After falling for most of the year, markets rebounded in the fourth quarter of 2022. Evidence of easing inflation paired with a resilient labor market spurred hopes that the Federal Reserve might slow the pace of monetary tightening, leaving room for a goldilocks "soft landing" scenario—whereby inflation reverts to pre-pandemic levels without triggering a significant recession.
Every asset class gained in the quarter, led by developed equity markets outside of the U.S. Despite this impressive Q4 rally, most also finished the year down by double-digits (save commodities and cash). As discussed in prior quarterly reviews, much of this had to do with the unprecedented pace of interest rate hikes by the Federal Reserve.
To swiftly beat back inflation (which peaked at a 9.1% annual rate in June), the U.S. central bank raised rates seven times in 2022, a cumulative 4.5% increase (Figure 1). This abrupt policy shift hammered bond prices. The Bloomberg Aggregate Bond index, the US intermediate bond benchmark, declined 13% for the year, its worst annual performance in at least 47 years (Figure 2). Meanwhile, the 30-year U.S. Treasury bond—among the most sensitive to changing interest rates—declined approximately 33%!
Balanced Portfolios Find No Quarter
With equity market declines in the high teens, the bond market's poor showing made it virtually impossible for balanced portfolios to limit the damage in 2022. Still, some of the strategic moves Bristlecone made improved our clients' relative performance and mitigated overall portfolio declines.
Within our fixed income allocation, we favored shorter-duration, higher credit-quality bonds. Instead of investing in passive intermediate-term bond indexes, which were increasingly exposed to interest rate shocks (via lengthening average bond maturities, a.k.a. duration), we also favored active bond managers who reined in interest-rate risk relative to their benchmarks. Proactively managing bond duration meant that our typical fixed income allocation only experienced about 60% of the decline of the Bloomberg Aggregate Bond index in 2022.
Source: Morningstar, Federal Reserve Economic Database
Source: JP Morgan Guide to the Markets, 12/31/22
Similarly, our longtime bias toward value investing paid off in 2022, as rapid monetary tightening brought high-growth equity market segments in for the most significant valuation adjustments. As the price of money (i.e., interest rates) increased, business models prioritizing rapid revenue growth over current profitability quickly fell out of fashion. Large-cap U.S growth stocks (particularly technology stocks) were among the worst-performing investments. The Morningstar U.S. Growth index lost nearly 37% in 2022, declining more than twice as much as the S&P 500 index. Meanwhile, value stocks (particularly those paying a stable dividend) significantly outperformed the broader market (Figure 3).
Figure 3 – Morningstar Equity Style Box Returns (%)
Source: Morningstar Direct, YTD as of 12/30/22
Finally, our allocation to natural resources stocks and commodities in general finally paid off after a few years of lagging the overall market.
Inflation: The $64K Question
The sharpest pace of monetary tightening in living memory is having the desired effect so far. December's CPI report showed an annual increase of 6.5%, down materially from the peak of 9.1% in June and representing a trailing 6-month annualized increase of only 1.9%. Essentially in line with the Fed's stated long-term target. This begs the question: when will the Fed slow down or even pause the current cycle of rate hikes?
Notwithstanding a slew of recent layoff announcements (heavily concentrated in the technology sector), overall employment data in the U.S. remains strong. December's unemployment rate was 3.5%, the lowest since 1969. Average hourly wages grew about 4.6% year-over-year in December, a slower pace than early 2022 but still well above the pre-pandemic trend. Part of the explanation for the persistently tight labor market may lie in the labor force participation rate (Figure 4), which remains below its pre-pandemic level, particularly for older workers. Economists point to several plausible explanations, including Covid-induced early retirements and a slowdown in legal immigration over the last several years, limiting the pool of available workers.
Figure 4 – Labor Force Participation
Source: Charles Schwab Quarterly Chartbook (Q1 2023)
While Fed rate hikes certainly played a role in cooling aggregate demand (e.g., housing) and in deflating speculative bubbles (SPACs, cryptocurrency, "meme" stocks), it's also fair to say that much of the progress on inflation over the last several months probably came from the simple normalization of temporary supply shocks.
The shift in consumer behavior during the early days of Covid lockdowns—towards goods and online retail instead of in-person services—led to a host of supply chain bottlenecks, shortages, and surging freight costs. Retailers responded by boosting inventories and scrambling to hire additional staff. However, by the time vaccinations became widely available, consumer preferences once again turned toward long-deferred services (travel, dining out, etc.), and retailers including Target, Walmart, and Amazon were forced to offer steep discounts to move excess inventory, helping keep a lid on aggregate price growth.
Another significant factor in 2022's inflation was the price of energy—particularly oil and gas—which surged in price over supply disruptions following Russia's invasion of Ukraine in late February. Spot prices for Brent Crude oil contracts began the year at about $77/barrel but climbed to over $133/barrel in the aftermath of Russia's invasion. European spot natural gas prices more than quadrupled in the six months following the start of the Russia/Ukraine war. Surging energy costs had a ripple effect on the price of virtually every good or service in the global economy.
In response to this energy crunch, the U.S. government sold over 180 million barrels of oil from the country's Strategic Petroleum Reserve (SPR) last spring at prices averaging $96/barrel. This incremental supply helped reverse a spike in gasoline prices, which peaked at over $5/gallon in June (Figure 5). In mid-December, the Department of Energy announced plans to buy back oil to replenish the SPR at prices between $67-$72 per barrel. By year-end, U.S. gasoline prices had approximately returned to their level from the beginning of the year.
