Quarterly Letter

A Tale as Old as Time: Don’t Fight the Fed

Company Updates

Market volatility was in full form for Q2 which garnered the majority of our attention as we navigated the choppy waters for client portfolios. Beyond the market, we are excited to announce the launch of our website, www.cordhavencapital.com where you can find past quarterly letters, thought pieces, and updates to the firm. We encourage you to stop by the office when convenient to review your quarterly report or just to say hello.

Market Perspective

Key Metrics

Inflation and interest rates over the past quarter were, and will remain, the focus for all investors as those two metrics work in tandem leading the market. We entered the quarter with a 0.25% hike already on the books with expectations for further hikes throughout the year and the possibility of half point hikes. Then in March, headline inflation came in above expectations at 8.5%. Because of this, the Fed felt it needed to accelerate the pace with which it was raising and declared a 0.50% hike. The Russian-Ukrainian war, supply chain issues from Covid, and the lockdown of major Chinese cities due to Covid, stoked inflation further into the quarter with headline CPI registering 8.3% for April and 8.6% for May; again, above expectations.

At that point, officials began realizing and admitting in some cases, their forecasts for inflation were wrong with Treasury Secretary Janet Yellen on record saying, “There have been unanticipated and large shocks to the economy that have boosted energy and food prices, and supply bottlenecks that affected our economy badly that I didn’t, at the time, fully understand.” Recognizing how far behind the curve they were, the Fed raised rates 0.75% to bring the Fed Funds Rate to 1.5%. This was the biggest rate increase since 1994 which the Fed acknowledged could be repeated for further hikes as the median Fed dot plot moved from 1.9% to 3.4% for year end and from 2.8% to 3.8% for 2023.

This was the biggest rate increase since 1994 which the Fed acknowledged could be repeated for further hikes

At the last Fed meeting in June, Fed Chairman Jerome Powell said he expected the US economy to be able to digest the current rate hike path without tipping over into a recession. The reasoning behind this notion was the inflation data they pay attention to, core inflation, is much more muted than headline inflation and the actions they plan on taking will be sufficient to tackle inflation without disrupting GDP growth in a significant way. We felt that attitude did not take into consideration the fact that the economy was already contracting, as GDP registered -1.4% for the first quarter and expectations for Q2 registering negative figures. The Fed was likely too late and could potentially overcompensate despite a naturally contracting economy. Our fears were actualized when the Fed late in the quarter changed their rhetoric to be more accepting of recessionary risks for the sake of corralling inflation. When asked what will cause the Fed to step back from rate hikes, Chair Powell’s response was they would need to see consecutive data readouts showing inflation meaningfully trending down, and a loosening of the labor market in the form of higher unemployment.

Our fears were actualized when the Fed late in the quarter changed their rhetoric to be more accepting of recessionary risks for the sake of corralling inflation.

With the threat of higher unemployment and a recession looming, along with average gas prices over $5.00/gallon, cracks in the consumer began to show over Q2. Consumer confidence slowly etched down over the quarter from 107.2 to 106.4 but was buoyed by home values steadily increasing due to a hot housing market. We are mindful of the risk a negative readjustment in housing prices poses to the consumer at the moment. Another area likely on the verge of slowing down, is manufacturing due to the excess inventory at big brand stores. Manufacturing PMI remained in expansion over the quarter as companies were catching up with supply and demand imbalances from Covid, but as the consumer eased up on spending through the second half of Q2, inventory levels began to balloon. Many retailers such as Target reported an excess amount of inventory and said they will need to heavily discount items to clear those levels.

Moving into the second half of the year, we expect the Fed to maintain its aggressive rate hike trajectory, ending the year between 3.5% – 4.0%. Two issues we feel are not being appreciated enough in regards to inflation is the EU’s embargo of Russian oil up to 90% and a looming diesel shortage domestically. These two factors along with continued issues in supply chains, rising rent prices, and geopolitical events in Ukraine could keep headline CPI elevated above 6% through the year. Although CPI is what most consumers experience day to day, the Fed will be focused on core inflation which doesn’t account for food and energy prices. If the Fed stays true to their word and focuses solely on core inflation, then we could have a situation where CPI remains elevated but core inflation levels off, creating a complex economic picture for the consumer as daily life necessities remain expensive.

With early signs of loosening from the labor market in the form of layoffs and hiring freezes, we expect unemployment to get closer to 4% by the end of the year. Consumer confidence will be impacted as people tighten their wallets in anticipation of rougher economic conditions. Manufacturing PMI is also likely to take a hit with high inventory levels causing retailers to scale back and businesses to slow down spending to conserve cash in an unknown future. As each economic domino begins to fall, with heavy encouragement from the Fed, we are now of the belief that we are headed for a mild recession at minimum, with the severity depending on how high and how fast the Fed raises rates.

As each economic domino begins to fall, with heavy encouragement from the Fed, we are now of the belief that we are headed for a mild recession at minimum

Market Sentiment

Fresh off one of the worst starts to the year in terms of market performance and inflation over Q1, investors entered Q2 with caution. No longer were investors willing to allocate capital to technology companies with exponential growth figures and negative cash flows. Almost overnight, cash flows and strong balance sheets came back in favor. The value investors, who for the past 10 years proclaimed value stocks would outperform soon, were finally correct. Energy, one of the most unloved sectors in recent years from the onset of ESG labeling, was the only positive performing sector in the S&P 500 for the year, leading all other market sectors by a wide margin.

