Third Quarter 2023 CIO Letter: Persistent Patience
The economic cycle’s influence on financial markets has been central to how I have invested since I began my professional career. My belief is the economic environment always matters; but overwhelms other factors at extremes. Absent extremes, a normal economic environment allows company fundamentals to drive returns. Stone Creek Advisors believes cycles may be shorter going forward which could mean economics impact market returns more often than they have over the last several decades.
A rosy, robust economic growth picture was priced into markets through the end of July. Multiple expansion and AI hype, not improving fundamentals drove returns. However, risks to the downside have been building since mid-summer and, in our view, the probability distribution has become more negatively skewed with a fatter and longer downside tail.
We believe very few of the risks outlined in this letter are priced into the market, keeping us extremely cautious and persistently patient while getting paid over 5.5% (annualized) in short-term Treasuries. The US equity market today is trading at a higher valuation than the risk-free alternative of short-term Treasuries (Chart 1). The equity risk premium measures the excess return investors demand for investing in the stock market beyond the risk-free rate and it is NEGATIVE today for the first time since the tech bubble. This market dislocation defies logic, especially at a time when risks are building, earnings expectations are optimistic, and tailwinds are turning into headwinds. Market dislocations can remain for periods of time but tend to prove unsustainable in the long term. Momentum works until it does not. When it stops working, get the heck out of the way.
At a time when many risk assets are trading at higher valuations than the risk-free rate we will not participate. We think there is a real possibility that investors may look back at this time as the easiest call there ever was. However, what looks obvious in the rearview mirror does not feel obvious in the present. The last leg of the market rally is painful for those defensively positioned. The volatility in the last two-thirds of the third quarter was what our client portfolios were positioned for.
Tailwinds Are Abating
Diving into the components of GDP (Chart 2), we believe the recession has been delayed, not avoided. Consumer and Government spending was remarkably strong in the first half of the year, while investment has detracted from growth since 2022.
Consumption has proven more resilient than we expected, propped up by pandemic savings. However, the San Francisco Fed estimates excess savings likely ran out in the third quarter. [1] Student loan repayments restarted for millions of American in October. Debt balances for credit cards, auto loans, student loans, and mortgage loans have ballooned to record highs at the same time debt servicing costs are increasing. This signals that many consumers have depleted their savings and are relying on credit to sustain their lifestyle. However, this will become more difficult as lending standards are tightening (Chart 3). Listening to earnings calls for consumer facing companies, consumers are beginning to reject further price increases being passed on. The August Fed Beige Book had commentary that retail spending on non-essential items slowed, and the pricing power of companies was waning quicker than input cost pressures were cooling, punishing margins.[2] Renewed strength in oil puts further pressure on consumers and corporations. As more wallet share goes to necessary goods, less is left for discretionary purchases.
We expected the Government tailwind to abate. Instead, it was a meaningful contributor to GDP growth in the first half of 2023. Federal, state, and local governments continued to invest in infrastructure and the federal government continued to spend on defense. The growing deficit will eventually become a problem and spending will need to be addressed. A recession could worsen problems as revenues fall further. Government spending, at the very least, should stop being a positive future contributor to growth. Digging into the Congressional Budget Office’s (CBO) federal budget deficit estimates, the situation is unsustainable.[3] Interest expenses are a ballooning piece of the budget. Especially given the recent turmoil in Israel, we believe defense spending cannot be the lever pulled.
Investment has historically been the swing factor. When adjusted for inflation, it has been negative year-over-year for the past three years. This is unlikely to change before companies’ growth outlooks improve. Our leading business activity indicators continue to weaken, pointing to slower future investment. Elevated uncertainty for small business owners and CEOs decreases the likelihood of investing in equipment, expansion, or hiring. Increasingly expensive capital and lending conditions tightening to these levels has historically choked off economic growth (Chart 3). With the return on capital bar set so high, fewer projects make sense. However, investments in automation are likely to bounce back significantly when the economy recovers as supply chains need to be restructured and labor has become more expensive, making the upfront cost of automating more palatable. We are vetting these names and building our fire drill list. When valuations become more attractive, we will take advantage of the opportunity to build exposure in client portfolios.
Investment has historically been the swing factor. When adjusted for inflation, it has been negative year-over-year for the past three years. This is unlikely to change before companies’ growth outlooks improve. Our leading business activity indicators continue to weaken, pointing to slower future investment. Elevated uncertainty for small business owners and CEOs decreases the likelihood of investing in equipment, expansion, or hiring. Increasingly expensive capital and lending conditions tightening to these levels has historically choked off economic growth (Chart 3). With the return on capital bar set so high, fewer projects make sense. However, investments in automation are likely to bounce back significantly when the economy recovers as supply chains need to be restructured and labor has become more expensive, making the upfront cost of automating more palatable. We are vetting these names and building our fire drill list. When valuations become more attractive, we will take advantage of the opportunity to build exposure in client portfolios.
Why the Recession Has Been Delayed and What Has Changed
Beyond the above reasons, there are several other contributors at play.
