Lockhart Capital 2022 mid-year commentary

The first half of 2022 has so far seen the largest ever destruction of financial wealth in history, both in US$ terms and as a % of GDP (source: BCA Research), and that is before one considers the additional losses that one could have had if exposed to more esoteric investments such as crypto currencies.  Market commentator and Evergreen Gavkal CIO David Hay refers to it as “a wealth wipe-out of historic proportions”, and Jason Goepfert, founder of SentimentTrader described the market price action in June as “the most overwhelming display of selling in history.”  So, what is going on?

Lockhart Capital Management clients will know that this is chickens coming home to roost, and that inflation was not “transitory” (as most market commentators and Central Banks suggested) and that financial markets are now reacting to a belated tightening of monetary policy into a weakening global economy and falling markets, and which is quite unprecedented.

The destruction being played out across both fixed interest and equity markets is the realisation by investors that interest rates are going to rise much further and faster than they previously had thought, causing a sudden repricing that has no historic parallel. The below chart shows the full extent of this year’s pain for bond investors, with the bold blue line showing the current year to date global bond market performance. Each of the other faint lines represent every other previous year’s performance, highlighting how severe and unprecedented this year’s losses have been.

Fig 1 (Source: Bianco Research)

Readers of our previous updates will recall of how we had been concerned that excess money printing, and artificially suppressed interest rates (“Financial Repression”) would lead at some stage to the unintended consequence of inflation.  We say “unintended”, although that is not the same as “unwelcome”, in that most central banks have been trying to induce some form of inflation for years, as it is the only way, bar formal default, for most developed nations to reduce their unsustainable levels of debt.  We have however often used the analogy that trying to create inflation is like pulling a brick on a piece of elastic.  That is, not much happens to start with, but eventually you get hit in the head by a brick.

Fig 2 (Source: @bespokeinvest)

It now turns out that inflation was already baked into the pie last year, when central banks failed to raise rates, and a significant inflation pulse became, in our view, inevitable. That is, it was already too late to be able to stop it, as we stated at the time, even before it became fully evident.  Ordinarily policy makers raise rates into a strong economy, but now they are significantly further behind the curve than they ever have been (see below chart), and so have left themselves in a position whereby they are tightening monetary policy into slowing economies, something they would never do given the option, but are forced to now given rampant inflation.  This inflation has been further exacerbated by supply chain disruptions, COVID shutdowns in China, and the war in Ukraine.

Inflation is not well understood as a concept, indeed there is not even agreement on what causes it.  The vast majority of investors have not operated in such an environment, and have been dismayed to find that the stocks and bonds in their portfolios no longer diversify each other, and instead have become correlated (which actually is the case for more than half of market history, just not recent history). Indeed, supposedly safe government bonds have shown just as much risk now as equities (see below chart) which leads to more portfolio volatility and greater drawdowns if that is all that is being held.

Fig 3 (Source: Minack Advisors)

Fig 4 (Source: Minack Advisors)

Unfortunately, many institutional portfolios are “geared” (have borrowed money to increase their invested exposure), and are having to sell, either to curb losses or to remain within volatility targets, thereby exacerbating the situation.

Our own view of inflation is that it has a large psychological component, and which is what allows it to become embedded in economies.  Higher prices necessitate higher salaries which drive prices higher again, as we saw in the 1970s.  A key difference now is that the debt burden is twice as high, and demographics worse.  It will therefore be impossible to tighten interest rates in the manner of Paul Volcker, brought in as Chair of the Federal Reserve in 1979, specifically to bring inflation under control.

One similarity, though, is that Volker’s predecessor, Chair Burns, was convinced (until 1975) that inflation was “transitory”, and subsequently required his team to remove more and more inputs (ultimately a plurality of inputs) from the inflation basket, to maintain this fiction, which is how we ended up with the “CPI ex Food & Energy” data series.

The current policy error(s) by central banks has resulted in a far nastier market sell-off, in our view, than otherwise would have been needed, which is frustrating to us, as much as anyone.  Reality caught up with the US Federal Reserve and ultimately, this year, with investor thinking too.  However, it is interesting to note that markets believe that the Fed will indeed control inflation, either through the now understood tightening cycle, or, and more likely they think, through breaking something before they get much further! This is important as investors’ greatest concern right now, is slowing economic growth – again, something we were worried about at the start of the year, and thought likely even a year ago.

