August 2022 Investor Letter

The simple explanation for why the markets are down: rising inflation, higher interest rates, and Quantitative Tightening by the Federal Reserve, is removing liquidity from the system and lowering consumer and corporate demand. This is causing the economy to slow and reducing corporate earnings leading to lower market valuations and prices.

As we move into the second half of the year, we will have to wait and see how the economy performs. If it continues to slow, interest rates keep rising, inflation continues to run hot, and consumer sentiment remains depressed, it will continue to be a challenging set-up for stocks and bonds. Alternatively, since the market is a forward-looking indicator, much of this bad news may already be priced in.

Despite all the negative news there has been some positive signs to point to in the economy. To start, we have seen continued strength in the jobs market as 372k jobs were gained in June, bringing the total number added since the post Covid lows to 21.5 million. This is only 500k short of the total before the start of the pandemic.

The US Unemployment Rate remains at 3.6%, the lowest level since the start of the pandemic and only 0.1% above the 50-year low we saw in February 2020 (3.5%)⁷. The number of job openings still exceeds the number of unemployed persons in the US by over 5 million, an indication that the demand for labor remains much higher than supply and hourly wages hit another record high in June, up 5.2% YOY⁸. Additionally, used car prices are down 7% over the last 6 months⁹. Hopefully, these data points are indications of lower inflation rates to come.

Many companies we own continue to deliver strong profitability and grow by virtue of price increases and expanding market share. However, some of this growth is beginning to slow as inflation, that is running at 40-year highs, impacts consumer and corporate spending.

The Market

We will have to wait and see how these trends play themselves out over the coming quarters but believe there will be some moderation as inflation hopefully stabilizes in the second half of the year as the Fed tries to navigate a soft economic landing. While we are not optimistic on the ability of the Fed to accomplish this, large cap, blue chip companies should be able to weather the storm better than most.

The bond market continues to flash intermittent warning signs with the yield curve (2yr vs 10yr US Treasury) having inverted a few times since April. Historically this has been a pretty good indicator of future economic weakness.

Lastly, we have experienced a sharp move lower in consumer confidence which does not bode well for the future direction of the economy as consumer spending has historically accounted for 70% of the US economy.

Consequently, the expectation is that things may get worse over the next six months, with the Expectations Index from the Conference Board at its lowest levels in over a decade.

Ultimately, our continued focus on your family’s financial well-being has been a respite from the market’s volatility, and we are especially honored during this time for the trust and faith you continue to place in us.

As we have mentioned in previous letters, rising interest rates presents a host of challenges for the markets going forward and we need to be mindful of these increasing risks while investing for the long term. Equity valuations, which are merely reflections of a company’s projected future cash flows discounted back to present value, are often impacted by higher interest rates as the elevated discount rate reduces the overall price. As interest rates rise, bond prices fall and investors with exposure to bonds may overreact when they open up their statements and feel the urge to sell to avoid further losses. Rising rates also has implications for the real estate and housing markets as mortgage rates rise thereby reducing demand and causing additional hardship for existing homeowners who may want to sell or refinance.

As the Federal Reserve is withdrawing liquidity from the economy and selling financial assets, it’s a good idea for investors to follow their lead and trend towards a more cautious approach. Moving forward, as the Fed reverses their accommodative position, we will have to wait and see how this all plays out. We continue to believe the highest probability is that one of the following scenarios will ultimately occur: either the Fed will raise interest rates and push the economy into a recession which will in turn lead to a reversal and a lowering of rates, or the Fed is so behind the curve and inflation is worse than expected that they will have to continue to raise interest rates more than the market anticipated. As we see below, the Fed’s balance sheet is finally moving lower with the start of quantitative tightening, but it remains less than 1% below its all-time high. The transition from QE to QT has only just begun. The question is will they follow through? If we head into a recession, will they reverse course and start quantitative easing?

In our opinion, the current Inflation, is a result of all the fiscal and monetary stimulus as well as supply chain and commodity shortages. If we add the war to the mix, we believe it is not an easy problem to solve in the short-term. Unfortunately, the Fed cannot print commodities or fix supply chains. They can try to reduce demand but this risks putting the US into a recession. They want to slow demand but they also don’t want to cause a recession, so in our opinion, they are caught between a rock and hard place, and we are not optimistic they will be able to navigate a soft landing.

We don’t think the Fed’s tool kit, given how high government debt levels are, is enough to properly fight inflation. Our issue is more of a fiscal problem and how we currently structure supply chains. In our opinion, we need real world changes, and they don’t happen quickly. As a result, we may be entering an inflationary decade, but it won’t be a straight line and we are still of the belief that eventually technology driven deflationary forces will win out. Unfortunately, no one has a crystal ball to predict how exactly this will play out and it is always a moving target. For this reason, we invest with a long-term focus in areas where we believe there are fundamental shifts that support mega long-term trends and then prepare for short-term volatility using our rules-based risk management process. Our goal is to minimize the impact of major draw downs and, as a result, be able to take advantage of them.

