BOURGEON CAPITAL MARKET INSIGHTS
Hoping for the best, prepared for the worst, and unsurprised by anything in between.
~ Maya Angelou
Change. There have been substantial changes in the economy, markets, and geopolitics in the last quarter. After decades of living in a low inflationary world, rising costs seem to be everywhere. To combat inflation, interest rates have risen at the fastest pace in history. More action by the Federal Reserve in the form of quantitative tightening is still to come, and there is no historical precedent of the potential magnitude. The most tragic change is the war in Ukraine, which brings untold human suffering from many angles. Each of these changes, in its own right, has the potential to disrupt markets in unanticipated ways. Taken together one should expect increased asset volatility, especially in the near-term. In his annual letter to shareholders, Jamie Dimon, CEO of JPMorgan, commented on these three changes by saying, “The confluence of these factors may be unprecedented… we should prepare for the potential negative outcomes.” After several years of outsized gains in the equity markets, and in recognition of the changes that are occurring, we believe it is appropriate to be prudent and flexible. Over the past six months we significantly reduced our allocation to stocks, and with higher interest rates we have finally started to add to bond portfolios. Our allocation to cash is significantly higher than normal.
Starting From a Position of Strength
Changes are starting to happen at a time when the economy is strong. Unemployment levels are near historic lows, wages are increasing, tax revenue is higher than expected, corporate profits are strong, and consumer and corporate balance sheets are in great shape. Travel and service consumption is expected to accelerate as COVID fears wane.
In our “hoping for the best” scenario, we look towards the current strength of the US economy to provide support and wiggle room as the Federal Reserve tries to engineer a soft landing in a very tricky environment. Historically when the Fed has begun a rate rising cycle, the probability of recession for the ensuing years increases. Today is no exception. Goldman Sachs believes the odds of a recession are 15% in the next 12 months and 35% within the next 24 months. Currently we do not believe that a recession is inevitable. Like the Federal Reserve, we are data dependent, and we will wait, watch, and be vigilant.
Be Careful What You Wish For
For the past decade, the Federal Reserve has struggled to achieve their target 2% inflation rate. Now they have way too much inflation. For example, in March 2022, the Consumer Price Index was up 8.5% over the past year, the largest 12 month increase since 1981. In our last quarterly letter, we discussed how the Federal Reserve was going to fight this inflationary pressure by raising rates and applying quantitative tightening. This would lead to tighter financial conditions, with the intent of slowing the economy and employment gains.
“Don’t Fight the Fed” is a common financial saying, and one in which we believe. As a result, we started to make several changes to our portfolio ahead of the increase in interest rates that began in March 2022. We cut back on our equity allocation, with a focus on tilting our holdings toward a slower (late stage) economy. In addition, we kept a higher-than-normal cash allocation in both your stock and bond portfolios.
Our strategy was directionally correct. Interest rates skyrocketed in the first quarter as bond markets attempted to anticipate the Fed’s moves. For example, the 2-yr US Treasury yield rose by 170 basis points, an historic Q1 selloff. The S&P 500 was also very volatile, ending down 4.6% in the first quarter. Large cap tech stocks, growth stocks with no earnings, and other highly speculative stocks suffered the most as valuation multiples contracted. While Bourgeon was not immune, a high cash allocation, underweight in technology, and overweight in energy helped to shield your portfolios from the worst of the declines.
Ukraine: A New Dimension of Uncertainty and Tragedy
The war in Ukraine has added new uncertainty and confusion to the worldwide economic outlook. In addition to the human tragedy, the world is now grappling with energy, wheat, and grain shortfalls. Economic sanctions exacerbated several existing COVID-induced supply chain shortages, adding to inflationary pressures. Commodity prices have soared.
While we cannot begin to predict how this conflict will resolve itself, we remain aware of the wide variation of scenarios and accompanying risks associated with them. We anticipate further unintended consequences from sanctions and are aware of increased concern over the potential behavior of isolated and desperate Russian leaders. Given the acute tension and uncertainty surrounding the war in Ukraine, we believe holding higher than normal cash positions is prudent.
New Challenges and New Strategies
To address war induced inflationary pressures, it is likely that the world will spend more on energy self-sufficiency, security, and commodities. We anticipate a continued resurgence in the old economy with the benefit of more environmentally friendly new technologies. The United States has a pivotal role to play given our strengths in natural resources and our businesses.
In the aftermath of supply chain disruptions during COVID, the concept of globalization was already waning. The war in Ukraine makes “onshoring” an even more important buzzword. This transition is likely to be expensive, take decades, and occur in fits and starts. However, the United States can be successful if it works with trusted partners to meet these challenges in a cautious, studious, and thoughtful way.
In many ways, increased coordination with the G-7 et al, could be very bullish for economic growth globally. One might consider onshoring a worldwide infrastructure project. We anticipate that many of the companies in your portfolio should benefit from onshoring.
