Fort Street Q2 2023 Quarterly Letter

Equity Markets Blast Off: A resilient economy, moderating inflation, and the excitement over AI unleashed investor’s animal spirits, igniting a blistering rally in equity markets. To paraphrase Mark Twain, rumors of the market’s death have been greatly exaggerated. Contrary to most “expert” forecasts and investor’s expectations, the S&P 500 surged 8.7% in the second quarter and 16.9% for the first half of the year. Yet another lesson in the futility of trying to time the market or predict the future. 

Recession Fears in Question: Convinced that the economy was on the precipice of a recession, most investors took their chips off the table, parking their cash in high yielding money market funds, which significantly reduced selling pressure from above. As the economy remained resilient, equities soared while bonds have languished thus far. Not even a regional banking crisis, the threat of a US debt default, or a mutiny in Russia could put the kibosh on this Teflon coated market. While the banking crisis was unfolding, the market started to turn its gaze to the promise of Artificial Intelligence (AI). Market sentiment abruptly shifted from widespread risk aversion to sudden fear that the AI gravy train was leaving the station, sending many tech stocks to the moon. 

Fort Street Fund’s Positioning: Even though the portfolio remained conservatively positioned due to the high level of macroeconomic uncertainty, we were more bullish than most on the shorter-term outlook for the economy and equity markets. While our call proved to be accurate, we did not foresee the AI fueled rally. Neither did anyone else. To illustrate, all 40 sell-side analysts missed Nvidia’s recent revenue guidance for 2024, from $7bn to $11bn. 

Market Leadership: Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta (dubbed the Magnificent Seven) accounted for a whopping 83% of the S&P 500’s total returns for the first half of the year. By comparison, if you exclude these seven stocks, the index would only have returned 6.3% in the first half. Not all of big tech’s returns were based on AI. The top five stocks in the S&P 500 in terms of market capitalization are expected to post a 16% increase in profits in the first half of the year. That compares to a 7% profit contraction for the S&P 500 overall. 

China and Hong Kong Lagging: While most equity markets are performing well this year, China and Hong Kong have struggled. Hopes for a Covid reopening rebound have been hindered by a challenging debt crisis, falling house prices, cautious consumer sentiment, a moribund economy, a regressive political system that is at odds with growth, and deteriorating demographics. The possibility that China might invade Taiwan doesn’t help economic prospects for the Greater China region. 


For the most part, our views have not changed much from last quarter. While the economy appears to be in decent shape, it’s unclear if we are completely out of the woods. If we had to hazard a guess, the markets could run into choppier waters come September and October. At current price levels, the market feels like it might be heading into no man’s land, confounding bears and bulls alike. We don’t possess a crystal ball so will continue to focus on the hard data, letting fundamentals guide our investment decisions. 

We thought it might be helpful to lay out some possible tailwinds and headwinds to get a sense of how things look going forward. On balance, the picture continues to remain mixed, and risks on the whole have increased as prices and valuations are now higher. With plenty of dry powder, we stand ready to take advantage of any potential sell-off but recognize that the market rarely gives you what you want when you want it – as we have seen this year in spades. In the meantime, we continue to look for selective money-making opportunities, stress testing and fortifying the portfolio, while collecting a risk-free 5.5% return on cash. 


AI Supercycle: In simple terms, AI involves using computers to do things that traditionally require human intelligence. While mindful of today’s hype, we recognize that AI could have a significant effect on growth and productivity over time; possibly changing the way we work and live in the same way as the Internet or the iPhone. 

Sensing the beginnings of a potential supercycle, animal spirits and FOMO sent a number of AI-related stocks into the stratosphere, pushing valuations to seemingly extreme levels. Over time, AI could offset inflationary pressures, saving us from a world of lower growth and pedestrian returns. 

“Generative AI is driving exponential growth in compute…you’re seeing the beginning of a 10-year transition” Jensen Huang, CEO Nvidia 

*** Please note that Fort Street will be hosting Josh Lospinoso on our next Podcast to give a crash course on what AI is and its practical implications today and in the future. Details to follow. 

Moderating Inflation: As we have been saying for the last six months or so, inflation is cooling, giving the Federal Reserve some breathing room to pause or stop its rate hiking cycle. While positive for equity markets for now, we suspect that inflation pressures could re-emerge over time as a tight labor market and rising wages puts upward pressure on prices. We also expect the positive base effects from last years’ high levels to dissipate as we head towards 2024. For now, the trend is creating a tailwind, but price volatility could turn it into a headwind. 

The Timex* Economy: Consumed with fear of an imminent recession, most investors failed to notice that the economy was actually in good shape. Rising wages, robust consumer spending, record air travel, and only a modest drop in corporate earnings were some of the signs that the economy was not on the verge of a recession. As one of my friends in California recently pointed out, many homeowners refinanced at generationally low interest rates, providing an effective savings of thousands of dollars a month on a recurring basis for many years to come. It doesn’t seem that many people have grokked this point. 

