Aloha friends! We hope you are all well in these troubled times. While it’s been a confounding and sadly tragic year, the portfolio avoided stepping on any land mines and even managed to make some money. For the third quarter, the FSAM Fund was flat, outperforming the S&P 500 and a blended 60/40 portfolio, which fell -3.6% and -2.06%, respectively. Year to date, the Fund is up 7.3%, and the S&P 500 and blended 60/40 portfolio are up 11.6% and 5%, respectively. Once again, the Fund performed as designed.
As the year progressed, we continued to spread our bets, incorporating a number of different views and possible outcomes into the portfolio. We were more bullish on the market than most as we saw inflation falling and what appeared to be a robust economy where consumers and corporations had plenty of cash to spend. Yet, we also remained concerned about the eventual impact of rising rates on the economy and the high probability that inflation would remain volatile. Accordingly, we were able to participate as the equity market went higher while insulating the portfolio against downside risks. In addition to implementing several protection strategies, our core equity portfolio is less correlated to the broader market, thereby increasing our odds of outperforming over time.
During the third quarter, our index options, cash, and bonds limited losses as the markets fell, while our long position in energy was a major contributor as oil prices rose. The specter of higher for longer interest rates put pressure on some of our positions in the technology, consumer, and real estate sectors due to a combination of rising discount rates, falling premium valuations, and refinancing risks.
After a dismal 2022 for both stocks and bonds, most investors entered the new year with considerable apprehension as the Fed aggressively hiked interest rates and political risks near and far became more prevalent. Many people opted for the relative safety of the sidelines and the comfort of rising money market rates. As recession fears loomed large, many investors anticipated that the Fed would have to reverse course and cut rates sooner than later, expecting bonds to shine and stocks to plunge. The market did not comply.
In fact, equities moved higher, in spite of an incipient banking crisis in March that could have triggered a systemic liquidity crisis. It didn’t. Equities suffered only a momentary dip, before a surprisingly strong economy and an AI-inspired rally sent stock prices into orbit. By August, the S&P 500 index was up 19.5%, while bond prices continued to rack up ever larger losses.
However, just as talk of a soft economic landing started to dominate the headlines by September, surging long term bond yields began to set off alarm bells, causing the S&P 500 to drop 10% from its August peak. Long-term Treasuries closed the quarter down a stunning 13%. Which begs the question, what is going on in the bond market?
Bonds market goes bananas
The transition to a new market era has not been kind to bond prices. Long-term Treasuries are down an eye-popping 42% over the last three years. In hindsight, it seems obvious as we bid adieu to the wild and wonderful days of zero interest rates. Still, the ongoing selloff and the velocity of such moves are nothing short of astonishing. Unlike equities, bonds usually move in teeny tiny increments, a few hundredths of a percent at a time. Swings of this magnitude are not “normal”. The 40-year bond bull market was preceded by a 35-year bear market. We sense that this new market regime may challenge bond prices going forward. Beyond current Fed policy, these abnormal moves seem to suggest that something else is amiss in the bond market.
Surging long-term bond yields
There seems to be a number of factors at work behind the recent surge in long-term yields:
For starters, the market has woken up to the realization that the Fed isn’t kidding about fighting inflation and the need for rates to remain higher for longer.
More critically, the sheer supply of bonds to fund the government’s burgeoning spending plans has met with a paucity of buyers, driving yields on longer-dated Treasurys ever higher.
Further complicating matters, traditional foreign buyers of U.S. debt are notably absent; while U.S. individual and institutional investors are more than content to gorge themselves on short-term high yielding, risk-free Treasury bills, present company included.
Additionally, it seems that some retail investors have been net-sellers of longer-dated bond ETFs, signaling their distaste and angst with U.S. government funding policies.
The upshot of all this is the growing concern about the fiscal health of the U.S. government and its exploding debt burden.
We would also point out that it is the market and not the Fed that is the ultimate arbiter of longer-term interest rates; and the market has made it resounding clear what it thinks. The yield on the 10-year Treasury climbed from 3.8% on July 1 to 4.8% on October 2, while short-term rates stayed flat.
