RECAP 1Q23
The tide receded last month and those swimming naked were not only embarrassed but exposed to frostbite and hypothermia.
Unless you live in a cave, you probably have a good idea what happened last month. However, for those cave dwellers* out there, here is an abridged version of events leading up to last month’s banking crisis. Everyone else, please feel free to skip ahead.
- The Fed flooded the market with money during the pandemic.
- The new supply of funds overwhelmed demand, letting the inflation genie out of the bottle.
- The Fed belatedly realized that inflation was not transitory (oops) and had to make a U-turn, raising interest rates at the fastest pace in 40 years.
- Higher rates (lower bond prices) lead to significant “unrealized” losses at a number of banks who were overextended and asleep at the wheel.
- A few bank customers got wind of these potential losses and with the click of a few buttons yanked their deposits, sparking a panic amongst other depositors. To meet the surge in withdrawals, those troubled banks were forced to sell their long-dated bonds at such a steep loss that they became insolvent.
*Full disclosure: Fort Street has nothing but the utmost respect and admiration for people (and bears) who currently live in a cave, have previously lived in a cave, or plan to live in a cave at some point in the future. Some of our best friends identify as cave people.
STOCKS & BONDS: OUT OF SYNC
Equities and bonds have rarely been this out of sync per the MOVE (bond volatility) and VIX (stock volatility) indices.
EQUITIES
It’s hard to imagine that the S&P 500 finished the quarter up 7% even as we flirted with the risk of a financial meltdown. Outside of the financial sector, which fell 14%, the broader market acted as if the recent bout of financial duress was merely a sideshow. The hope for a Fed pause or pivot seemed to entice investors back into the market. A lot of that buying was concentrated in technology stocks whose valuations are more sensitive to interest rate moves, pushing the Nasdaq up 16.6%.
BONDS
While the equity markets were downright giddy, the bond market went completely bonkers. The 2-year Treasury note fell a whopping 0.74% to 3.846%, its biggest move since 1987. Just to put that in perspective, yields on these bonds usually rise and fall in tiny increments measured in hundredths of a percentage point, or “basis points.” But in the last two weeks of March, the yield on two-year Treasury notes consistently moved within a range of 0.3 to 0.7 percentage points each day, 15 times the average over the past decade. The largest day-to-day move in yields was when the two-year yield on March 13 slid to 3.98 percent from 4.59 percent, the biggest lurch lower since 1982 — worse than anything we witnessed in the 1987 “Black Monday” stock market crash, the bursting of the tech bubble at the turn of the century or the 2008 financial crisis. These are monster moves for single days. More evidence that we are no longer in Kansas.
60/40 PORTFOLIOS: RIP?
For more than two years we have been suggesting that the 60/40 portfolio is toast. BlackRock recently announced that they are finally ditching the beloved 60/40 portfolio saying that in the new high-inflation regime, bonds are unlikely to provide portfolio ballast like they used. The first step to recovery is recognizing that we have a problem. Now comes the hard part. Fort Street’s portfolios are designed for the end of the 60/40 era.
BANK RUNS
The tradition of freaking out and demanding one’s money is thousands of years old. In the fourth century BC, besieged by angry lenders, Dionysius of Syracuse ordered that all metal coins be collected under penalty of death, restamped one-drachma pieces as two drachmas, and used his newly doubled assets to pay his IOUs. In the immortal words of Mel Brooks in History of the World Part I, “it’s good to be the king”. Fort Street currently has no plans to re-price our fund in two-drachma pieces.
What’s up with March? It seems like bad things tend to happen in March. Julius Caesar’s assassination, Hitler’s invasion of Czechoslovakia, SARS, the Covid pandemic, and now a series of bank runs. Ever since Caesar got whacked on the Ideas of March in 44 BCE, the month subsequently became associated with bad omens, betrayal, and misfortune. We may need to de-risk the portfolio before next March.
LIQUIDITY CRISIS
For a bank to meet its demise due to a duration mismatch between assets and liabilities is both ignominious and inexcusable, the equivalent of drowning in a puddle. It’s “Banking 101”.
In Hemmingway’s the Sun Also Rises, Mike is asked how he went bankrupt, to which he replies: “Two ways, gradually, then suddenly”. The recent wave of bankruptcies (SVB, Signature, CSFB) is a testament to what can happen once confidence is lost. The belief that our bank deposits are safe is the bedrock of an economic system based on credit creation. Once that trust cracks, things can unravel faster than you can say SVB.