Just as Central Banks around the world have begun to coalesce around their resolve to stave off inflation by finally raising rates, credit market participants have largely already “skated to where the puck is going.” Treasury yields have risen substantially, spiking US mortgage rates to levels that may have a cooling effect on the previously solid housing market. While inflation may stay well above normal for some time, the rate of inflation may move closer from its current 8.5% to the 2% goal over the upcoming few years. To this point, we have begun to read reports of declining used car prices and falling shipping prices. This is an intriguing new idea for us and could mean that the Federal Reserve’s ultimate actions might be less drastic than their current words. We will watch the data.
Cash is King
Our goal is to both grow and protect your assets. It is a difficult balancing act, and at times we tilt more one way than the other. Today we are tilting more towards protection. Early in Q1 2022, we moved to an underweight position in stocks, raising cash to represent about 15-20% of your stock portfolio. We took some long-term profit on positions we thought might be vulnerable to the newly developing dynamics. We have begun to add some investments in areas where we continue to see long term secular growth, such as alternative energy, industrials, and onshoring. However, we have been slow to put cash to work because of our concerns about Ukraine and the rapid interest rate rise. There is no precedent to our current situation: from the dramatic rise in interest rates, to the significant amount of quantitative tightening, ending with a new modern cold war era. In this environment, we think it is prudent to be cautious.
First Quarter 2022 Stock Portfolio Changes
We sold several companies where we had sizable long-term gains but believed the risk/reward had become less favorable given the current environment and our outlook.
We trimmed several companies where we still believe in the potential for long-term growth but felt the stock had moved too far too fast in the near-term.
A few years ago, we added gold to the portfolio. Given the significant rise in gold prices as a result of the war in Ukraine, we decided to trim our position.
We added to our holdings in companies that we believed had fallen too far and offered an opportunity for a good risk/reward in secular growth areas. For example, we believe that alternative energy will see significant growth in the future. As a result, we added to several of our positions on weakness. We also believe that the demand for electric vehicles will continue to grow. Because rising rates tend to slow economic growth, we added to some defensive positions. As interest rates rose, stock market multiples contracted, leading to significant declines in many stocks, and most especially technology stocks. We are underweight technology relative to the S&P 500, but there are several technology equities with stock-specific catalysts where we like the risk/reward, even in this environment. During February 2022, at the height of the recent stock price weakness, we added to several of these companies.
Addressing Peak Inflation in Our Mutual Fund Portfolios
During the first quarter of 2022 we made some modifications to the mutual fund portfolios. During the first few weeks of the attack on Ukraine, the price of gold soared. Like our stock portfolios, we took the opportunity to reduce our allocation to gold. With a nod toward our peak inflation theory, and with the central bank so focused on inflation in a “do whatever it takes” moment, we also believed it was appropriate to reduce our holdings in TIPs, or inflation protected bonds. We took the proceeds and added to the intermediate term bond fund.
Rebuilding Bond Portfolios After Worst Bond Market Performance in Decades
While we were concerned that market participants were being too complacent about inflation last year, we never expected interest rates to rise as quickly as they did in Q1. We certainly never expected to see a 10% selloff in the broader bond market in just one quarter.
Investing in bond portfolios has been incredibly difficult in the past few years. During 2021, with the real return on bonds negative, we did not reinvest many of the bonds that matured. We kept much of those funds in cash. Where appropriate, we also added some alternative investments with a focus on income. Finally, we have kept the duration on our bond portfolios very short. Thus, while your bond portfolios did decline in Q1, our high cash and alternative investments helped lessen the impact compared with the broader bond market index.
However, we now think the time is right to start taking advantage of higher interest rates. Along with peak inflation, we also believe we may be near peak hawkishness. With the idea that credit market participants have already “skated to where the puck is going”, we believe it is appropriate to focus on rebuilding client bond portfolios. At the moment, yield-to-maturity rates on 3–5-year investment grade bonds are in the 3-4% range compared with around 1% only a few months ago. We look forward to speaking with you soon and thank you for entrusting us with the management of your money.
This letter should not be relied upon as investment advice. Any mention of particular stocks or companies does not constitute and should not be considered an investment recommendation by Bourgeon Capital Management, LLC. Any forward-looking statement is inherently uncertain. Due to changing market conditions and other factors, the content in this letter may no longer reflect our current opinions. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this letter will be profitable or suitable for your individual portfolio. In addition, past performance is no indication of future results. Please contact us if you have any questions regarding the applicability of any matter discussed in this letter to your individual situation. Please contact us if your financial situation or investment objectives change or if you wish to impose new restrictions or modify existing restrictions on your accounts. Our current firm brochure and brochure supplement is available on the website maintained by the Securities and Exchange Commission or from us upon request. You should be receiving, at least quarterly, statements from your account custodian or custodians showing transactions in your accounts. We urge you to compare your custodial statements with any reports that you receive from us.