As if the chaos in the bond market was not enough, we have had to endure Washington’s pathetic handling of a potential government shutdown. The recent actions of our so-called leaders in Congress leave us gobsmacked. Is this really the best we have? For the speaker of the house to lose his job because he did something that is good for the country is both confounding and depressing. Unfortunately, we can look forward to more dysfunction as the threat of a shutdown remains unresolved, which could have some impact on the economy. As the former comedian George Carlin once quipped about our political system, “garbage in, garbage out”. Fort Street Asset Management Q3 Update
LOOKING FORWARD: RISKS AND OPPORTUNITIES
The possibility of a wider Middle East war, increasing odds of a recession, and the untenable fiscal situation in the U.S. increases risks to asset prices, encouraging us stay in a more defensive posture. Add a war of attrition in Ukraine, and the non-zero possibility of China invading Taiwan into the mix, and maintaining an optimistic disposition becomes a bit more challenging.
With debt to GDP at 122%, the U.S. is in its weakest fiscal position in generations during the most challenging geopolitical environment since WWII. During times like these, we prefer our lucky color to be invisible. Not the best setup for risk assets especially if Israel’s actions in Gaza trigger a non-linear outcome. To be on the safe side, we are increasing our exposure to gold and Bitcoin, as well as adding to investments in other protection strategies.
However, despite the increasing odds of a recession and the risk that the war in Israel escalates, not all is doom and gloom. Moderating inflation, improving earnings outlook, and an economy that defies expectations could see the equity market rally into year end. Markets, like life, rarely move in a linear fashion. Furthermore, we recognize that we could be wrong about a lot of things (shocking as that be to some of you), so will attempt to position ourselves accordingly.
Risks are rising as the war in Israel could escalate, higher long-term rates and an inverted yield curve is likely to tip us into a recession, persistent wage pressures will probably reignite inflation, and exploding U.S. debt keeps interest rates elevated which is likely to hurt economic growth.
As this is not an op-ed piece, we will keep our analysis and comments focused on the global investment implications of the war in Israel. It is of course beyond heartbreaking, and while we are realistic as to what lies ahead, we maintain hope, as difficult as that might be, and pray for a peaceful resolution.
As long as men believe in absurdities, they will commit atrocities – Voltaire
If this conflict does go beyond Israel and Gaza, the economic and political repercussions are likely to be significant. However, it’s too early to tell how it will all play out. We will have to watch the situation unfold over the days, weeks, and months ahead. From a portfolio stance, we will look for ways to add to our protection strategies as the situation progresses.
Hopes for a safe landing appear to be diminishing with each passing day as rising long-term rates and the threat of a wider war increase the risk of tipping the economy into a recession. We aren’t in the business of trying to time the market or predict economic cycles. We simply note tthat rate hikes work with a long and variable lag. We are no economist (that’s a good thing), but it seems logical that higher rates will eventually restrict credit creation to a point that it contracts economic growth. Our suspicion is that this will probably take time to play out as there still seems to be plenty of energy in the economy, but we would note that higher rates combined with an inverted yield curve suggest that a recession is probably lurking somewhere on the horizon..
U.S. Government Debt – a ticking time bomb
As the chart on the right illustrates, federal debt has increased by $8 trillion or 50% in the last two years alone. This is not sustainable. With debt to GDP at 122%, the U.S. is in its weakest fiscal position since WWII.
Hamas’ incursion and massacre in Israel was yet another Black Swan – a rare event that no one expected. By contrast, the U.S.’s fiscal predicament is the opposite of a Black Swan. It’s more like an 800-pound gorilla sitting in our lap to which we have become oddly accustomed, except said gorilla is rapidly gaining weight, feasting on a diet of ice cream and cake. The good news is that the risks and remedies are strikingly obvious. The bad news is that nothing is likely to happen without some enlightened leadership and a more selfless and motivated public.