Real yields (what investors receive after adjusting for inflation) remained negative until April of this year. Until then, the risk-free benchmark was trailing inflation and thus was not a great alternative as a store of wealth. We are now nearing levels in real yields that have historically triggered a recession (Chart 4).
One of the big stories in the third quarter, which continued into October, was the complete meltdown on the long end of the Treasury curve (Chart 5). In late July we came to the realization that the long end was not going to behave well this cycle given the amount of new Treasury supply and the decrease in demand. A few days later, we made the decision to sell out of the small exposure we had begun building in client accounts and have remained very short-term (mainly under a year and completely under two years) on the Treasury curve.
This is significant because the market believed until mid-Q3 that the Fed was going to cut interest rates, keeping the middle and long end of the Treasury curve pinned very low. The Ten-Year Treasury yield has a large impact on households and businesses. We have been in the higher for longer camp since founding SCA, recognizing that near zero interest rates were likely a thing of the past. Our view continues to be the Fed will not cut rates unless something significant breaks or the economy falls off a cliff. However, we believe the Fed will not need to go much higher. Higher bond yields can now do more of the Fed’s work.
The higher interest rates for longer view change likely influenced the middle of the curve more than the longer-end of the curve. The longer end selloff was more driven by both supply and demand dynamics. On the demand side, four huge segments of price insensitive buyers have decreased their demand:
1) The Fed is shrinking its holdings of Treasuries.
2) China is diversifying away from the United States.
3) Japan’s own debt is becoming more attractive.
4) Banks are wearier of longer dated treasuries after the collapse of Silicon Valley Bank.
While price insensitive demand is falling, the supply of long-term Treasuries is increasing. A horrible combination, resulting in increasing yields on Treasuries at issuance. The massive upward move on longer-term Treasuries over the past month (Chart 4) happened in concert with the Treasury announcing it would need to borrow $1 trillion in the third quarter, over $250 billion more than previously estimated. The last several Treasury auctions have been disappointing with demand declining meaningfully. As Treasuries act more volatile, they are seen as less “safe”, feeding the spiral further. Higher Treasury yields also feed into yields for other debt instruments at a very inopportune time.
Long and variable lags may be longer this time partly because a larger portion of debt is fixed rate versus variable, meaning the impact is not felt by the borrower unless and until the debt needs to be rolled over at higher rates. A wall of commercial real estate and corporate debt is coming due starting this year. In the commercial real estate sector, the declines in property values are occurring in concert with this massive wave of debt that needs to be refinanced. The wave began this year, but 2024 is the largest year with an estimated $495 billion in commercial debt maturing and another estimated $465 billion in 2025.
The estimated $1.8 trillion corporate debt maturity wall has arrived. Corporate spreads widened slightly since mid-September but remain shockingly narrow. This complacency is occurring in the face of higher refinancing costs which is likely to send some highly leveraged corporations who managed to survive during the free money era into default as their debt service burden balloons higher. When fear starts to take hold, corporate spreads historically widen very quickly and can become a self-fulfilling cycle as investors demand a higher return for the perceived risk, increasing debt servicing costs further. The highest rated corporations, states and even the US federal government now must pay more for new debt than those companies issuing speculative grade debt just two years ago. With more corporate revenues allocated to servicing debt, corporations have fewer dollars available to devote to business expansion.
The collapse of Long-Term Capital Management 25 years ago created the playbook for the Fed to deal with every crisis after it. Slashing interest rates each time the stock market crashed essentially provided investors with a put option, insuring against catastrophic losses. Then, the Fed kept rates lower for longer than necessary given the absence of inflation, essentially allowing that put to be repriced higher. This dared investors to take more risk than their tolerance should allow. It also fueled an environment where borrowers made irresponsible spending decisions, binging on debt, because money was essentially free. This same business model does not work when the cost of capital is much higher. Low yields force investors to move up the risk curve to get the yield necessary to meet their goals. The expectation the Fed would come to the rescue anytime things got too bad exacerbated this risk taking. Today we have inflation. The Fed cannot cut rates at the first hint of pain and cannot keep rates low for as long as the economy and market recover. We believe there may need to be a shift in the reaction function of the Fed and the knight in shining armor may have exited the room.
Recommended by LinkedIn
The longer-term outcome of this environment may be slower growth. The path of potential GDP growth has slowed. This could cause more bouts of volatility and shorter cycles. If a pilot flies an airplane at 30,000 feet and he hits turbulence, he has more room to drop and correct his course before hitting the ground than if he is flying at 5,000 feet. The same is true for the economy.
Rising Geopolitical Tensions
Geopolitical risk is the highest it has been in decades. The war in Ukraine continues, BRICS (Brazil, Russia, India, China, South Africa) are becoming a stronger political and economic force, political and economic changes are brewing in the Middle East, tensions between China and Taiwan are bubbling, relations between China and the US remain on edge, the West’s political landscape is becoming more divisive, North Korea’s Kim Jong Un has called for an exponential increase in nuclear weapon production and amended the constitution to expand the nuclear program, and the Israel-Hamas war has erupted.
