningful and that’s at 10%.
The other key thing about this year that’s really added insult to a difficult year is that not only have stocks done poorly, which happens from time to time, particularly when people anticipate or are worried about a recession, but the bond portfolio that normally helps you in a difficult time period – it’s serves as sort of the anchor to windward if you will, if you’re a boater – when times get tough, the ballast in your portfolio didn’t work.
The obvious reason for this is interest rates essentially started at almost zero at the beginning of the year, which obviously were unsustainably low, but it’s only happened two other times in the history of stock markets since like 1926 where you lost money in both stocks and bonds. So very, very unusual and has made for a very tough year for many of us.
This has been really the key reason. What you see is the 2-year Treasury, which is really controlled by the Fed and the Federal Reserve’s actions. It really started the year, if you go back roughly to November, it was almost zero and then it’s gone all the way up to 4.5%. I think today it’s around 4.25 or 4.30 but that’s a huge increase in a very short amount of time, basically just over a year, going from zero to 4.5% is a monumental increase and obviously has had a big impact on asset prices, equities and bonds.
This is now gotten to a point where we talked many times before about the shape of the yield curve an inversion. An inversion is when short-term rates are higher than long-term rates. That’s periods like this, like this, like this, and what you see here is normally once the yield curve inverts and it’s more inverted now than it has been in the last 40 years, So this is a material inversion. If it lasts for an extended period of time, which the clock starts ticking once you do this, this will ultimately lead to recessions, which you see almost every time when the yield curve inverts to this degree and stays that way for an extended period of time. So many people are focused on this, and the Fed is acutely aware of this as well.
And the reason that we go into recessions when the yield curve inverts, is that this is a little chart that shows bank loan officers’ willingness to make a loan and when this crosses zero, it goes negative in periods like this… and this… historically, back here and here… there’s been nine periods where this has happened since 1968. Eight times we’ve gone into a recession.
And the reason is simple. If somebody wants to borrow money from a bank at 4% and the bank has to pay 4% or 4.5% to the depositors to get the money, they’re not going to make any loans. Why would you, you can’t make any money and you’re taking credit risk so that’d be suicidal. Nobody’s going to do that and that’s the reason ultimately that the economy shuts down when the yield curve flips negative like this.
How about, not only do most people think we’re going into recession, fund managers actually have a lower growth outlook going forward than they did at the trough of COVID when the global economy was shut down. So, people are fully anticipating this, people are very well aware of this and bracing for it, I would argue.
So, here’s another quick pop quiz. You’re going to have to pretend you’re a time traveler and go back to May of 1981. And if we’re sitting here in May 1981, this is how the yield curve looked. It was very, very inverted, very similar to today, even more inverted than it is now. And short-term interest rates were actually up around 20% -- short-term being like 3 months. So, the 3-month bond was at 20% and you could also buy a 30-year bond at about 13.5%. So, the question for the poll is, what would you do as an investor? Would you buy the 20% or would you buy the 13.5%? Which one appears more attractive? I’ll give you a few minutes to answer this question.
So, the point of this exercise is to try to point out that the shape of the yield curve is tricky, and where to invest in the shape of the yield curve is very tricky too, which, of course, is what fixed income managers get paid to do for a living. But it’s not always what it seems, the best deal isn’t always where you think it is.
So, let’s see what we’ve got. Oh, we’ve got an overwhelming percentage that would take 13.5% versus the 20%. I’ll tell you at the time most people took 20% not the 13.5% because it seemed like a no brainer, right?
Now how did it turn out? Over the next 5 years from that point in May through 1986, you got about 10.5%, that’s a great return in cash, I’m not sneezing at that, but if you bought the 30-year bond at a lower yield, you actually made over twice that, over 20% -- 23.2%. So, the returns were actually higher there.
So once again right now we have a similar situation, it’s not quite as inverted and it’s not that big of a difference between short-term and long-term yields, but it is significant, and it is not always what you think. So, pay particular attention to that as we move forward.
How’s the consumer feeling these days? Well, consumer sentiment is awful. People are getting stung by high gas prices, high utility bills, high food prices at the grocery story, so they’re not feeling great about things obviously, and that’s the bad news. The good news is that usually from here you get great returns when people are feeling bad about the outlook, particularly consumers.
Why consumers? Because consumers are about 70% of the economy, they’re an important driver of aggregate demand, but what you see historically, almost routinely, you not only get positive returns… So, things usually get better, consumer sentiment improves, the bad news, whatever’s causing the bad news, passes, and then people get back to more normal in terms of how they spend, and how they feel and how they think, and so does the stock market.
