Accretive Q3 2022 Client Letter

Dear Clients and Friends of Accretive,

At the end of the third quarter, billable assets under management at Accretive totaled approximately $206 million.  As a result, we are waiving 7.5% of our management fee for the fourth quarter of 2022 under our Client Alignment Program™ (CAP).

Third Quarter Recap

The third quarter was, in many ways, simply a continuation of the difficult first & second quarters.  The broad equity indices all experienced steep declines.  

More conservative bond investments suffered a near 5% decline as interest rates continued to rise, and riskier bond investments fell less as higher current yields offset interest rate rises and US debt markets were more resilient.  The rise in interest rates, modest widening of credit spreads, and general market weakness are signs that financial conditions have tightened significantly.  While the Fed has tightened policy, the market itself has arguably tightened more.  As we write this, the market is pricing in more rate hikes than forecast in the Fed’s most recent “dot plot” in the summary of economic projections.  In the first three quarters, the market tended to forecast less hawkishness from the Fed than the Fed itself was projecting.  For now, that no longer appears to be the case.  

The format of this letter, up to this point, should be familiar to clients and readers.  Given what’s transpired this year, we feel a slightly different approach to the remainder of the letter is warranted.  We would like to share our thoughts on what’s transpired, as investors, and our assessment of how to move forward.  

To call 2022 a difficult year in markets is a bit of an understatement. Rates have risen all year in the face of greater than expected inflation.  The Fed has grown increasingly hawkish as they attempt to prevent inflation from becoming embedded in the US economy.  The central bankers are trying to tamp down on demand and manage the psychology of inflation, the idea that higher prices are expected and start to become priced into wages and longer-term agreements.  

While nobody enjoys bear markets, investors generally expect years like 2022 to happen in the stock market from time to time.  What has been historic are the declines in the bond market.  Usually when stock markets are declining interest rates tend to fall, causing price appreciation in bonds that offsets losses in the stock market.  This year, the stock market has been falling, and interest rates are rising, leading to losses in both asset classes.  The scope and scale of bond market losses have been historic, as it has been, by far, the worst year on record for bonds.  Generally speaking, cash has been the one broad asset class that has held value.  Cash went into 2022 being trash and many are now crowning cash king.  It is our observation that trash tends not to occupy a throne or live in a landfill for long.  

A year like 2022 can leave retail investors searching for answers.  Among professional investors it causes some soul searching, as it should.  To go through a period like this without gaining insights and learnings that may be helpful in the future would be a wasted experience.  

What have we learned?

We have learned that the bond market, even the US treasury market, is not as liquid as it appears.  Volatility in the treasury market is nearing levels seen during the Great Financial Crisis (GFC) and March of 2020, previous times where the Fed has intervened.  

About a year ago, inflation became a political problem, in addition to it being an economic issue.  We have learned that US central bankers, after a decade of generally undershooting an inflation target, are willing to prioritize the inflation fight over the economic consequences of that fight (at least for a time).

We thought that the financialization of the economy made rate increases, with higher rates re-directing a large percentage of GDP to debt service, difficult for the US economy to digest.  That may prove to be true over time, but it may take longer than we initially thought for that to happen.  As a practical matter, much of the US economy has financed itself at longer term rates, creating more of a lag between rate increases and the effects of those rate increases showing up.  Outside the US, economies are more interest rate sensitive.  As an example, mortgages in the US are overwhelmingly fixed rate and long term.  Most of the developed world has either floating rate mortgages, or mortgages that are fixed for a short period of time and have resets.  As a result, the effects of rate increases abroad are felt nearly immediately or shortly thereafter.  It is also worth noting that developed foreign economies tend to be more financialized and with higher debt levels than the US economy.  There is a fear that “something may break” due to interest rate increases, but we have come to view the location of that break outside our borders.  To the degree that breakage has spillover effects, the Fed’s reaction function may change, particularly if the inflation numbers begin trending the right way.  

