After a challenging run for both equities and fixed income last year, many expected more of the same in 2023. That said, few, if any investors likely predicted that the first half of this year would see interest rates continuing to move higher in the face of elevated (if decelerating) inflation, a banking “mini-crisis” and a growing number of signs the global economy was slowing. Even if one managed to foresee all of this, it would seem natural to assume that the tough times for risk assets would indeed persist. However, this proved far from the case, with the S&P 500 up 16.9% in the first six months of the year, and the Bloomberg Aggregate Bond Index up 2.1%.
Though certainly an impressive run, we would point out, as many have as of late, that it is worth looking at the underlying composition of this year’s equity performance. While the S&P 500 may indeed be up 16.9%, the average stock in the index is only up 7.0%, meaning that a select number of businesses seem to be doing the “heavy lifting” when it comes to generating returns this year. Size seems to be a factor, as we consider the performance of the index versus its 10 largest holdings:
Beyond a preference for larger businesses, we feel there are other factors at play here. Markets appear to have once again embraced “high duration” equities, growth-oriented businesses whose elevated valuations reflect the promise of profits in the (sometimes distant) future, versus those being earned today. Consider the valuation metrics of those 10 largest components of the S&P 500 versus the index itself:
We would also note that a number of these 10 largest holdings appear to have their outsized growth expectations tied to a single trend: artificial intelligence. While we (along with everyone else) can make conjectures about how artificial intelligence will change society and the global economy, the fact is, the ultimate outcome remains very uncertain at this stage. In particular, we would question the timeline for this transformative technology to truly have an impact on economic productivity, corporate profits, etc. One need only to look to the railroad manias of the 1800s, or more recently, the dot-com boom of the late 1990s/early 2000s, to see that the growth paths of nascent industries can be quite volatile, and identifying the ultimate winners is a challenging task to say the least. While both technologies proved transformative in the long run, no shortage of capital was misallocated, or worse yet, evaporated, along the way in ventures that proved “too early”.
At the moment, we do believe there is likely a similar environment of overexuberance. Consider the case of Mistral AI, a Paris-based startup that recently raised $113 million at a valuation of $260 million within four weeks of its founding. While we are making no comment on the prospects of any specific business involved in the artificial intelligence space, whether a pre-revenue startup or a publicly traded business with a multi-trillion-dollar market capitalization, we do believe that the “AI-driven” rally we have seen this year is more than anything a sign that speculation is once again pushing the prices of risk assets higher.
In our eyes, this has been the result of an increasingly accepted belief that the global tightening cycle is coming to a close, and that, in the face of a weakening economy, central banks may begin to reverse course as early as the back half of this year. While we are unsure whether a loosening of monetary policy is just around the corner (more on that later), we actually would not disagree with the notion that there are clear signs the economy is slowing. For example, in June, we had the opportunity to meet with the investor relations teams of a number of companies in the chemicals space, an industry whose performance we perceive to be a leading indicator. The readthrough, as far as demand is concerned, could not be more clear: industrial customers are “destocking”- working through the large inventories accumulated during the supply chain disruptions of recent years; but as these stocks are whittled away, they are reticent to place large new orders, given the great deal of uncertainty about the trajectory of global growth going forward.
Obviously, this is just one piece of anecdotal evidence, but there is no shortage of economic statistics to bear out this contractionary narrative. Germany, the Eurozone’s largest economy, is believed to have entered a technical recession in the first quarter of the year. As 2023 began, many expected China to again become a major driver of global growth as it emerged from strict COVID-related regulations. However, this has proven to be a disappointment, as it appears the issues surrounding its interrelated property and debt “bubbles” in China are creating the potential for an era of stagnation, not unlike that seen in Japan beginning in the early 1990s. While China’s long-term prospects are decidedly uncertain, it is clear that exports out of the world’s second-largest economy have shrunk, mirroring what we have seen in flagging manufacturing statistics globally. Part of this is likely the result of a “decoupling” between China and the West, as companies seek to avoid the fallout from both future supply chain disruptions and geopolitical tensions by relocating manufacturing closer to the consumer. At the same time, we believe a more immediate driver may be weaker demand in the West, where consumers are contending with ongoing inflationary pressures, falling commercial real estate prices and waning consumer sentiment.