Now what’s the bugaboo been all year and really started last November? Inflation. Inflation has obviously been unacceptably high around 8% still in September, fell down to 7.8 in October, but the point is inflation has been stubbornly high and stubbornly difficult.
So what you see here in June, it peaked at 9.1%, and inflation has been falling since then pretty routinely and we think all of these inputs – if you look at the inputs to the inflation equation, whether it’s rent down here, or gasoline, etc. – energy prices, we think they’re finally heading in the right direction.
Even rents, which has been the stickiest of all the components of the CPI, are now heading south. Housing, back early in the year, people were lining up to buy properties, multiple offers, multiple bids, and the housing market and housing starts have been crushed since then by high interest rates, which is exactly, of course, what monetary policy attempts to do when it tries to slow the economy down.
Bonds, how bad has it been for bonds this year? If you look in the historical context, down around 14%. This is very, very unusual – 42 of 46 years, you’ve got a positive return out of bonds, even the years that were negative – 3%, -1%, -2% -- modest losses. This has really been a cataclysmic loss for the bond market, if you will. And obviously it’s been triggered by the start from zero, but the point is that value has been restored to the fixed income market, so it should serve, at a minimum, as a ballast when times get tough in the equity markets as we move forward.
There are other things going on. Obviously, the Russian-Ukraine war. I don’t pretend to be able to predict how that is going to turn out. But is has obviously impacted commodities, particularly the price of oil. But notice the price of oil even has managed… I think it’s lower now than the day before Russia invaded Ukraine. So, the system is working itself out in that shortage. And there’s an increased risk of recession obviously in Europe that’s highly likely given the dependence on energy from Russia.
China – China’s been weak all year. Property sector slowdown, regulatory changes that have been really negative for many of the businesses, and continued zero-COVID policy, which now finally seems to be changing and actually, the Chinese market is showing some signs of life. It actually looks like it may be bottoming and starting to improve finally after a long period of deceleration. And that’s important for global growth and stability too as we go forward.
The midterm elections – Obviously, it was a red ripple, not a red wave. I normally don’t bring up politics and returns because it’s a spotty record at best, but the midterm is sort of interesting where the record is 21 wins and no losses for the stock market after midterms are over, over the next 9-12 months. So that’s a pretty impressive record. I don’t know if we can make it 22 and 0, but it’s something to look forward to and see how that pans out over the next year.
Corporate profit margins – Margins have peaked, no doubt. They peaked back in the third quarter of last year and mainly because companies have experienced increased raw material prices so their costs of consuming materials has gone up a lot, their transportation costs have gone up a lot, shipping costs have goes up a lot, all the things that are driving inflation that the Fed and everybody else is worried about, it’s crimped their margins and we’ve seen a decline.
And notice the decline is in line with some historical periods as well, and so it’s not insignificant what is happening. We do think if these areas when inflation has finally peaked, we do think this has some potential to stabilize at some point. But notice we’re still at solid double-digit territory. So, companies are still doing relatively well even in this slow low-growth environment with a very harsh monetary policy.
Now we talked before about this, the VIX, which is sort of a fear index. When the VIX crosses 30, it’s typically a good time to buy. It means fear is running high and people are very concerned about something and that something frequently will disappear in 6-12 months and be replaced by something else that people are concerned about on the six o’clock news.
This year it’s been very volatile, not doubt about it, we’ve had multiple times where the VIX has crossed 30. The latest one was in the middle of October and we’re already up 5-10% on the S&P since that happened. So, it seems to be working again so far. We’ll see, though, if this is just a bear market bounce that blows over again or has more sustained legs behind it as we move into 2023.
This is one of our wealth advisor’s favorite charts. It shows the fact that this decline is about 25%. And if you look at this chart closely, what you see is there’s only a few periods here – back in 2008, 2007, and 2000, and also the COVID crisis, which was relatively brief, a whopping 24 days, as many of you know, most of us lived through this recently – there’s only a couple periods that have been worse than this drawdown. And these are all recessions and/or meaningful corrections in the stock market since 1990.
And notice the subsequent returns, they’re almost positive in every single category and in the 12- and 18-month period, they’re very significant.
So, this is the only business in the world that when the store marks everything down and prices go on sale in the store, customers run out of the store. We try to get our customers to stay in the store and then enjoy the bargains because inevitably things will recover and do better over time as this chart shows you.