The nightmare for investors has been that all this bad news has happened at a time of historically high valuations for capital markets – bonds because they were kept at artificially high prices by central banks that are now departing the scene, and equites because that is where the proceeds of bond sales to central banks went, plus other excess liquidity.  In that way, much of the decline in markets is more a removal of “froth” rather than a journey to dirt cheap valuations.  Or at least we think not yet.

These markets are much cheaper than they were at the start of the year for sure, and we are minded to begin to close up some of our largest ever underweight position to core assets (equities and bonds), bit by bit.   We then have the option to make a more significant move if we get to the kind of levels that we were able to take advantage of in 2008 and 2011.

So, there may be some value starting to appear in core assets, not for the already fully invested, but for those of us who took a more cautious stance and who took the prospect of ‘higher inflation for longer’ possibility seriously. Bear in mind that any purchases we make here, will come from our Alternatives and Real Assets sub strategies, which are at all-time highs in terms of portfolio weight.

At the time of writing these two asset classes are up 7% and 2% respectively, on the year, which is very favourable compared to core assets, with both equities and bonds down well into the double digits. On that note, and again as clients already know, we have been very defensive and inflation orientated within our fixed interest allocation, itself far smaller than historically, which means that it has fallen just 1% this year, versus a 15% fall in the average gilt fund, for example.

That being said, we will be careful with how we manage our Real Assets sub strategy, and any profit taking (absolute and relative).  The reason for this is that many other investors currently do not see the need to hedge the inflation risk in their portfolios, as they assume, as previously mentioned, that inflation is going to come back down, swiftly and soon.

They may be right, and we hope that they are, but there is enough chance that they are wrong, and with significant enough implications, to make it sensible to lean the other way.  That is, to own inflation hedging assets, which are still not expensive, and could move dramatically on any “FOMO” in the investment community if it becomes clear that inflation is stickier than they had assumed.  It also helps us defend against the risk that inflation does indeed decline, only for policy makers to turn on the taps again, monetary and fiscal, to alleviate recessionary conditions, and for inflation to have another wave.

This investor view of slowing growth and inflation has also led to something of a rout in the previously high-flying commodity markets, right now, which appears rather indiscriminate, and, we think, possibly premature.  However, again, it may reveal opportunities.  We feel that this particular inflation hedge is under owned and underappreciated.

We are absolutely sympathetic with the slowing growth argument, however, in fact it has been our central case for the last year, but Wall Street analysts are yet to take a red pen to their earnings forecasts for individual companies (see following chart).  That is, there remains a disconnect between what investors fear and macro analysts are starting to foresee, and what “bottom up” analysts are saying for the companies that they follow.  The latter are always the last to get the proverbial memo (they entered 2008 expecting double digits earnings growth…), but until they do so it is likely that equity market valuations, as a consequence, remain too high.

Fig 5 (Source: Bloomberg/

Shelby Cullom Davis famously said that: “You make most of your money in a bear market; you just don’t realize it at the time.”  We take that to mean that if you can defend your portfolio reasonably well in the bad times, then it is easier to compound better long-term returns, and all the more so if you are in the fortuitous position to add opportunistically during said bad times.

You do need some luck as well as judgement, and the future is unknowable.  We moved to our riskiest positions ever in November 2008, from our most defensive, which did indeed turn out to be the valuation bottom.  However, the price bottom was not until March 2009, and so our clients had to stick with some extra volatility before getting their rewards.  The Cautious portfolio that we were managing at the time made a return in 2008 of 0.0%, which remains one of our most proud achievements. Some supposedly Cautious portfolios fell by in excess of 30% in that year.

So, defending against volatile markets can lead to the opportunity to build in greater longer-term gains.  It seems counter-intuitive, however our client portfolios performed better because of the 2008 financial crisis than they would have done without it.  You can’t step in the same river twice, but we would agree that our most crucial work is done during the toughest market conditions.

 Andrew Wilson, Chief Investment Officer, June 2022


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