As past editions of our outlooks have detailed, midterm years have historically been the most volatile of the four-year election cycle. Midterm years have experienced an average (peak to trough) intra-year decline of -19%, compared to -13% for the other three years. The S&P 500 has followed this pattern closely this year with a -18% correction through October 31. Astute readers of Clarendon’s outlooks will remember that stocks tend to benefit from the policy shift and sentiment change that occurs during the period between midterms and the presidential election. In fact, the S&P 500 has posted a positive return in the 12 months following midterms in every instance since 1946, with an average return of +15% (Exhibit 1).
The midterms carry importance beyond the fiscal support and seasonality. Tax rates, energy policy, drug pricing, minimum wage, and the debt ceiling are just a few key topics in limbo as we turn the corner towards the 2024 presidential election. While we are fundamental investors, we also believe it is important to stay apprised of the prevailing legislative agenda as key issues will have an impact on revenues and margins for a variety of companies, sectors, and global relations. Ultimately, long-term equity returns are determined by the value creation from free cash flow generation of companies over time.
Source: Strategas
While we don’t know the full outcome of the U.S. midterm elections yet, here are some initial thoughts on the political, policy and market-related implications. We expect legislative gridlock for at least the next two years as Republicans appear on track to narrowly win a majority in the House, while Democrats will hold a slight edge in the senate. Republican control of the House, albeit narrow, is the salient policy point for investors because it means the end of the affirmative legislative phase of Biden’s presidency. That likely means no tax increases or approval of large progressive spending packages. Defense spending is likely to increase as a result of deteriorating relations with China and Russia’s invasion of Ukraine. As of today, the most likely outcome has historically produced above average returns for stocks: +13.6% per year (Exhibit 2).
Source: Strategas
Other Potential Implications of the Most Likely Outcome: Republican House, Democratic Senate
1. Taxes: It is hard to imagine we will see tax increases with a Republican majority in the House
2. Stocks: potential winners and losers amid political gridlock?
Historically, quality stocks (strong free cash flow growth, high returns on capital, and dividend payors) have outperformed following midterms, particularly when gridlock prevails
Potential winners: Healthcare, Communication Services, Energy, Industrials, Aerospace & Defense stocks, and Consumer Discretionary
Potential losers: Clean energy stocks, Build Back Better program beneficiaries, and cannabis stocks
3. U.S. Debt Ceiling: The lame duck session of Congress will be motivated to avoid a 2011 situation when the Republican House leveraged the borrowing limit to boost their agenda
Last quarter we discussed that there would be a longer road to reach the Fed’s target of 2% inflation than what was implied by investor expectations at the time. Much to our surprise, markets began to anticipate a Fed pivot (reversal to more accommodative monetary policies) in the middle of the summer (Exhibit 3). That optimism ended abruptly when Fed Chairman Jay Powell took the podium at the annual Jackson Hole symposium in August. Powell made it clear that the Fed is committed to getting inflation under control and that the Fed “must keep at it” until the job is done. This was notable to us in that he was explicitly referencing the lessons learned in the 1970s - and likely a nod to the book written by former Fed Chairman Paul Volcker (1979-1987) titled “Keeping at It: The Quest for Sound Money and Good Government.”
Source: Bloomberg, Morgan Stanley Research
Chairman Powell went on to say that this could entail near-term pressure on financial markets and households as the cost for achieving price stability. This aggressive policy stance has dashed hopes for a rate cut in early 2023 and the expected Fed Funds Rate for May 2023 increased to 5% (Exhibit 3). Following the Jackson Hole speech in late August, the S&P 500 declined by 12% and investment grade corporate bonds fell by 8% during the final month of Q3.
We continue to believe that we have seen peak inflation. In addition, we expect the pace and magnitude of rate hikes will slow in the coming months as the lagged effect of policy tightening curtails growth and likely induces an earnings/economic contraction (Exhibit 4). Powell is following Volker’s playbook to tame inflation through aggressive rate hikes. The current chairman has been vocal about his goal to avoid his predecessor’s mistake of prematurely ending the rate hiking cycle, which led to a double-dip recession during the inflationary period of the early 1980s.
Nonetheless, inflation remains stubbornly high and it will take time to get close to the Fed’s stated 2% core inflation target from the current level of ~6%. This is particularly true with wage growth and housing costs likely to continue exerting upward pressure on (core) inflation in the near-term.
For years we have referenced the adage “don’t fight the Fed” to contextualize why higher valuation multiples made sense throughout the Quantitative Easing era. However, as we have articulated for the past year (in the midst of a move to more restrictive policies), investors would be well served to remember that this dynamic works in both directions. In early 2022, Fed policies (money supply growth) became restrictive; a headwind to valuations (Exhibit 4). In this paradigm, we have been favoring short-duration bonds and cash as well as high-quality stocks with pricing power, stable free cash flows, and dividend growth.
Source: Bloomberg, Morgan Stanley Research
We expect elevated volatility to continue into early 2023. However, looking further into next year, our view is that moderating inflationary pressures, a reset of earnings growth expectations, and a potentially more accommodative Fed will result in a better environment for stocks and bonds. It is worth noting that U.S. 10-year Treasuries have lost 23% (annualized) YTD. The last time U.S. Treasuries fell more than 5% and were negative the following year was in 1861.