With that, I’ll throw it open to Steve for some further questions.
STEVE RIGALI: Thank you, Doug. The first question is, what indicators do you look for to determine when the Fed’s policy of tightening has been completed?
DOUG FOREMAN: The number one indicator is the inverted yield curve. Why is that? The Fed is determining short-term rates. The market is determining long-term rates. When long-term rates are significantly lower than short-term rates like they are right now, it’s the market’s message to the Fed that you’ve done enough, that you need to stop, or risk a more meaningful recession than we’re currently already in, a period of very slow growth already. As I showed you the market is already concerned greatly about that in the way that it’s investing its money in the different sectors.
So, that’s the number one thing is an inverted yield curve, which will signal the fact that the Fed is closer than people think to stopping raising rates. The Fed is well aware of this. They may not talk about it in public, but in private I assure you they do, and then the other key thing, of course, that will give them the flexibility to do that, inflation needs to start falling faster than what they expect, which I think is entirely possible because every component on that chart that I showed you on inflation is now heading south – just the opposite of where we were last year at this time when every component on that chart was heading north.
So, it’s just a matter of time until these numbers flow through to the headline CPI number. We saw a little bit about this last month. The markets responded very positively, and I think we’re likely to see more of that as we move forward. Now I’m not smart enough to tell you that it’s going to happen every single month for the next 12 months, but I do believe the trend now is going to be better-than-expected inflation numbers as opposed to worse.
I think the other key thing is just to see some continued loosening up of the labor market. The labor market has been strong and relatively strong but we’re starting to see temporary help has weakened dramatically and that’s one of the first things that happens. Employers don’t lay off people unless they have to – that’s the last resort – but the first thing they can do is not use as much temporary help, and we’re seeing that in spades over the last six months already.
STEVE RIGALI: As those indicators become more evident, how do you think the equity and fixed income markets will react to that?
DOUG FOREMAN: I think both markets will react very positively. That’s been the whole problem in this market. The problem that we’ve had with both stocks and bonds over the last year has been driven entirely in my opinion by inflation fears and the Fed’s hawkish stance. So, if the Fed stops raising rates and the yield curve returns to a more normal shape – and the Fed actually starts lowering rates at some point in time, when the inflation data gives them the ability to do that – then I think you’ll see both bonds and stocks do much better. Bonds probably need to recover first before equities can stage a really meaningful rally, and I think you’re starting to see some stability in the bond market already. I think going forward we need to see more of that.
STEVE RIGALI: I’m going to switch over to a couple of questions we had in the equity markets. The one question is about investing in the S&P 500. We lived through a decade where it was a simple decision, buy the S&P 500 and go away and it’s compounded at an attractive rate over a long period of time, but the environment has changed. Can you speak to that environment change and the implications associated with just an indexed approach to investing?
DOUG FOREMAN: Yes, that’s a good question. If you look at the S&P 500 as you pointed out for about 13 years from like 2008/2009 to really, call it the end of last year, the FAANGs that became so famous for their price action, they came up with an acronym for them – the Facebooks, Alphabet, Netflix, Googles of the world – these companies went from 8% of the S&P to 24% of the S&P 500 – they tripled.
And for good reasons. Their fundamentals were superb. They’re dominant companies in their areas. They grew revenues and cash flows at astonishing rates, etc. So, it happened for a good reason and that drove the S&P returns sort of above normal what you’d expect long-term S&P 500-type returns.
What you’re seeing now all these companies are starting to have trouble. They’ve gotten too big. They’ve gotten on the targets of regulators in many areas of the world, not just here but abroad as well. I think they’re starting to have individual business issues that are all material in different ways. So, it’s not the no-brainer decision that you could make 13 years, 14, 15 years ago. Now you’re going to have to get a little bit more selective. I think it bodes well for some small and medium-size companies.
I think that capital’s going to more elsewhere over time. It doesn’t mean those companies are going to go bankrupt or that clients should run out and short them. I’m not making that case. I just don’t think they’re going to be market leaders as we move forward and that’s been a big source of incremental return for the S&P 500. So, I think the days of buying a no-brainer index fund are going to be behind over the next 5-10 years.
STEVE RIGALI: Doug, can you extend your thoughts to international equities, both developed markets and emerging markets?
DOUG FOREMAN: As most of you know, I’ve always been a fan of U.S. companies, first simply because they tend to dominate these other parts of the world when they go into these markets, whether it’s China or Europe or Japan, etc. Companies that are well positioned in the U.S. tend to do exceptionally well in these other markets and end up taking market share and giving the embedded competitors a lot of trouble.