While this latest episode seems to have been contained, we suspect that we are not out of the woods yet. Low yielding bank deposits (1%) continue to move into higher yielding money market funds (4-5%) at a torrid pace, putting enormous pressure on the banking system which could lead to yet another liquidity crisis. Not a prediction, just a possibility.
We actually flagged the risk of a liquidity crisis in our 3Q22 investor letter, not that we had any clue about SVB. At that time, we were concerned about being too much of a wet blanket and no one would want to hang out with us (or give us money), so we diverted the blame to our friends at Ruffer Investment as it was their idea to begin with.
OUTLOOK
As we stare into our crystal ball, we need to remind ourselves that spending too much time prognosticating about the future is generally not good for one’s mental or financial health. The endless stream of “experts” making grand proclamations about the future isn’t too far removed from the Auguries of Rome, who interpreted omens from the behavior of birds. Maybe it’s time we launched the Fort Street Avian Divination Fund? With that said, we still find ourselves pondering what lies ahead and how best to be positioned.
RECESSION ON THE HORIZON
The tug-of-war between recession and inflation rages on, frustrating bears and bulls alike. An economic slowdown is coming, and the markets will eventually retest 2022 lows. An inverted yield curve, Fed rate hikes, tighter lending conditions, a contraction in the money supply all point to some sort of downturn.
However, as we have been saying for a while, it will probably take longer than most investors expect for a recession to arrive, especially when everyone and his brother are convinced that a downturn is imminent, and positioning is overwhelmingly bearish. We also suspect that the economy has been stronger than most people realize, helping to delay the day of reckoning. The Atlanta Fed estimates 1Q GDP was a surprisingly robust 2.5%.
Investors have not been so underweight stocks vs bonds since 2009.
VALUATIONS ARE TOO HIGH
The problem for the equity market is that valuations are stretched. The S&P 500 currently trades at a P/E of 19x with the top ten stocks (mostly mega cap tech) trading at a rather steep 25x 2023 earnings. The good news is that the remaining 490 stocks trade at a more compelling 15.8x. The bad news is that as the economy slows, earning estimates will fall, making the market’s valuation even richer. Prices are ultimately driven by earnings growth, or the lack thereof. We suspect the consensus estimates are still too high.
INFLATION, A TEMPORARY REPRIEVE
Inflation pressures have dissipated, with the CPI falling from 9% to 5% within the last six months. Inflation is likely to continue to ease, albeit slowly, as there are many countervailing forces at play. We doubt the Fed is anywhere near ready to cut rates, despite what the bond market is saying as inflation levels remain too elevated and the economy too strong as evidenced by the strong labor market. However, the Fed could have some wiggle room to pause its rate hikes, courtesy of tighter lending conditions. The hope of a pause could temporarily increase investors’ appetite for risk and help the market scale the proverbial wall of worry, or at least keep it in a trading range for a while.
WAGES ON THE RISE
Real wage growth is likely to keep price pressures elevated. We experience the effects of a tight labor market on a daily basis when ordering food, buying a car, or trying to hire workers. The pandemic accelerated demographic trends that were already in motion well before Covid as the baby boomer generation was approaching retirement age. The upshot is that fewer available workers is likely to put upward pressure on real wage growth, which will drive inflation higher for everything. As wages outpace inflation, people will feel wealthier, driving demand higher and creating more inflation. Throw in the possibility of a commodity super cycle and we could be looking at volatile times ahead.
BANKING TURMOIL RAMIFICATIONS
Financial institutions will reduce the amount of credit they make available, causing some borrowers to be left out. SVB’s particular failure will probably make it harder for start-ups to get financing. Regional and community banks will be under greater scrutiny and experience deposit flight as cash flows to money market funds and larger banks perceived to be safer.
It will become tough sledding for property owners and developers, just as office buildings, brick-and-mortar retail, and perhaps even multifamily are coming under pressure in many regions. Commercial real estate, especially office buildings, is one of the biggest worries facing banks and the markets today, potentially spooking lenders and gumming up the gears of financing, and further adding to a sense of heightened risk.
Bottom line: stay frosty.
GEOPOLITICAL RISKS
As if the transition to a more inflationary, higher interest rate world was not enough of a challenge, we are also faced with a world order that is highly fluid and under attack. Once again, we are confronted with the futility of trying to make predictions. To that extent, the following points are mere observations.