The economist Milton Friedman is famous for saying, “inflation is always and everywhere a monetary phenomenon.”  During the Covid pandemic through the end of 2021, the money supply, defined as M2, increased by about 40%.  Since the beginning of 2022, the money supply has been mainly flat.  For all the inflation fighting the Fed is doing, it has not meaningfully decreased the money supply.  We knew that a good portion of that money would move through the economy but underestimated how fast it would.  Since March of 2020, we have experienced nearly 16% cumulative inflation (as measured by CPI-U), or about half of the money supply increase related to the pandemic response.  How much of the remaining 20% moves through the US economy and over what period remains to be seen.  One could argue that much of the fast-moving money has already been spent, as a good portion of the funds landed in the bank accounts of savers who do not spend as freely. How fast the rest of the money moves, or if it moves at all, and over what time, remains to be seen. (Sources for M2 & CPI-U:  St. Louis Federal Reserve)    

Some excesses in markets were easier to see in real-time and more or less avoid than others.  Those excesses were meme stocks, special purpose acquisition corporations, IPOs, cryptocurrencies and tokens, and some speculative growth stocks.  However, we underestimated the degree to which investors underwrote the 2021 environment too far into the future.  In hindsight, more stocks were expensive than appeared, given the assumptions made at the time, but we also know that hindsight is always 20/20.  A normalization of valuations, expectation, and a taming of animal spirits is, in our view, a healthy and good thing.  

The world is changing and evolving, as it always does.  In many ways the pandemic was a watershed moment for the world.  Globalization had been in slow decline since the GFC, but the Covid pandemic and increasing geopolitical issues have accelerated that trend.  A decline in globalization is an incremental negative in the fight against inflation that will play out over time.  

The Fed has acted more swiftly and decisively than other central banks.  One needs to look no further than the US dollar to see how that has played out in markets.  The trade-weighted US dollar is up considerably year to date.  An overly strong US dollar is disruptive to foreign markets and foreign banking systems and is a headwind to US multinational corporations, but it increases a US consumer’s purchasing power vis a vis the rest of the world.  

What do we think today?

We think the Fed has become increasingly credible in its quest to quell inflation. However, there is the risk that they do too much and need to backtrack in some way, which could damage their newly enhanced credibility. It seems prudent to take their statements at face value, cognizant of the fact that their forecasts and priorities have a way of changing.  

Inflation data is lagging in nature and messy, but real time data suggests the Fed is making significant progress in achieving its goals.  It is our view that that progress will become increasingly clear over the coming months and quarters.  In the meantime, an unstable treasury market creates issues of financial stability.  The Fed has a dual mandate of maximum employment and stable prices, but its whole reason for being is the safety and soundness of the financial system.  As the data improves and financial stability potentially deteriorates, particularly among systemically important institutions abroad, the priorities may shift.  

We think the inflation fight could be a two steps forward, one step back process as our economy adjusts to the increased money supply.  However long that process takes is anybody’s guess.  It seems reasonable to assume the era of ultra-easy monetary policy appears to be over, at least for the foreseeable future.  This introduces the potential for generally higher volatility in markets and more caution among investors.  That caution, in our view, is not such a bad thing and lends itself to more opportunities.  The end of easy money also benefits established, well-capitalized, and cash-flowing businesses, as there are fewer cash burning upstarts competing on an uneconomic basis.  

As it relates to the treasury and investment-grade bond market, most damage appears to be done.  While it is possible rates gap higher still, as the market is less liquid and influenced by the incremental buyer and seller to a greater degree than we previously thought, we do not think significantly higher rates from here are sustainable in the current economic environment. If we believe the Fed ultimately accomplishes its goal, there is the potential for real returns to be had in the market for high-quality bonds, a condition that hasn’t existed in quite some time.  The market for riskier borrowers is more challenging because the business cycle may not support the level of indebtedness those corporations have taken on.  

Cash is king for now, as short-term rates head higher.  Short-term rates tend to take the escalator up (though the current escalator has been historically steep) and the elevator down.  For most people, the gut reaction is to shun longer dated CDs, treasuries, and corporate/municipal bonds, but one day an elevator down move in short term rates could create a reinvestment risk for holders of short-dated bonds and cash.  As with most things, we think it makes sense to diversify that risk.  