In Q3 2022 both stocks and bonds posted their third consecutive quarterly decline for the first time since 1976. The mid-summer rally in stock prices proved fleeting as the Fed reaffirmed its determination to curtail inflation. The S&P 500 declined by -5% in Q3, bringing the (YTD) swoon to -24%.
Non-U.S. stocks underperformed in the quarter, down -11%, and have lagged YTD -27%, as a strong U.S. dollar has been a significant headwind. The Nasdaq remains one of the worst performing indices with a return of -33% YTD as growth stocks have struggled in the face of rising rates. The bond market also remained under pressure in Q3: Investment grade corporate bonds underperformed the S&P 500 as they fell by 6.2%, bringing the YTD collapse to -21.2%.
Historically, a portfolio strategy comprised of 60% stocks (S&P 500) and 40% bonds (Bloomberg U.S. Aggregate Bond Index) has served investors well, generating a +7.5% annualized return over the last twenty years. However, due to the rout in bonds, 2022 has been quite a different experience (Exhibit 5). According to Bank of America, the annualized return for 60/40 portfolios (through Q3) is the worst in the past 100 years. This historic year for financial markets has unfolded as global central banks have transitioned to highly restrictive monetary policies from the accommodative policies that have largely been in place since the 2008 Great Financial Crisis. We previewed this policy shift as the key risk to markets in our 2022 Outlook published last November.
Source: The Leuthold Group
In such an environment, employing thoughtful active management and positioning portfolios differently than a static index has been critical. As Sir John Templeton famously said “If you want to have better performance than the crowd, you must do things differently from the crowd.” While not immune to market stress, our portfolios have been defensively positioned. As a result, Clarendon has provided downside protection relative to passive equity and fixed income strategies through both top-down allocation decisions and bottom-up security selection:
1) Key underweights: long duration bonds, growth stocks, and non-U.S. stocks
2) Key overweights: energy, healthcare, insurance, aerospace & defense, and consumer staples
Our long-term approach and disciplined process have allowed us to take advantage of market dislocations to increase exposure to high-quality investments across asset classes and harvest some tax losses where appropriate.
One of the bright spots amid the broad selloff across global asset classes is that prospective long-term returns have improved considerably over the course of the year. Additionally, inflation expectations for the next five years have declined significantly from 3.6% per year to 2.1% annually. This implies better real (after-inflation) returns as well.
The role dividends play in equity portfolios tends to get overshadowed during periods of outperformance by growth stocks where returns are driven more by price changes, such as 2009–2021. Conversely, the merits of dividends become clearer in volatile markets. Historically, dividends have accounted for nearly 60% of the total return from stocks since the 1930s (Exhibit 6a).
Not only do dividends provide income and enhance total return, they can also be a sign of a healthy balance sheet, stable cash flow generation, and prudent capital allocation by company management.
Consistently paying and increasing a dividend imposes capital discipline on management and directors. Our preference is to own great businesses that we expect to grow their dividends at a faster rate than the average company. Many investors focus on current yield, but dividend growers have historically outperformed all other dividend cohorts by at least 1% per annum (Exhibit 6b).
Don’t look now, but the U.S. 1-year T-bill is yielding 4.6% for the first time in more than 15 years (Exhibit 7). The current interest rate environment offers unique opportunities for investors holding cash. One could be forgiven for having forgotten about Treasury bills. The last time short maturity yields were at these levels was in 2007: Apple had just introduced the first iPhone and Netflix was a DVD rental company.
Source: FactSet
The increase in short-term Treasury rates has created opportunities. Clarendon Private’s customized cash solutions offer yields of 4.5% or more, while maintaining liquidity and preserving capital. In addition, our approach provides optionality and flexibility to reassess (and take advantage of) opportunities that present themselves amid a volatile market backdrop.
Certain longer-dated investment grade bonds are also offering attractive total return potential for investors with longer investment horizons (Exhibit 8). High-grade municipal bonds are now trading with tax-equivalent yields of 5% or more.
In line with our view coming into the year, markets have been extremely volatile. However, it is not all doom and gloom as:
1. A lot of bad news is already priced into risk assets
2. Prospective long-term returns have improved materially
Importantly, inflation expectations have also come down considerably, which suggests better real (inflation-adjusted) returns in the coming years. A disciplined research process with a long-term focus is well positioned to take advantage of the current market dynamics.
Source: The Irrelevant Investor
Conclusion
Within equity markets we are finding opportunities among high-quality businesses with pricing power, stable free cash flows and dividend growth. Many of these companies are in more defensive sectors such as beverages, pharmaceuticals, insurance, managed care, aerospace and defense, and household products. We have also been overweight select energy stocks this year that are trading at attractive free cash flow yields, much of which is being returned to shareholders via dividends and buybacks. Conversely, we remain comfortable being underweight profitless technology stocks in the face of tighter monetary conditions. We also see an improving risk to reward for U.S. mid cap stocks, but remain underweight international equities.
The information provided is illustrative, for educational and informational purposes only, does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Clarendon Private strategies are disclosed in the publicly available Form ADV Part 2A.
Clarendon Private, LLC (“Clarendon Private”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Clarendon Private and its representatives are properly licensed or exempt from licensure.