The Fed Giveth and the Fed Taketh

Financial markets got off to a rocky start in 2022 as inflationary pressures, tightening monetary policy, a Covid resurgence in China, and the outbreak of war in Ukraine led to a selloff in both stock and bond markets. The S&P 500 experienced its first negative quarter since the onset of the pandemic two years ago. Growth stocks were hit especially hard, with the Nasdaq 100 Index declining nearly 20% before recovering to finish the quarter at a 9% deficit. Even bonds were no haven, with the Barclays Aggregate Bond Index falling 6%--its worst quarterly return in almost 40 years (long-term bonds fared even worse, dropping about 10% on average). 

On average, our balanced portfolios declined less than a similarly blended benchmark during the quarter and outperformed for the prior 12 months. The lone bright spot in client portfolios? Natural resource and commodities investments rallied sharply in reaction to supply disruptions and broader inflationary concerns.
 

Background: Monetary Manipulations

By late last year, the U.S. central bank was telegraphing its intention to tighten monetary policy throughout 2022: gradually raising the Fed Funds Rate (then at 0%) while allowing bonds held on its balance sheet to mature, thereby pulling dollars out of circulation. Figure 1 (below) summarizes the Fed’s asset purchases scale, which began during the 2008 financial crisis and accelerated during the pandemic. 

Figure 1: U.S. Federal Reserve Balance Sheet Growth

Source: JP Morgan Guide to the Markets, 3/31/22

These monetary interventions—combined with a series of fiscal stimulus measures passed by Congress—blunted the economic impact of the pandemic but also skewed consumer behavior. With many service businesses closed or restricted by covid protocols, consumers shifted more purchases to goods. This relatively modest change in spending type overwhelmed a finely tuned global supply chain optimized for years to minimize costs and excess inventory. The stimulus measures combined with supply chain bottlenecks were the genesis of today’s inflation, which broke out beyond the Fed’s target 2% range about a year ago (Figure 2).

Figure 2: Headline (Blue) & Core (Red) Annual Change in CPI

Source: Federal Reserve Bank of St. Louis

By February of this year, inflation had reached a 40-year high of 7.9%, and a consensus was building among bond investors that the Fed would accelerate the pace of monetary tightening. Then on February 24, Russia invaded Ukraine, and the U.S. and western allies responded with an unprecedented series of financial sanctions. Uncertainty over the impact of these sanctions and further potential disruption of global trade sent commodity markets soaring. Oil futures spiked as high as $130 per barrel in March. Corn and soybean futures reached 10-year highs, and wheat hit an all-time record (together, Russia and Ukraine account for more than a quarter of global wheat exports).

Meanwhile, the futures market for nickel (a major Russian export and critical component in stainless steel and EV batteries) seized up entirely. In March, the Fed raised its target rate to 0.25%, the first increase since December 2018. However, the bond market had already priced in this increase (and several more). The yield on the 2-year treasury increased from 0.73% to 2.28% during a quarter, a much steeper increase compared to more distant maturities (Figure 3).

Figure 3: Q1 2022 U.S. Treasury Yield Changes by Maturity

Implications of Rising Rates – Growth vs. Value

As investors recalibrated their interest rate expectations, the 1st quarter saw one of the most dramatic short-term divergences between growth and value stocks in recent memory (Figure 4). 

Figure 4: U.S. Equity “Style” Returns

Benjamin Graham, an investor, and professor at Columbia Business School defined the “intrinsic value” of a business as the sum of all its future cash flows, discounted to the present day. While conceptually simple, this calculation necessarily involves a lot of subjective inputs. After all, nobody can know how long a company will remain in business or what kinds of profits it will generate over decades or even centuries. Moreover, discounting future cash flows requires estimating a reasonable market interest rate or implied “cost of capital” over that period. All else being equal, a lower discount rate yields a higher present value of distant future cashflows. The Fed’s monetary interventions since 2008 kept a lid on long-term interest rates. It made it easier for some investors to justify optimistic valuations on companies that were growing sales at a rapid clip, even if those companies did not expect to generate many profits until several years into the future.

Sure enough, as the 10-year treasury yield reached a cyclical low in the summer of 2020 (it bottomed out at 0.52% that August), valuations for some fast-growing companies reached truly absurd levels—capitalizing not 30 or even 50 years of earnings, but in some cases over 50 years of sales! Conversely, as the 10-year rate nearly doubled over the first four months of 2022, the most speculative growth stocks have come in for the largest price correction (Figure 5).