There is much talk about recession, whether we are in one or will be in one.  It certainly feels like we are in or headed for one.  What that recession may look like for the US is an open question.  There are mitigating factors.  US consumers, which make up about two-thirds of GDP, are in pretty good shape from a balance sheet perspective.  From a long-term perspective, betting against the US consumer to consume has been a losing proposition.  Profitable US companies are in a similar situation, while better able to manage their cost structures and use cash flows to buy in debt or retire their shares at lower prices.  A period of belt-tightening is probably healthy for corporate America and we expect corporations to deploy cash flows opportunistically.  

In the US stock market, valuations appear a lot more reasonable to us today.  The aggregate valuation is pushed higher by a few companies with meaningful weights in the market.  Other profitable US companies may have to deal with the business cycle, and estimate revisions, but have starting valuations that appear more reality-based.  It is possible that valuations come in and become even more reasonable, but from where they stand today profitable US companies seem to be a decent long-term proposition.

Ultimately, we feel the economy will settle into a new normal that looks like the old, pre-pandemic normal but with some structurally higher inflation for a time.  How long that process takes is anybody’s guess.  Markets tend to bottom when news looks bad, in anticipation and ahead of better times.  We do not know if that has happened or, if it has yet to happen, when that will occur.  It is one of those things that is only knowable in hindsight.  

From an investment perspective, we believe having a sound philosophy is more important than ever.  We strive to invest for the long-term in vehicles that are transparent, with relatively low expenses.  We also try to invest in companies that are understandable with justifiable valuations while we count on the businesses to grow their intrinsic value over time.  We recognize we are not going to get everything right, and there are some decisions we would prefer to have a do-over on, but our goal is to learn from the outcomes and separate the investing process from the outcome to improve the process.

From a behavioral perspective, we continue to encourage clients to invest in a manner they can stick with through the economic cycle.  For those in prime earning years, we believe in having a plan to deploy long-term funds amidst the uncertainty.  For retirees, we believe that the best way to make it through a difficult time is not to have to do anything.  Both stocks and bonds are down a similar amount, so the sunk cost of taking less stock market risk by shifting to bonds is relatively small.  To the extent we can mitigate behavioral urges and emotions by matching a client’s income needs to the portfolio for some time, we can also try to do that.  

What are we doing?

From our perspective, there are things to do now and things to do when the environment improves.  For example, understanding bond market fragility is helpful but there may be a better time to do something about it.

In the current environment, we think about prospective changes as trying to make lemonade out of lemons.  Most non-cash investments are lower to a similar degree.  We recognize that where there are losses, those losses do not necessarily need to be recouped the way they were incurred.  We are also cognizant of the risk in trading something we know well for something we know less well.  However, to the extent we feel a change needs to be made, we will make it.  As a reminder, we do not change objectives for a portfolio without discussing it with clients first and getting a mutual agreement on the change.  

Between now and year-end, we expect to be active.  We anticipate a handful of position and positioning changes, but any changes are intended to be made for the long-term.  We expect significant tax-loss harvesting to reduce capital gains on our clients’ behalf, though that will vary client by client depending on which state they reside.  As an example, our home state of New Jersey does not allow residents to carry-forward tax losses so a net number below the $3,000 federal deduction limit may not make sense.  In other states, it may make sense to realize whatever tax losses are available.  Overall, it is our expectation that activity will be elevated.  If you have any questions, please reach out to any of us.

Concluding Thoughts

The market environment has been and continues to be challenging.  Often times, the comfortable thing and the right thing may not be the same.  We have consistently said we believe the right investment approach is one that you can stick with, in good markets and bad.  To that end, almost all our clients have done just that.  

We appreciate the trust and confidence our clients have in us. If you have any questions or concerns, please feel free to contact us.  We would welcome speaking with you.

Sincerely,

‍

Gary C. Ribe, CFA, CFP®

Chief Investment Officer, Managing Partner

gary@accretivewealthpartners.com

‍