CHINA AND TAIWAN
President Xi Jinping’s consolidation of power, the expansion of China’s modern military, and a US distracted with a host of domestic and global challenges has increased the odds of a Taiwan invasion.
As we have previously stated, China’s pivot away from economic (and by default, political) reforms will have an adverse effect on growth, challenging the country’s ability to avoid the middle-income trap and potentially even its hold on power. This is not to say that there is an imminent threat to leaders of the Chinese Communist Party (CCP), but should economic conditions deteriorate, risks of domestic unrest could increase. To some extent that was what we witnessed with Covid.
At the same time, China is bumping up against a demographic time bomb which could have further deleterious effects on the Chinese economy for years to come, thereby, threatening the CCP’s iron grip on power. Ironically, the fear of a severe economic slowdown might be the catalyst that forces Xi to launch some sort of attack against Taiwan and risk a confrontation with the US which would have unimaginable consequences.
While the odds might not be high, we need to be realistic about the possibility. The optimist in us is looking for a more peaceful resolution to the end of Taiwan’s status quo, but at this point the outlook remains sketchy. The upshot of all this is that Fort Street will continue to limit our direct exposure to the Greater China region. Warren Buffet recently sold most of his holdings in Taiwan Semiconductor especially for political risks. While he might not be the Oracle on matters in China and Taiwan, it’s still worth noting.
THE WAR IN UKRAINE
What an utter travesty. It’s hard to see how the war gets resolved anytime soon. Ukraine could always surprise as it has done so before, but to what end is unclear as Russia digs in. A diplomatic solution looks elusive at this point. We’d like to keep an open mind, but it seems like the war could drag on, keeping global tensions high. If we had to guess, Ukraine should eventually prevail as they are playing for an “infinite goal”, to survive. There are some parallels to America’s finite war in Vietnam as the Vietnamese were playing for keeps.
PERSPECTIVE AND HOPE
It’s easy and completely understandable to look at the state of the world and the situation here in the US and be overwhelmed with a sense of despair. The last 50-60 years have been one of the most peaceful and prosperous periods in history. Not for everyone, but certainly for the vast majority of the planet. Today, in parallel with an investment regime in transition, the world is also in a state of flux. While change is often disruptive and scary, it can also be for the better, over time. The point is not to get too despondent and lose hope for hope is the secret sauce to survive and thrive in a wild and crazy world. That plus good health, friends, family, and community. And a sense of humor. And perhaps some choice waves.
FORT STREET’S GAME PLAN
Now that we have laid out our rigorous analysis (guess work) of the path ahead, we wanted to discuss how Fort Street plans to protect assets and profit from the challenges and opportunities ahead.
STAYING CAUTIOUS
Given the heightened uncertainty, conflicting signals, and increased risks, we are opting to stay defensive. Now is not a time to be prancing around in a potential minefield. The banking turmoil has made the waters even muddier. As such, we continue to spread our bets, erring on the side of caution. In times like these, patience is a virtue. At the same time, we can’t compound returns without taking some risk and there are always money-making opportunities, even, or especially, in the most dire of circumstances.
This is why Fort Street has recently upgraded its investment strategy. We now use a two-pronged approach to protect and grow assets: 1) a newly launched bond fund for safety and income (Protect), and 2) our existing “enhanced” equity fund for compounding returns (Compound).
BOND FUND –
“PORTFOLIO PROTECT”
We empathize with investors’ concerns about the markets today. To address clients and prospects’ desire to find a safe place to park cash and still generate some income, we recently launched a new bond fund in partnership with BlackRock. Investors can toggle back and forth between our Protect and Compound portfolios based on external conditions and their own personal circumstances and objectives. The bond portfolio is completely customizable, tax-advantaged, and liquid. This new fund gives us access to Michael Hanratty and his team, one of BlackRock’s premier bond fund managers, as well as BlackRock’s huge inventory of fixed income products. To access Michael and his team directly normally requires a minimum investment of $400m.
EQUITY FUND –
“PORTFOLIO COMPOUND”
Risk And Reward
While no two people are the same, most investors want their assets to be both safe and productive. Compounding returns by default requires some exposure to risk assets like equities. No risk, no reward. Fort Street’s equity portfolio has evolved over time to work in a variety of economic and market conditions. During significant transitions or in times of stress, our multi-pronged approach tends to shine. However, we are also able to participate when markets are in an uptrend. We generate excess returns (alpha) by having fresh powder to buy when everyone else is selling and through superior asset allocation, sector selection and stock picking.