We certainly recognize that the economic backdrop has not been entirely gloomy. The labor market, to the surprise of many, remains fairly tight so far, and inflation, at least on a headline basis, has been falling since last summer. On that second point, we would note that this has been primarily driven by more volatile items like food and energy, while core inflation remains elevated. Overall, regardless of how one reads into the currently muddled set of economic data, we do believe it important to note that the yield curve has been inverted for some time now. This atypical situation, where short-term borrowing costs are greater than long-term borrowing costs, has typically been a reliable harbinger of a recession. The current inversion is the most pronounced since the early 1980s, a period which saw a “double dip” of successive economic contractions. While none of this means that a recession is a foregone conclusion, there is a strong likelihood that much of the global economy may be on the verge of a deceleration. Whether such a deceleration is major or minor is anyone’s guess, but the fact is there is a good deal of evidence that economic activity appears to be on the downswing.
All of that said, we believe the main question is not necessarily whether the global economy slows, but rather what such a slowdown actually looks like. It seems to us that markets are pricing in a fairly uniform narrative: a weakening economy means a return to the past decade and a half of muted inflation, loose monetary policy and buoyant asset prices. Consider U.S. equity markets at the moment: valuations, though off the peaks encountered during the 2021/2022 period, remain high or at least above their long-term averages, especially given the clear outsized weighting to “high duration” equities mentioned earlier in this letter. These valuations are even higher on a forward basis if one assumes an impending recession means shrinking earnings. Interestingly, consensus from Wall Street analysts does not seem to account for this, with S&P 500 earnings expected to be roughly flat in 2023 and growing another ~10% the following year- a difficult task if this widely expected recession were to occur.
Fixed income markets appear to be predicting a similarly dissonant story. As we previously noted, the Bloomberg Aggregate Bond Index rose in the first six months of this year, with credit spreads tightening slightly, suggesting corporate bond markets are pricing in a constructive economic backdrop. Yet at the same time, the rate-sensitive 2 Year Treasury yield spent most of the year lower than it began 2023. Following the “mini crisis” in the banking system in March, yields fell dramatically, only to begin rising again in May after the Federal Reserve hiked another quarter of a percentage point. Despite this, the 2 Year Treasury yield remained below its pre-March high, and interest rate futures continue to imply the Federal Reserve will reverse course by December of this year. Even with short-term rates rising a good bit more since the end of June, we still feel that markets may be too greatly overestimating the likelihood that the Federal Reserve will react quickly and decisively to signs of an economic slowdown.
To be clear, we do not discount the possibility that the Fed may be near the end of the hiking cycle, but rather wonder whether rates may stay elevated for longer than markets seem to be expecting. While we have noted that the economic picture appears to be weakening, it is by no means dramatically deteriorating, and the issue of inflation is far from resolved. Most likely, it would take another major dislocation for the world’s central banks to dramatically cut rates as they did during the Global Financial Crisis in 2008 or the COVID-19 pandemic in 2020. If investors are expecting another cataclysmic chain of events like these, perhaps one must then reconsider the somewhat benign outlook for corporates and households that equity and credit markets seem to be pricing in at the moment.