Anecdotally, it feels like there is plenty of economic energy and not much evidence of a dramatic slowdown. Admittedly, save for some travel, our small window of Hawaii might not be representative of the whole country. *The Timex reference is probably lost on a number of our readers, be they too young or didn’t grow up in America. It refers to Timex watch commercials with the tagline, “it takes a licking but keeps on ticking”. 

Abundant Supply of Money: While money circulating in the U.S. contracted for the six straight month (not a great sign in and of itself), money supply as measured by M2 is still 35% above pre-pandemic levels, lending some support to equity markets and the economy. 

Fiscal Stimulus: The US spent an estimated $5 trillion on Covid stimulus, avoiding an economic depression but letting the inflation genie out of the bottle. As those stimulus payments started to dry up, the government passed the Inflation Reduction Act (IRA) in 2022 whose stated aim is to curb inflation by reducing the budget deficit, lowering drug prices, and investing in domestic energy production with an emphasis on clean energy. In actual fact, the IRA has nothing to do with inflation. Like many government initiatives, they tend to start out with noble goals and aspirations but end up exacerbating the problem they set out to solve. It looks like fiscal spending could offset the Fed’s restrictive policy over time. We would not underestimate the effect of fiscal policy, especially as politicians vie for votes in an increasingly partisan world. Priming the pump helps win elections. The amount of money that the government plans to splash out on various infrastructure and energy projects is mind-boggling. The portfolio has already started to invest in companies that will benefit from these government initiatives.


Valuations: As prices have rallied, the market looks to be fully priced. Valuations for the S&P 500 index are now more than at 19x, well above the historical averages of 17x. Valuations for many technology stocks are now stretched and signs of frothiness have re-emerged in areas like profitless tech and meme stocks. Stripping out the tech sector, the broader market is trading at a more reasonable valuation of 17.1x. With the tech sector trading at an average of 27x, 30% above their 10-year average, we have been diversifying into non-tech stocks. The Magnificent Seven are trading at a 1.5x premium to actual underlying profits. The overall market’s equity risk premium – the excess return of equities above risk-free bonds – is currently 3.6% versus 5.6% pre-Covid, not leaving much of a margin of safety. 

Yield Curve Flashing Red: The difference between 2-year and 10-year Treasury bond yields (the yield curve) is now 1.1%, the biggest gap since 1981. The curve inverts when investors anticipate a period of less growth and central banks want to cool off the economy by raising short-term rates. Yield curve inversions have proceeded 9 out of 9 recessions since 1960. While we would not bet against the signal, we would note that the Fed’s interventions in the bond markets over the last decade could distort traditional indicators.

Robust Labor Market: If the Fed intends to drive inflation back down to 2%, it will have to restrict monetary policy to the point where unemployment rises, and the economy suffers a downturn. A strong labor market is one of the main reasons for the Fed to keep interest rates higher for longer. The accelerated demographic trends, shifting attitudes to work, and fiscal handouts led to a decline in labor force availability and participation. Once these trends take hold, they tend to create a vicious cycle that is not easy to break. 

Restrictive Monetary Policy: Not that we predicted the regional banking crisis, but raising rates from zero to 5% was bound to have adverse economic effects. More shoes could drop as the Fed’s policy remains restrictive and credit conditions have tightened. The commercial real estate market looks vulnerable as Work-From-Home (WFH) suppresses demand for office space and the cost of debt rises. There could also be a lag effect as higher rates work their way through the economy, creating more bumps down the road. 

China’s Sluggish Economy: China’s post-Covid economic recovery seems to have run out of steam, moving at a snail’s pace. The country inability to stimulate its economy is putting a damper on global demand as China accounts for 22% of world growth. Could the People’s Republic be facing a lost decade of growth, similar to what Japan experienced? It’s certainly possible as the country faces a complicated debt crisis, a troubled property market, less open global markets, and deteriorating demographics – all compounded by a government that favors political control over free markets. 

Building Roads to Nowhere: Zunyi, a city of 6.6 million in China’s poor and mountainous Guizhou province, is but one example of China’s debt struggles. The city built a six-lane freeway that no one seems to use (photo left). Housing projects and tourist attractions stand incomplete. These are symbolic of the stark debt crisis that many local Chinese governments are now facing after years of credit-fueled stimulus to juice growth. Guizhou has half the world’s tallest bridges. 

With the right political leadership, we are confident that China could resolve many of these issues. However, current government policies run the risk of retarding economic growth to a level that could eventually lead to political instability. 

China and Taiwan: While the odds of China invading Taiwan are not high, we are concerned that Taiwan is not doing enough to prepare itself for a possible confrontation. The Taiwan government seems to be behind the eight ball while the average Taiwanese appears somewhat ambivalent about the prospect of a fight with China, unlike the situation in Ukraine. We hope to get a better sense of where Taiwan stands on our next visit to the island this autumn. While it would be hard for China to successfully take over Taiwan, we wonder if Taiwan’s lack of commitment runs the risk of losing American support. 