Figure 5: Selected Price-to-Sales Ratios vs. 10 Year U.S. Treasury Yield

For several years now, we have pointed out the increasing concentration within the S&P 500 index. That trend continued in the first quarter, with the top 10 stocks comprising 30.7% of the index weight on March 31. However, one meaningful change is that the largest ten companies now only accounted for 23.8% of the trailing twelve-month aggregate earnings of the index. Those ten stocks now trade at nearly double the earnings multiple of the other 490 stocks in the index (Figure 6). 

Figure 6: S&P 500 – Top 10 Holdings

Source: JP Morgan Guide to the Markets, 3/31/22

While we do use index funds in constructing client portfolios, we’ve exercised caution due to the valuation skew (i.e., growth bias) within the S&P 500 index and preferred instead other US large-cap indexes with different weighting methodologies (and very low costs).  

For example, the Schwab Fundamental U.S. Large Company index fund (ticker: FNDX) tracks an index that weights constituent companies not by market cap but by adjusted sales, retained operating cash flows, and the sum of dividends and buybacks. These underlying business performance measures result in an index less reliant on expectations, with more diversification than the S&P 500, a lower average multiple of earnings, and a higher weighted average dividend yield. Over time, we believe these factors should improve risk-adjusted returns relative to the S&P 500 index, particularly during periods of market turbulence.
   

Large Cap Value Review 

(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the size of the overall portfolio and the client’s objectives and constraints).

During the first quarter, the typical Large Cap Value (LCV) portfolio slightly outperformed the S&P 500 index (-4.6%) while lagging the Morningstar Large Value Index (+0.9%). 

Top positive contributors to quarterly performance included several companies levered to rising commodity prices (mainly agricultural inputs), such as Nutrien (crop nutrition), AGCO (farm equipment), and Bayer (crop protection). The conflict in Ukraine has curtailed the supply of grain exports (especially wheat), driving up global prices. Higher crop prices support demand for fertilizer, which is also supply-constrained. Sanctions on Russia and Belarus (the 2nd and 3rd largest potash fertilizer producers) have directly benefited Nutrien (based in Canada), the world’s largest potash producer. 

Additionally, the soaring price of European natural gas (the primary feedstock for nitrogen fertilizers) led several European producers to shut down nitrogen plants which are no longer economical at prevailing gas prices. Cost-advantaged North American nitrogen producers (who have access to cheaper shale gas) are now earning windfall profits, which they are using to pay down debt and repurchase stock. Given this period of unusually high (but likely temporary) profitability, we took the opportunity to trim our investment in Nutrien during the quarter.  

Also positively impacted by the rising rates were two insurance conglomerates (Markel and Berkshire Hathaway) which stand to earn higher income on their large pools of assets—most of which is typically allocated to bonds. Finally, credit card issuer American Express outperformed many financial peers as solid job growth and resurgent travel & leisure spending are expected to bolster their consumer charge and lending volume. Several of the economic indicators that we’ve monitored throughout the pandemic appear to be on the cusp of finally surpassing their pre-pandemic levels (Figure 7).

Figure 7: Selected Consumer Spending Data

Source: JP Morgan Guide to the Markets, 3/31/22

Among the detractors were a handful of companies with more idiosyncratic issues. Americo (the parent company of U-Haul) typically experiences a seasonal lull in demand for their moving and storage products during the winter months. Moreover, after riding a tailwind of strong “Zoom Town” demand in 2021, the company may face tougher year-over-year comparisons in 2022 as higher mortgages rates and limited home inventory present a headwind to domestic migration. 

Qurate Retail (QRTEA), already struggling to manage its supply chain in an intensely competitive online retail environment, had to deal with additional disruption after a fire destroyed one of its major distribution warehouses in North Carolina last December. 

Most significantly, Meta Platforms (the parent company of Facebook) suffered a single-day decline of 25% in early February after disappointing quarterly earnings. The company reported a slowdown in new user growth and declining year-over-year net income due to lower ad monetization and higher operating expenses. 

Apple’s recently instituted privacy settings on iOS devices hampered Facebook’s and Instagram’s ability to deliver targeted ads to the same degree as they had previously. Additional spending on content moderation and new products also reduced operating margins. 

That said, Meta remains a tremendously profitable company, generating roughly $40 billion of free cash flow in 2021 alone (nearly 10% of the company’s current enterprise value). At today’s moderate valuation, with additional revenue growth projected from the long-term secular shift toward online advertising, we believe Meta is poised to deliver well above average returns on invested capital for many years to come. We took advantage of the stock’s weakness in the quarter to modestly increase our position size.  

We welcome any questions or comments you may have and appreciate your confidence in our services.