Some of the markets internationally like Brazil has shown signs of life. It’s been spotty in the EM space and China, as I mentioned earlier, it’s been difficult all year though it is beginning to show some signs of life. We’ll see how sustainable that is. But there is some good news potentially brewing there after a long period of negative news.
But I think when we’re in markets like this, it’s sort of like munis have to recover, investment grade bonds have to recover, then large-cap stocks have to start doing better in the U.S., and then medium and small stocks will start doing better in the U.S., and then you’ll start to see international markets on better footing. I think they’ll still serve their purpose of diversification, but I don’t think you have to be there first in this inevitable recovery that we’ll probably have at some point over the next year or two.
STEVE RIGALI: The last question. Obviously, a lot of interest in both technology and energy stocks. Energy has been a leadership over the last 12 months. Technology has corrected significantly. Any general comments on those two particular sectors?
DOUG FOREMAN: Well, energy is not an area that we spend a lot of time on here at Kayne because of capital intensity and really the unpredictability of the price of the commodity, i.e., oil. So, oil prices have been really strong over the last couple of years and the oil companies have been very disciplined about their capital spending, and really have returned a lot of capital to shareholders.
In the old days, when prices went up, they all punched a lot more holes in the ground and made sure the prices came down, and most of the public producers right now are following a more disciplined strategy and returning excess capital when they are making a lot of money to shareholders and not expanding their production footprint materially.
And the reason for this, the Biden administration and the clean energy movement has made them reluctant to invest. So, they don’t want to invest in expanding their asset base. They want to invest in what they have and maintain what they have which is generate excess cash flow. In a market that’s been looking for yield, looking for income and looking for some stability in the earnings, energy has provided that, and really not just last year but the year before as well. It’s been a couple of years energy has done exceptionally well. Bear in mind, though, before this, from the middle of 2014 through a couple of years ago, energy was an unmitigated disaster in terms of shareholder returns. So, they’ve gotten some religion and clearly done better.
And tech, of course, has been the weakest group in the market over the last 12 months. They’re hurt by rising rates. Many of the companies don’t make money short term, so they’re very long duration assets – like a 100-year bond as opposed to a 30-year bond – and have been hurt really badly by this rise in interest rates and also by the lack of spending as companies are starting to tighten their belts because they’re “quote” preparing for this next recession, which may or may not come – time will tell – but that’s clearly what’s been happening, so spending has been cut back as well in many areas of technology, which has created some weakness in the stocks.
STEVE RIGALI: So, Doug, just as we finish out the webinar, can you provide our clients the key messages that you want to leave with them as we finish up?
DOUG FOREMAN: Yes, I think the biggest messages I can impart to clients are, this is going to take time to recover, and what you should expect as we move forward, is just the opposite of what we experienced over the last 12 months. The last 12 months if you think about it – 12 months ago, the Fed made it clear they were going to start raising rates and the market started acting poorly, particularly growth stocks, starting November of last year.
What you saw was the companies performed great. They had a great fourth quarter last year in terms of their revenue earnings and cash flow. Business was wonderful. People were lining up to buy homes, multiple bids, 20-30 people way over asking, everything was great. First quarter, same thing. Everything was great but stocks not reacting to the earnings, going down 20-30% on great news. So, times were good, and the stock market fell apart, and things have been very difficult.
As we move forward, I think we’re going to see the exact opposite where times are tough, things are difficult, growth is hard to come by, but interest rates start to come down or at least stabilize at a minimum, and the big increase in rates is behind us and that becomes increasingly obvious and the market will start to discount because it’s always looking forward.
This is the hardest thing that both professionals and individuals that aren’t involved in the stock market all the time find difficult to understand. The market’s very forward looking so even if business is weak short term, even if we are in a mild recession already, even if the earnings outlook is bleak, once the Fed starts taking their foot off the accelerator on interest rates, the market will instantly start to react to that and start to improve as we move forward, discounting the fact that business will get better down the road. It may not be better that month; it may not be better the next month or even the next quarter, but markets will start to anticipate that in advance just like they did this downturn. So, stay patient, stay involved, stay in your seats, that would be my message.
STEVE RIGALI: Thank you, Doug. Great content today. We appreciate your comments. So, on behalf of Doug and myself and everyone at Kayne Anderson Rudnick, we’d like to thank you for joining us today.
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