This needs to be a central part of our political dialogue. We need political leaders who will tell the public the truth. Trump and Biden put us over the edge. Trump aggressively cut taxes, while Biden raised fiscal spending to unprecedented levels. Build Back Better became Build Back Debtor. The sugar high was so good that we went from eating a few cookies to binging on the entire box. As Albert Einstein said, the people who create the problem can’t be the ones to solve it. One can only hope that by some miracle we get better options for President than what’s currently on the menu. Time for fresh blood.
Meanwhile, the costs to service the interest on our debt is reaching untenable levels. In just a few years, interests costs will soon exceed defense spending and 20% of our taxes will be used just to service the interest payments alone. We are caught in a vicious circle – higher rates increase our funding costs, which leads to an increase in the supply of bonds, and fewer bond buyers leads to back to higher rates, until the market sets a clearing price. Our fear is that rates could rise a lot more than most investors expect.
We will have to elect politicians who are ready to put everything on the table, both higher taxes and less spending. Politicians who put nation before self-interest. I know, a crazy idea. The American public is going to have to listen, put their differences aside, and find a way to compromise. It will require sacrifice from all of us. Fiscal retrenchment is inevitable. It’s a question of when, not if. This is based on the hard numbers, not opinion. We either bite the bullet now on our own terms or leave it up to wishful thinking and risk even worse outcomes. We don’t know how long this will take to play but suspect nothing will happen until something breaks. Such is human nature.
On a cheerier note, it’s not all doom and gloom. There is still some cause for cautious optimism as earnings are improving, households still have excess savings, an election year guarantees a surfeit of fiscal stimulus, and inflation is still moderating.
Recent data seems to indicate that economic growth remains strong and a year-long slump in profits for Corporate America is about to end. However, relief may be short-lived given the fragile economic and political outlook combined with the highest level of interest rates in 16 years. Analysts project that earnings for the S&P 500 will drop 1.2% in the third quarter – the fourth straight quarter of declines – before rebounding 6.5% in the final three months of the year. Consensus forecasts are seeing upward revisions which is usually a bullish sign for equities. Wall Street expects that earnings will grow 12% in 2024. We suspect those forecasts may prove too optimistic; a fragile recovery and the lack of breath tempers our enthusiasm. Most of the growth and outperformance continues to be driven by a handful of companies, such as the so-called “magnificent seven” technology stocks. At 18x forward earnings, the S&P 500 does not appear to be excessive, especially if we were to strip out those top seven stocks which now account for 30% of the index.
Households still have excess savings
Recent reports of the demise of excess U.S. household savings seem to have been greatly exaggerated. It appears that consumers still have more than $1 trillion in excess savings, which could help cushion the economy in the face of headwinds from surging bond yields. To be sure, the lion’s share of this excess wealth is held by households in the top 10% income bracket. We also suspect that the market is underestimating the accumulated savings when many individuals and corporations refinanced at rock-bottom rates during the pandemic.
Election year guarantees a surfeit of fiscal stimulus
The incumbent party will do all it can to support the economy into an election year. Three massive fiscal stimulus programs (Chips Act, Inflation Reduction Act, Infrastructure Act) have already been enacted into law and will start distributing funds in the fourth quarter of this year. If there is one thing politicians are good at, it’s spending taxpayer’s money. The government plans on handing out copious amounts of money on infrastructure, defense, and technology. Elections are ultimately won and lost on the economy.
Inflation: down, but not out
Thanks to favorable year-on-year comparisons, inflation is likely to moderate over the next 3-6 months, easing pressure for the Fed to raise short term rates and perhaps tolerate less restrictive financial conditions. Unfortunately, persistent wage pressures are likely to reignite inflationary pressures down the road, especially as labor reasserts itself into the conversation and politicians seize on the chance to win more votes. Unionization efforts and an increase in labor strikes such as the United Auto Workers (UAW) and Kaiser Permanente, are likely a sign of things to come. Deglobalization, reshoring, commodity supply shortages and energy transition will also contribute to ongoing price pressures. Over time, we accept that advances in A.I. will boost productivity, offsetting some inflationary pressures.