Conversely, if the widely expected economic slowdown is more of a “controlled deceleration” (or “soft landing”, as many have come to refer to it), conditions may look somewhat different. Unemployment could kick up slightly as economic activity comes off the boil, leading prices to fall, but not enough to get to the Federal Reserve’s stated goal of 2% inflation. In such a scenario, rates may indeed have to remain higher than expected. We would highlight that we see a number of secular factors at play that may keep prices higher going forward. An aging (and retiring) workforce in much of the world means labor continues to command a premium, as reflected by services inflation. Further reinforcing this trend is an increased focus on economic policies which afford labor a great share of economic gains, and recent events seem to suggest workers are confident in their ability to extract said gains. Finally, industrial policy, especially in the West, has been focused on building new energy and industrial infrastructure, which we believe will be supportive for commodities demand in the long-term. Should that be the case, recent price drops in raw materials may prove temporary. Taking these factors into account, even if the economy should weaken further, we see a distinct possibility inflation may stay elevated versus the relatively low levels seen in the decade and a half after the Great Financial Crisis.
Obviously, such a scenario would likely be problematic for the “high duration” assets that have driven markets higher so far this year. While we could point to a number of clear examples, one which has received plenty of attention lately has been the real estate sector. The combination of falling valuations, rising rates and reduced rents (especially in office) have changed the return arithmetic for many projects, impacting equity and debtholders alike. Though receiving less attention, we also are similarly concerned about the health of highly levered corporations, especially those with private equity sponsors. These businesses, frequently unable to issue debt in traditional bond markets, have been increasingly reliant on the leveraged loan market for financing. Given the low interest rate environment that existed until recently, investor demand for these high-yielding securities allowed this market to grow significantly over the past decade.
Even as rates began to rise last year, the adjustable-rate features of these loans meant that investors took little duration risk. This factor, combined with the seniority of these loans in the capital stack, likely explained why these securities did not sell off like other segments of the credit market last year. Since that time, many investors have increased their weightings to leveraged loans (and other forms of private credit), frequently pointing to the double-digit yields currently on offer in the space, the highest seen since the early 2000s. While certainly interesting at first glance, we have our misgivings.
First off, we would note that while yields look attractive in absolute terms, when compared to base rates, things appear somewhat less interesting versus history:
Secondly, while seniority in the capital stack is an attractive feature of these debt securities, the quality of leveraged loans has deteriorated in recent years. In the event of the type of economic dislocation so much of the market seems to be pricing in, we question whether historical default and recovery rates in the leveraged loan market are in any way instructive for measuring risk at the moment. While we believe that there may well be a time, perhaps in the not-too-distant future, where lending in this space will offer handsome returns, we believe that day is certainly not today.
Overall, we have maintained a generally defensive positioning in client portfolios. We continue to see value in owning short-dated, high-quality fixed income securities given where yields are, and the optionality these securities provide as other opportunities make themselves apparent. Though risk assets have been quite buoyant in 2023, there have been pockets of opportunity along the way. While certain corners of the technology sector have been “white hot”, others have seen their valuations remain somewhat depressed versus history, despite supportive long-term fundamentals, especially given the need to improve and expand digital infrastructure. Similarly, we see the drive to improve tangible infrastructure as supportive for commodities in the coming years, and thus continue to see opportunities in this space. While raw materials prices have indeed fallen due to concerns over global growth, the economics of many of these commodity-related businesses remain robust, offering an attractive risk/reward proposition in our eyes. Similarly, concerns over slowing economic growth appear to be weighing on a number of industries, creating opportunities to own assets at clear discounts to their long-term earnings potential. While we would reiterate that valuations for risk assets in general still appear demanding, we are encouraged by what we are seeing on the margins.
While markets are rarely easy to navigate, we do find the mixed signals being put forth at the moment to be particularly confounding, as risks to both the downside and upside abound. We believe it continues to make sense to remain deliberate in committing capital, setting the bar quite high when it comes to an acceptable level of risk-adjusted return. While we believe there is a strong possibility that the opportunity set may soon widen significantly, we also feel patient investors may reap the greatest rewards. If you are interested in discussing our views on the market or the potential opportunities we are seeing in greater detail, do not hesitate to reach out. Similarly, if your financial situation or investment objectives have changed, we ask that you get in touch, so that we may adjust your portfolio positioning accordingly.
As always, we greatly appreciate your support, and the trust you place in our team. We hope you enjoy a relaxing summer and all the best for the second half of 2023.