Current Enthusiasm Overshadowing Headwinds
An investment process that consistently generates positive risk-adjusted returns over extended timeframes needs to do two things well: capitalize on the right assets and protect on the downside. We continuously search for assets with compelling cash flows and a high margin of safety. When risk assets don’t offer these features, patiently waiting for more attractive prices is essential. While many investors appear to be chasing the future at increasingly heady valuations, we have focused our investments on asset classes we believe offer solid returns over the next 18-24 months:
- Quality – Highly profitable companies with durable income streams even during economic slowdowns
- Energy – Very attractive valuations and favorable fundamentals
- Emerging Markets – Long-term growth at reasonable prices
- Short-Term Treasuries — Yielding above 5% while waiting for better options
Combined as a portfolio, we believe these investments provide healthy returns with limited downside, even during periods plagued by choppiness and volatility. This posture takes advantage of today’s most attractive opportunities and acknowledges the current headwinds facing today’s macro-economic outlook.
Tighter for Longer
Financial markets have been adjusting to the implications of higher interest rates for the past 16 months. Some believe we will avoid a significant economic slowdown despite the speed and magnitude of this historic rate-hike cycle. We believe it is important to recognize that the Fed has only managed to turn monetary policy into a restrictive position over the last 6 months and that the full ramifications of policy changes have not yet been felt, as the chart below shows.
The Fed did not embark on its hiking cycle until approximately 12 months past the point when Core PCE inflation rose above the 2% Fed target. By the time the Fed started hiking, inflation was running above 5%. As a result, we believe the Fed was playing catch up during all of 2022 and was still accommodative in its posture. This would suggest that the markets may have only experienced limited impacts thus far from the Fed’s regime of rate increases.
The implications for core PCE inflation are resoundingly clear: it is proving to be persistently higher and lingering longer than the Fed would like. Fed Chair Powell echoed as much in a recent press conference when he said monetary policy “may not be restrictive enough and it has not been restrictive for long enough”. The Fed has telegraphed a tighter-for-longer message throughout 2023 and it’s suggesting more hikes to come.
Signs of Decelerating Conditions Continue to Mount
A healthy corporate profit outlook is a key tenet of equity investing with a margin of safety. Unfortunately, lengthy periods of monetary policy tightening almost always lead to weaker profits. We have already witnessed multiple warning signs that growth expectations for the intermediate term are continuing to come under pressure. Leading indicators have been weakening for the past 14 months. As an example, the current yield curve has been inverted for over a year, which is often a harbinger for a more severe economic slowdown.
A more recent and ominous sign for markets has been the tightening of lending standards for the banking sector. Tighter lending standards generally lead to weaker corporate profits. Lending standards were already high, but the fallout from bank failures has forced banks to become more restrictive, even for some of their biggest customers. As the chart below indicates, over the last 30 years when the percentage of banks’ tightening standards reaches current levels, it has historically coincided with recessionary conditions.
With the Federal Reserve and the banking sector both tightening their belts, a period of weaker corporate profits is highly likely to ensue. This holds significant implications for portfolio strategy.
Recent Market Activity
The gains in the stock market year to date have been concentrated in a small handful of stocks. Most of the companies in that narrow list, now referred to as “The Magnificent Seven” or “The Elite Eight”, are unlikely to deliver results commensurate with their valuations over any reasonable period. This is eerily reminiscent of “The Four Horsemen” of the internet during the tech bubble, and that experience ended rather poorly. This time around we would associate the excitement around artificial intelligence (AI) with speculation rather than healthy investment.
A noteworthy data point from last quarter highlights the unprecedented nature of this current environment: less than 20% of stocks outperformed the S&P index over the trailing 3-month period at the end of May. The tech bubble never reached such an extreme level.
We have already highlighted the pockets of opportunity that we believe offer strong returns on a forward-looking basis. Our position in energy has been a stalwart over the past couple of years and we continue to see tremendous return potential. The following points demonstrate the upside opportunity in energy at current levels:
- Forward P/E for energy is just above 10 times versus about 20 times for the S&P 500.
- The current dividend yield is 3.6% versus a yield for the S&P 500 of 1.6% — more than double.
- Long-term earnings offer more stability over the coming cycle. The energy sector is not spending capital to increase production as they have in the past, as you’ll see in the chart below.
- The sector is returning its strong free cash flow generation (the dark blue line in the chart) back to shareholders through dividends and buybacks. These are shareholder-friendly activities that should lead to less volatility for the energy sector moving forward.
It is readily apparent that contrasting energy with the overall equity market highlights a meaningful valuation disconnect. Valuations for the overall market suggest an implied long-term return ranging from less than 5% (at best) to negative.
While we can comfortably illustrate the attractiveness of the energy sector and other market segments, the overall risk in many sectors is not worth the commitment when risk-free yields above 5% are available in short-term treasuries. For now, we patiently wait for more attractive prices with the knowledge that treasuries are offering appealing returns.
We are always looking to invest in the most attractive assets, and we believe our current portfolio reflects the best opportunities in today’s environment. We are also always looking at tomorrow’s opportunities. The equity market appears to be paying a rather steep price for a corporate profits stream that is facing increasing headwinds from tightening conditions throughout the economy. When PE multiples contract to make select assets we don’t currently own more attractive, we will have ample resources to take advantage of better prices.
We continue to believe asset allocation will need to be dynamic over the next several years, which is why it is an overriding principle of our investment process. As the long and variable lags of tightening policy flow through the economy, opportunities may quickly emerge while others will take time to become truly attractive. We remain steadfast and patient.
As always, we thank you for the privilege of allowing us to guide your assets forward. Should you have any questions or observations, please don’t hesitate to contact us.