Figure 5 – U.S. Gasoline Prices
Similarly, European leaders moved quickly to reduce their reliance on Russian natural gas by instituting conservation measures, switching to alternative fuels (where feasible), and importing liquified natural gas (LNG) to build stockpiles for anticipated winter demand. In a bit of additional good fortune, Europe has been blessed with an exceptionally mild winter thus far, reducing natural gas demand for heating and allowing the benchmark European gas price to settle back below the level it held before the outbreak of Russia-Ukraine hostilities (Figure 6).
Finally, another factor quickly normalizing is the purchasing power of the U.S. Consumer. During the pandemic, extraordinary relief measures and stimulus payments boosted the average household savings rate to well above its historical average, leaving more "dry powder" in the consumer spending cannon.
As government relief programs have rolled off and retail prices have increased, consumers are straining to cover necessities, avoiding large discretionary purchases or relying more on revolving credit card loans. Moreover, higher mortgage rates and stagnant (or declining) home prices discourage refinancing activity and the wealth effect traditionally accompanying it.
All of which is to say that many issues contributing to rising prices earlier in the year are no longer as prevalent, bolstering the case that inflation will continue to wane, even without further rate increases.
Figure 6 – Dutch TTF Natural Gas Futures
Large Cap Value (LCV) Portfolio 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.)
U.S. stocks hit their lowest point of the year early in the 4th quarter before rebounding strongly. Such volatility frequently offers the best opportunities for disciplined investors to take advantage of Mr. Market's manic-depressive tendencies. Thus, we were again active in the LCV portfolio last quarter, trimming three long-held positions (Valmont, NRG Energy, and Graham Holdings) while adding to another (Intel) and re-initiating an investment in another former holding after an almost 19-year hiatus (Disney). Overall, the median LCV account increased about 12.7% in Q4, well ahead of the S&P 500 (+7.6%) but behind the Morningstar Large Value Index (+14.8%).
Valmont Industries (VMI), initially purchased in 2015, was the LCV portfolio's best-performing stock last year, as a strong market for agricultural products and a significant uptick in federal infrastructure spending bolstered the company's prospects. Moreover, a $2 billion backlog in the company's infrastructure and irrigation segments (representing more than 50% of 2021's total sales) increased visibility for future earnings, and investors awarded the company with a higher multiple than at almost any time in the last decade (Figure 7). VMI's fuller valuation made it the second-largest position in the LCV portfolio at the end of Q3, so we trimmed our investment to free up capital for other opportunities.
Figure 7 – VMI: Enterprise Value to EBITDA Ratio
When we originally purchased NRG Energy (NRG) for the LCV portfolio in 2010, the company's revenues and earnings were heavily influenced by the market for wholesale electricity in Texas, which is notoriously volatile and prone to boom-and-bust cycles as producers struggle to accurately match supply with anticipated demand. Periodically, the stock price of independent power producers such as NRG would trade at large discounts to the present value of their expected mid-cycle cash flows, usually during temporary periods of low demand or excess supply. Over the long run, electricity demand tends to rise steadily in correlation with population and GDP growth. However, supply disruptions, adverse weather, and substitution risk from alternative fuels can lead to swings in wholesale electricity prices in the short run. Over time, NRG attempted to naturally hedge its wholesale electricity exposure by adding a retail electricity distribution business (which has the effect of smoothing out profitability). As the retail business grew (it now accounts for the majority of company earnings), NRG divested much of its legacy power generation portfolio and used the proceeds to pay down debt and increase share buybacks. Investors awarded the less cyclical business with a higher valuation multiple. Since we felt that much of the value of the shares had been realized, we elected to reduce our investment in favor of better opportunities.
Graham Holdings (GHC) is what remains of an original investment we made in The Washington Post Company during the depths of the Great Financial Crisis in October 2008. The namesake newspaper was sold to Jeff Bezos in 2013. The founding Graham family reorganized the company around a diverse portfolio of other businesses such as television broadcasting, education, healthcare, and manufacturing. We've increased and decreased our allocation to GHC numerous times over our holding period as the stock price fluctuated around our estimate of intrinsic value. With the stock having roughly doubled since our last purchase in June 2020, it was an appropriate time to reduce our investment once again.
With some of the capital generated by the sales mentioned above, we bought additional shares of Intel (INTC), a portfolio holding since 2006. Like many large technology companies, Intel's stock price was clobbered last year (down 46%). Historically the 800-pound gorilla of semiconductor manufacturing, Intel is in the midst of a multi-year restructuring effort. The pre-eminence of mobile devices and cloud computing has undercut some of the firm's historical competitive advantages, leading to a more fragmented end-market for semiconductor chips and opening the door for niche competitors to gain market share. Nevertheless, Intel remains a formidable competitor with the resources to adapt to a changing market, as it has many times previously in its 54-year history.
Finally, we welcomed another former LCV investment back into the portfolio in December and early January, purchasing shares in The Walt Disney Company (DIS) for the first time since 2004. The stock recently hit a multi-year low (surpassing even the lows of the Covid lockdown when its theme parks were closed) after a messy (and ultimately aborted) CEO transition. Historically well-entrenched in cable television and theatrical distribution, the company has stumbled in adapting to a new hybrid/direct-to-consumer model across various streaming platforms. Looking at the bigger picture, we feel confident that whatever the distribution model, Disney's invaluable content library—bolstered by savvy acquisitions of Pixar, Star Wars, 20th Century, and Marvel—will continue to pay dividends for many years to come.
As always, we welcome your comments, questions, and feedback, and appreciate your trust in our services.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly, and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
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