Human Nature
It’s tempting to sit in cash and wait for the “right moment” to buy equities. The problem is those moments are hard to identify and they are often accompanied by periods of severe duress. Humans struggle in these types of situations as we are hard-wired to be risk adverse, at least most of us. Despite Warren Buffett’s sage advice, our nature is to be fearful when everyone else is fearful. Kind of a safety in numbers approach. Back on the African savannah, early humans who went against the crowd were prone to being eaten by a lion.
Inhibiting Our Inherent Instincts
Recognizing our natural aversion to risk, we have tried to construct and manage a portfolio that allows us to take selective risks without becoming lion food. To protect and grow capital, we spread our bets across a number of assets and strategies, including but not limited to stocks, bonds, commodities, gold, cash, options, and external funds that are less correlated to the S&P 500. This approach allows us to swim against the tide without fear of drowning.
Actions Speak Louder Than Words
We endeavor to practice what we preach. Fort Street’s Compound portfolio lowered its net equity exposure to 50%, down from a historical range of 80-90%. Unlike most funds that rely on staying invested to raise new assets, we have no such obligation. Our risk exposure is based on our analysis of the opportunities and dangers that we see in front of us. When the pickings are slim, we are happy to sit on the sidelines until circumstances change and the odds shift in our favor.
FSAM PORTFOLIO HIGHLIGHTS FOR 1Q23
Highest conviction ideas: Short-term treasuries and commodities such as oil & gas, copper, uranium, and gold.
Tech: We reduced our exposure to big tech as valuations became more stretched. We wrote calls on some core positions for downside protection and to generate some income.
Defensive: We increased our investment in a few companies who should fare better in either a recession or a period of higher inflation – such as TECK (copper), PM (tobacco), WM (garbage disposal), TJX (discount retail), AMT (telecoms REIT), LMT (defense).
Banks and Real Estate: Our total exposure to the banking sector was less than 3%, almost half of which was outside the US. We have limited exposure to the commercial real estate market. Given our outlook, we remain cautious on banks and property in general.
Options: We modestly trimmed our index hedges as an imminent downturn seemed less likely. We are maintaining an index collar to generate income and protect downside. We also plan to add some longer term portfolio insurance using a bearish put spread.
Quality: Recent events highlight the danger of using short-term gains to obviate the gradual benefits of quality. Since we started the portfolio more than seven years ago, we have always focused on high quality opportunities. Most of our holdings are larger, more well-established companies with consistent sales, strong cash flows, high returns on capital, minimal debt, and reasonable dividends. We are not out beating the bushes looking for the next Amazon.
Geographic: While the portfolio is likely to remain heavily skewed to US companies, we are looking to increase our international exposure as macroeconomic dynamics could lead to more headwinds for US securities, shrinking the wide gap in valuations.
External funds: We have invested in three external funds – Ruffer (defensive), Indus (Asian equity), and Moerus (international value). Total external funds account for approximately 5% of total assets.
CONCLUSION
We are living in highly uncertain times. The future, while never clear, looks hazier than usual. It’s also likely that we are at the beginning of a significant market transition, bringing forth both risk and opportunity.
It’s important to recognize and adapt to the circumstances as they are, not as they were or as we hope. We don’t pretend to know how the future will unfold. We survive and thrive by taking a measured approach, basing our decisions on facts and not fantasy, keeping an open mind to all the possibilities, and spreading our bets in a manner that minimizes downside, yet allows us to generate returns in a variety of market conditions. We place and size our bets only after we have done our homework and in line with a thoughtful analysis of the perceived odds.
We do our best to avoid chasing the markets or investing in the flavor of the day. We attempt to drown-proof our investment ideas by flipping them upside down or taking the opposite view to see where we could be wrong. Inversion is the power of avoiding stupidity. As Charlie Munger (Warren Buffet’s sidekick) once said, “all I want to know is where I’m going to die, so I’ll never go there”.
“The good news is that when psychology swings in the direction of hopelessness, it becomes reasonable to believe that bargain hunters and providers of capital will be holding the better cards and will have opportunities for better returns. We consider the meltdown of SVB an early step in that direction”. – Howard Marx, April 2023 Investor Memo
As we often say, we are paranoid optimists. Our mission is to find a safe passage through whatever rough seas might lie ahead while looking for compelling investment opportunities along the way. We are confident that we have the resources and wherewithal to do so.
We want to express our gratitude for those of you who have entrusted your monies with us. We will do our utmost to ensure those funds are both safe and productive.