What Have We Done

From an asset allocation standpoint, our internal indicators have moved us into a more conservative posture, as we have seen declines in all global asset classes which has caused a significant buildup of cash in the portfolios in an attempt to minimize the declines within our Managed Volatility Growth and Balanced portfolios.

From an equity standpoint, we have seen some significant shifts as our US portfolio moved to a 50% cash weighting towards the end of the quarter and the trend continues to be down. Our International strategies, on the other hand, have continued their downward trend and we have moved to a 100% cash weighting since late April across all asset allocation models. Despite these moves, we continue to focus on finding companies that coincide with the long-term macro trends we believe will be paramount moving forward such as: decarbonization and green energy (wind, solar, rebuilding the electrical grid, and electric vehicles), technology and science innovation, digital transformation in consumer and business behaviors, infrastructure, the reopening trade. Many of the companies in the sectors hardest hit by the pandemic like hospitality, financial services, and consumer discretionary, are re-emerging, however, not all of them have fully reopened or recovered to pre-pandemic business activity and others are also dealing with weaker consumer spending due to a slowing economy and asset price declines. During the second quarter, a more hawkish Federal Reserve and rising interest rates continued to produce a noticeable headwind to many growth company stocks we own as valuations are most adversely affected by this.

Finally, an area of the portfolios that we have addressed over the past few quarters has been the introduction of digital assets into our investment portfolios. To reiterate, Bitcoin is the first global, private (open source no govt involvement), digital, rules based monetary system in the world. Economically, everything we’ve seen in the last 12 months such as inflation, money printing, war in Ukraine and Russian sanctions, have all been long-term bullish for bitcoin. Although they are unfortunate and unpleasant for the world, these events have underscored to many objective observers the use case for a global non-sovereign store of value digital asset like bitcoin.

While there has been heightened volatility in the asset class in the second quarter due to forced liquidations of highly over leveraged parts of the market (Terra collapse, Celsius freezing customer assets, and the collapse of 3AC Hedge Fund), we continue to maintain our conviction in the long-term benefits and transformational aspects of this asset class in general and bitcoin specifically.

We continue to believe that Bitcoin’s technology (the network) will fundamentally change the financial services industry specifically around, but not limited to, global payments (i.e.: wires and remittances) and asset settlement (i.e.: eliminating ~2% of the credit card expense to merchants and possibly being used to settle many physical and digital assets: stocks, bonds, houses, cars, etc. are all distinct possibilities). In our opinion, this will have a significant impact on the price of bitcoin. While other blockchains may ultimately gain some of this market share, we believe Bitcoin will be one of, if not the dominant beneficiary, so we continue to want the long-term exposure.

If we think about the internet in 1997, this is where we believe we are with Bitcoin today. The internet has had a profound impact on our lives, and if you had been able to own a piece of the internet, how valuable would it be today (although it would have been a volatile investment experience). We think we are on a similar trajectory with Bitcoin.
We are not dismissing the fact that we likely will see more volatility, however, all asset classes (stocks, bonds, and commodities including bitcoin) have seen significant volatility recently, and in many instances significant drawdowns. Nonetheless, we remain very optimistic about bitcoin’s prospects long-term.

We maintained our exposure throughout the quarter and will tactically look for opportunities to minimize the volatility. We believe we are still early in the use case adoption phase, and as bitcoin begins to gain commercial and institutional and retail investor adoption, we believe we will see significant long-term appreciation in the asset. In order to address some of this inherent volatility in the asset, we will be rolling out new investment solutions soon that will incorporate various risk management approaches that seek to minimize the drawdowns and enhance risk adjusted returns.

As we mentioned last quarter, bonds remain the final hurdle for investors to digest in a higher inflation and interest rate environment. Traditionally, bonds are used to diversify away risk and to act as a ballast to investor’s portfolios, and that works well in a stable or declining interest rate environment. However, as rates rise, bonds become more of a liability in investor portfolios as we witnessed in the first half of this year. To fight rising inflation, the Fed increased rates from 0 -.25% to 1.50-1.75% at the end of the 2nd quarter, and has signaled their intention to continue to raise rates. The bond market has priced in a number of future rate hikes as the 5 yr treasury finished Q2 at 3.01%¹⁰. As a result of the increased yields, but still cautious of what may happen moving forward, we decided to reinvest our bond exposure that had been sitting in cash and cash equivalents into very short duration ladders. This will allow us to provide exposure to the higher interest rates while still maintaining flexibility as the interest rate environment moving forward is still uncertain.