FORT STREET FUND – INVESTMENT STRATEGY
The Fort Street Fund’s net market exposure is currently around 65%. We will probably reduce overall portfolio risk after recent events in Israel and in the bond market. Approximately 25% of our assets are in cash and bonds, with the bulk concentrated in short-term bills yielding in excess of 5%. We have covered some of our index options but plan to establish new positions as the quarter progresses. We recently increased our allocation to gold to about 4% and started buying some bitcoin as they are less directionally correlated to moves in the equity market and tend to protect the portfolio when times are hard. We also plan on increasing our investment with Ruffer, as they tend to shine whenever markets take a significant turn for the worse.
In a world of higher interest rates and more elevated levels of inflation, we may need to add some more arrows to our investment quiver. Howard Marks, co-founder of Oaktree Capital, recently proposed that investors should make a much bigger allocation to high yield bonds as they now offer equity-like returns but with a lot less risk. Perhaps. We would need to do a lot more work before making any major allocation to non-investment grade bonds. We do agree that a new market era is upon us and demands that we explore alternative investment ideas. What worked in the past is unlikely to work as well going forward.
Our core equity portfolio accounts for 70% of our gross asset value. We are likely to trim some positions if it appears that a recession is closer than expected. Thematically, we remain bullish on energy, selective base metals, infrastructure, and defense. We try to avoid playing flavor of the moment. Our holdings are predicated on either specific industry trends or bottom-up investment opportunities with solid, long-term fundamentals that we can own for years to come. We are fairly agnostic when it comes to things like factor and style investing, not paying much attention to industry-defined categories like growth, value, defensive, momentum, and volatility.
We often talk about being prepared for the punch we don’t see coming as that’s often the one that knocks you out. Clint Dodson, my erstwhile partner-in-crime, is the living embodiment of such a mindset. He is hard-wired to be ready for anything and everything, partly due to his military training and partly a function of who he is. I once witnessed this in action when a person had a medical emergency in a theater and Clint was Johnny on the spot before I even knew something was wrong. It was impressive to see. I’m grateful and honored that we all get to share a foxhole with Clint.
Just in the last couple of years, it seems like those punches are taking place with greater frequency – Covid, Ukraine, Silicon Valley Bank, Maui, Israel. What next? If this keeps up, they’re going to have to replace Black Swan with something slightly more common. Speckled Marmot?
Our sense is that periods of transitions often experience an uptick in Speckled Marmot events. We have had the benefit of living in a post WWII period of incredible prosperity and peace, at least on a historical basis. Change by its very nature is uncertain, which leads to an increase in volatility and fear. We seem to be at the beginning of an economic, political, and social sea change.
Recognizing and accepting this transition allows us to craft an investment strategy which can navigate all manner of conditions. Be it represented by Black Swans, Speckled Marmots, or Fluffy Bunnies. While we don’t possess a crystal ball, we must rely on our ability to construct a portfolio that can absorb whatever punch, or animal, the market throws at us. Conversely, we would be willing to pay good money if anyone has a functioning crystal ball for sale.
We don’t mean to make light of the state of the world today. Far from it. In difficult times, humor is one of the most powerful weapons we possess. And hope.
“It is well known that humor, more than anything else in the human make-up, can afford an aloofness and an ability to rise above any situation, even if only for a few seconds.”― Viktor Frankl, Man’s Search for Meaning
As fiduciaries and guardians of your hard-earned treasure, we will use whatever tools necessary to protect and grow the assets you have entrusted to us. Our mission is not to swing for home runs but to survive in order to thrive. We are forever grateful for the trust you place in us, especially in these trying times, and thank you for your ongoing support.
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.
OUTLOOK AND STRATEGY
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.
NEW MARKET REGIME
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.
INTEREST RATE FORECASTS
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.
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.
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%.
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.
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.
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.
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.
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.
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 –
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 –
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.
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.
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.