The Israel conflict added significantly to geopolitical risk. Since October 7th, oil and natural gas prices have risen, the price of gold has rallied, and the amount of uncertainty in the economy and markets globally has risen drastically. The escalation and expansion of the war from here could have massive impacts on inflation, energy prices, food prices, trade, and geopolitical relationships with many countries. We are closely monitoring several factors for clues into whether the war will expand.
Our thesis has been that geopolitical tensions will continue to brew as countries become less economically dependent on each other. We took an initial position in a basket of defense contractors in the third quarter following a sell-off in the names on concerns that defense spending would be cut. We thought cutting defense spending was unlikely before the Israel war, now we think there it is even more unlikely. We also maintain, and have increased, a position in gold which acts as a hedge to increasing geopolitical risks among other things.
What This Means from an Investment Perspective
In a vacuum, higher interest rates for longer should force a re-rating of stocks. A higher risk-free rate increases the hurdle for additional risk taking. Interest rates matter for stocks for several reasons:
1) Higher interest rates push the brakes on the economy, impacting corporate revenues.
2) For companies with heavy debt loads, servicing debt becomes more expensive as yields rise.
3) Professional investors incorporate interest rates into valuation models. Interest rates influence the present value of a stock’s future earnings because they are used to discount future cash flows back to today. Rising interest rates decrease the present value of future earnings, decreasing the value of the company. This is why growth stocks, where most earnings are in the future, tend to be very sensitive to rising interest rates.
4) The equity risk premium (Chart 1). Investors own stocks because they expect a higher return than owning a risk-free government bond to offset the additional risk. When the opposite happens, like today, the relationship becomes untenable.
Carving out the pandemic, margins remain near historical highs. What, in our view, are extremely optimistic earnings forecasts are built on the assumption that margins will continue to expand to all-time highs. A perfect storm of potentially weaker volumes, softening pricing power, increased input costs (wages and energy), and higher cost of capital may rain on this parade.
Typically, near the end of the cycle wage increases (costs) outpace goods and services inflation (revenue) and unit sales growth (revenue), causing margins to roll over. Lower inflation expectations make consumers less likely to accept higher prices, especially if the economic outlook is uncertain. Moderating inflation late in the cycle weighs on revenues. Companies that lose pricing power at this inflection point are the more cyclical companies. Healthcare, staples, and utilities tend to hold up better and are more likely to benefit from input cost pressures easing, explaining our overweight to these sectors.
We believe that earnings estimates and valuations have become too complacent, a common occurrence near the end of the cycle. The soft-landing scenario seems to appear on the front page of papers before the end of every cycle. The Fed’s track record of landing the plane is abysmal. Coming off easy monetary policy with so many uncertain factors at play, and the pace of tightening so much quicker than historical cycles, it is baffling that the market seems to believe this scenario.
Company fundamentals continue to weaken, real rates drive higher, and the cost of capital is increasingly restrictive. In our view the tailwinds for the market continue to subside while the headwinds are strengthening. Our leading indicators have not reached levels consistent with economic activity washing out and the cycle is resetting, keeping us extremely cautious.
Valuations remain elevated, disconnected from a slowing business cycle. And, these are on, what we believe are extremely optimistic earnings expectations. Valuations tend to be an awful short-term timing tool and markets can become disconnected from fundamentals for periods of time. However, in the end valuations and fundamentals tend to prevail.
We think we may be nearing the end of the interest rate hiking cycle. High quality, defensive companies have sold off this year. Utilities and higher dividend yielding names have been in direct competition with US Treasuries over the last few months. However, valuations in these parts of the market are more compelling now. If the economy rolls over and once real rates plateau these sectors should perform well on a relative basis. We have increased our exposure to these areas of the market throughout the past two months as valuations have improved. Defensive sectors tend to outperform after the final rate hike. At some point, longer duration Treasuries are attractive enough to lock in these yields, especially for our more conservative and income-oriented clients, however we have not jumped back in yet.
Timing every market zig and zag is impossible and a good way to drive yourself nuts. We view investing through a risk versus reward lens. In this type of euphoria (at least through July), where prices are so disconnected from reality, investors need to be aware of the risk of permanent damage to their nest egg. Especially if investors are in the phase of life where they are, or are close to, living off those assets. For most of our clients, the 6-month Treasury we bought yielding 5.57% (annualized) in their accounts is the perfect place to wait for a better risk versus reward profile in risk assets.
We continue to be extremely cautious and persistently patient. However, we are not perma-bears. When our economic indicators weaken to washout levels, valuations are discounting reality, and/or monetary policy is less restrictive we have dry powder ready to be put to work.
As always, please reach out to the Stone Creek Advisors team with any questions.
Go Bills!
Kasey
MGO One Seven LLC (“MGO One Seven”) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. Services are provided under the name Stone Creek Advisors, LLC, a DBA of MGO One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value.