Weak Market Internals: As we noted above, the current rally could stall if market breadth does not improve. Old economy stocks’ performance has been lackluster this year and a rally in some meme stocks and a rebound in profitless tech shares is a bit disconcerting. 

Bulls Outnumber Bears: Earlier in the year, it was hard to find anyone who was bullish. It seemed like just about everyone was negative and expecting the worst. The one notable exception was our friend Andrew Slimmon, who manages Applied Equity Advisors in conjunction with Morgan Stanley. After a powerful rally and some encouraging data and news flow, more people seem to be morphing into bulls, as some bears choose to hibernate. Inflows into US equity ETFs hit their highest levels since the market bottomed out in October 2022. This change in investor sentiment is not necessarily a headwind, more of a potential contrarian indicator as incremental buyers become more scarce. 


One thing that seems clear is that the era of free money is over, changing the rules of the game for the foreseeable future. Companies and investors need to adapt to this new “normal”. In just the last few years, we’ve seen the greatest monetary policy experiment of all time, with negative real interest rates, trillions of dollars of quantitative easing, and a record amount of transfer payments to support the economy through the pandemic. Virtually overnight, these distortionary impulses were withdrawn, increasing the risks of more dislocations. A higher rate world will challenge fundamental assumptions in our way of thinking. For the past forty years interest rates have been declining. A trend that persists for so long inevitably becomes ingrained into investor psychology. The problem is that most investors’ portfolios are still shaped for a zero-interest rate world. The latest bout of animal spirits runs the risk of reinforcing the wrong message. 


Based on our commentary above, the Fort Street Fund’s net market exposure is currently around 55%. We feel that is an appropriate level of risk given that the scales between risk and reward are somewhat balanced. Thirty percent of our assets are in bonds, mostly short-term Treasury bills yielding 4-5%. We also own some index options for downside protection as well as some gold. Our investment in Ruffer’s international total return fund also provides an additional layer of protection and performance against a number of potential market dislocations.. 

Equity portfolio: In our equity portfolio, we predominately own reasonably valued blue-chip companies with consistent sales growth, defendable margins (pricing power), minimal debt, high returns on assets, and sufficient free cash flow to weather any storm, even if it lasts longer than anticipated. We are not beating the bushes, looking for the next Amazon. The portfolio is predicated on generating excess returns but always with an eye on safety and downside protection. 


Just in case anyone is feeling overly sanguine now that equities have rallied, we wanted to point out that the risk of a liquidity crisis is not zero. If you listen to our friends at Ruffer, and we do, they would argue that those risks actually remain quite elevated. They suggest that just because the narrative has changed doesn’t mean the risks have disappeared. On the contrary, many of the factors that lead to the banking turmoil are still in place – short-term rates are significantly higher than long-term rates, making it difficult for banks to secure or maintain deposits and increasing the risk of a mismatch in assets and liabilities. Deposits are the life blood for banks. Money continues to flow out of bank deposits to high yielding, “liquid” risk-free money market mutual funds and T-bills. The flip side of this conundrum is that those borrowers who have based their cash flows on near-zero yields will not be able to afford the higher costs to service their debt, which is particularly acute in the commercial real estate market. 


Fed policy makers and investors don’t always see eye to eye, but when it comes to where interest rates will end up over the long haul, they agree that it will be much lower than now. We think they’re wrong. The Fed forecasts that the longer run target on overnight rates is 2.5%, versus 5.07% today. A survey of primary dealers (banks) and large investors showed the same median level expectations. These forecasts equate to the Fed’s inflation target rate of 2%. The Fed calculates its real or neutral rate (also called the r-star) by subtracting expected long term inflation rate from long term interest rates (2.5% – 2% = 0.5%). 

The problem is that after unprecedented levels of monetary and fiscal stimulus it only seems logical to expect the neutral rate (r-star) to rise, as it did after the GFC in 2009. A higher than presently anticipated r-star will have wide ranging ramifications, specifically that inflation and long-term interest expectations are currently too low. We find it odd that investors would expect the clock to turn back to the days of easy money. That train has already left the station and is now crossing into new and uncharted territory. 


Our strategy has served us well this year. We were able to participate in an up-trending market even while staying defensively positioned. With the exception of the Magnificent Seven, the Fort Street Fund outperformed the broader market of 493 stocks, even with a net market exposure of only 55%. Our priority is on downside protection, even if that means missing out on some returns in a given period. Key takeaways from the first half of 2023: 

– Be prepared for the unexpected. 

– Be mindful when consensus is extreme. 

– Don’t try to time the market. Take a systemic approach that uses a combination of fundamentals, time, and price. 

– Don’t pay attention to predictions about the future, especially from people who get paid to make them. 

– Remember this is a marathon, not a sprint. 

– Breathing helps, in and out. 

Yesterday  Era of Free MoneyToday Return to Reality
Free Money5% Risk-Free Rate
Abundance of GrowthLower Growth
Bubble ValuationsRational Valuations
Capital Driven GrowthInnovation and Execution Driven Growth
Growth at All CostsProfitable Growth