With 126.8% debt to GDP¹¹ and the US and world relying on the dollar as its reserve currency, we have a hard time seeing rates normalizing above inflation. Ultimately, this plays into our thesis that the Fed will have no choice but to continue to debase the dollar keeping the US in a negative real rate environment. Historically, this has been a bullish backdrop for asset prices. We believe stocks, commodities, real estate and digital assets should all do well as bond holders either suffer losses or own an asset that is producing a negative real return. We will continue to actively monitor the situation.

What Comes Next?

The global economy is facing many issues: inflation, supply chain disruptions and localization, monetary policy, war, weakened consumer, economic slowdown, currency debasements, and high levels of government debt. These combined effects are impacting equities, bonds and commodities in a way we have not seen in the past 40 years. While 2022 has started out as we assumed it would: a challenging environment for risk assets and increased volatility, especially in the first half, it has snowballed at a pace we were not expecting. However, if we look at the historical context, we should not be overly surprised since in the past 42 years, the S&P has experienced average intra year declines of 14% yet produced annual returns that were positive in 32 of those 42 years.¹²

During the quarter global equity markets entered a bear market (defined as down 20% from its peak). In addition to the overhangs/potential headwinds mentioned earlier, we also have mid-term elections this year which may have a significant impact on Government policy and spending. However, once we have greater clarity around Fed policy and the election, and should commodity prices continue to ease, we believe the markets should settle down which could lead to further gains into year end.

As we have mentioned previously, despite this backdrop, the long-term structural characteristics of our investment themes remain intact and continue, in our opinion, to gain steam. We believe the market will return to a focus on fundamentals and that stock selection will be more important than in prior years. It seems unwise to try to guess what the Fed will do in 2022, but if the economy enters a recession they may be forced to stop raising rates or even reduce them. While rising rates has presented a challenge in the first half of 2022, it does not necessarily mean that equity markets need to continue to go through a serious decline. There is still ample liquidity sitting on the sidelines and sloshing around in the economy, and eventually it will need to find a home. What seems more likely is that assets get re-rated as investors preferences shift from a world dominated by narratives to a world in which fundamentals suddenly matter again. Companies with pristine balance sheets, dominant market share, and pricing power appear to be more stable.

As a reminder of our core investment principles, we don’t try to predict the future, we prepare for it. In other words, we use our Dynamic Cash Allocation® to adjust our risk exposure between cash and investment assets. This systematic rules-based approach eliminates emotion from our investment process, allowing us to focus our attention on asset allocation, long-term thematic trends, and individual investments.

We remain confident heading into the remainder of the year that our conservative, rules-based approach will help us continue to navigate the impending uncertainty. As we have mentioned before, we believe that many financial firms will not be properly positioned for what lies ahead. In our opinion, traditional forms of risk management, such as portfolios that rely heavily on bonds, or equity strategies that take a buy and hold approach, may not provide the risk-return characteristics investors have come to rely on.

Please feel free to share this market commentary with those you believe would benefit from it and know we will do our best to be available to assist anyone you refer to us. As always, we know and respect the enormous amount of trust and faith you have placed in us, and we assure you we are more than up to the task. Please feel free to reach out at any time – we are all here for you and eager to assist however we can.

Sincerely,

Jay Bluestine
Founding and Managing Principal & Chief Investment Officer

Andrew J. Ceisler
Principal & Director, Asset Management

1) Source: Ycharts, 4/1/2022 – 6/30/2022
2) Source: Ycharts, Bloomberg US Aggregate Bond Index 4/1/2022 – 6/30/2022
3) Source: Ycharts, 1/1/2022 – 6/30/2022
4) Source: Ycharts, 1/1/2022 – 6/30/2022
5) Source: Ycharts, 1/1/2022 – 6/30/2022
6) Source: Ycharts, Blue Square, S&P 500 TR Index, Bloomberg US Aggregate Bond Index, 60/40 rebalanced yearly 1/1/1997 – 6/30/2022
7) Source: Ycharts, US Employment rate, 2/29/2020, 6/30/2022
8) Source: Ycharts, US Average Hourly Earnings YOY 6/30/2022
9) Source: Manheim Used Car Price Index as of 6/30/2022
10) Source: Ycharts, 5 Year Treasury Rate
11) Source: CEIC, 6/30/2022
12) Source: JP Morgan Asset management Guide to the Markets

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to the portfolios as they have different underlying investments and may use different strategies or have different objectives than the portfolios. Past performance is not indicative of future returns.
All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
This document contains forward-looking statements relating to the opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “should,” “potential” and other similar terms. Examples of forward-looking statements include the success or lack of success of any particular investment strategy. All are subject to various factors, including general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation and other economic, competitive, and technological factors affecting a portfolio’s operations that could cause adverse effects. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of Blue Square Wealth or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.