With the Russian-Ukraine conflict continuing to impact energy and commodity markets, inflation was still top of mind for consumers, the Fed, and politicians alike, with President Biden stating inflation is a “top domestic priority.” As the Fed took it’s most hawkish stance in recent history, investors and company executives braced for what they see as an impending, Fed induced, recession. From this, the market entered price discovery mode, sending volatility to heightened levels and bearish sentiment at extremes only experienced in prior severe bear markets. BofA Fund Manager Survey cash levels reached the highest point since 9/11 and global growth optimism marked an all-time low of net -72%. Midway through the quarter it was obvious the market was unclear where prices for growth assets should settle due to the fact their value is directly tied with the discount rate the Fed sets and the Fed themselves were unsure of where it would end up.

BofA Fund Manager Survey cash levels reached the highest point since 9/11 and global growth optimism marked an all-time low of net -72%.

Through the end of the quarter, using the median severity (-23.9%) and duration (282 days) of market selloffs in recessions, the market was pricing in roughly a 75% chance of recession and about 65% of the way through until a bottom was reached. While there is always a myriad of reasons as to why the market acts the way it does, one of the main reasons we aren’t seeing full capitulation to the downside is due to the unknown. Unknown in the market is almost always a cause for volatility and in this case the unknown is interest rates, which is due to the unknown on how inflation will track, how quickly the job market loosens, and how soon supply chains can settle.

Heading into Q3, getting answers to these topics will determine the market’s path forward. If the Fed maintains or extends its hawkish stance to rein in inflation at any cost, which it says it’s comfortable with, then more downside is to be expected. We would anticipate any move down to be relatively quick as full capitulation is reached and a bottom is set. From there, the market would look beyond a recession and into the recovery as it is naturally a forward-looking mechanism. However, if the Fed backs off it’s hawkish regime in any way, the market would likely price in a bottom more immediately as fears of a recession or a deep recession would be subdued. Again, investors would likely look past any pain on the near horizon and begin looking towards growth again.

In late June at the ECB Forum, Chairman Powell had a few strong quotes, emphasizing his commitment to defeat inflation even if it means causing a recession: “Is there a risk we would go too far? Certainly there’s a risk… the bigger mistake to make—let’s put it that way—would be to fail to restore price stability.” “There’s a clock running here… the risk is that because of the multiplicity of shocks, you start to transition into a higher-inflation regime. Our job is literally to prevent that from happening, and we will prevent that from happening.” As we continue to see more hike announcements, removing uncertainty along the way, the market will likely further fade downward until commentary from Chairman Powell softens from a series of compelling data showing inflation and labor markets trending towards their goals. We believe the market would take any dovish commentary as a positive sign and find a solid bottom. Further rate hikes would still follow but the light at the end of the tunnel would be visible. Barring any black swan events, it is likely we will see equities recover while the actual economy experiences a recession as the market looks forward and will have already priced in the economic shock. Looking out into the next bull market poses an interesting question as value is the current trend: will value hold strong and lead the next bull market or will growth take flight yet again and lead the charge? Time will tell.

Barring any black swan events, it is likely we will see equities recover while the actual economy experiences a recession

Performance Breakdown

Following a turbulent start to the year in Q1, the second quarter took the bear market baton and ran with it. The market closed for the quarter with the worst first half performance since 1970; the Nasdaq was worst performer of the major indices on the quarter and year, followed by the S&P 500 then the Dow Jones Industrial. The utility, energy, and consumer staples sectors fared best for the quarter but were still down around 5% while the IT, communications, and consumer discretionary sectors saw the steepest selloffs of 21+%. The relative sector performance was a follow-through from Q1 with the exception of energy joining the selloff. Despite the negative quarter for energy, it is still the only sector in the positive for the year with a significant return of 30.21%.

As the recession fears continue to take hold of the market, the energy sector’s strong performance will likely see retracement as investors look out to a slower global economy which means less demand for traditional energy. Defensive sectors such as consumer staples and utilities should see relative outperformance until the market finds a bottom at which point we see a setup for growth names with healthy balance sheets to take the lead.

Investment Themes

Looking Back

Following through from our adjustments in Q1, we further positioned ourselves with a positive tilt towards energy and lightening in growth names, specifically tech with cash providing a buffer and dry powder for opportunities. We saw the hawkish nature from the Fed and a growing demand for energy despite elevated prices, as our reasoning for maintaining our stance in these sectors. Through the second quarter we also witnessed further materialization towards a recession due to the Fed’s actions and a natural slowdown in the economy. Due to recession fears actualizing in the form of hiring freezes, layoffs, and the early stages of a housing slowdown, we began lightening exposure to consumer discretionary names as rising prices and an economic slowdown paint a dim future for discretionary spending. Below are charts that gave us perspective over the quarter on where we were and where we might be headed:

Using median data on recessionary markets, we can see there is still more pain to be had.

Source: Macro-Ops, Deutsche Bank

Record low optimism for global growth shows us people and businesses are preparing for an economic slowdown.

Source: Macro-Ops, BofA Global Fund Manager Survey
Looking Forward

With the Fed’s foot on the rate hike pedal for the foreseeable future, consumer confidence deteriorating, and businesses laying off employees, we are maintaining our defensive posture and will continue to position accounts this way until the Fed indicates there is light at the end of the tunnel. When this occurs, whether its Q3 or 2023, we will likely begin shifting portfolios back to select growth opportunities. The biggest difference from investing in growth names moving forward, is the focus on free cash flowing companies. Previously, companies could get away with being cash flow negative so long as their growth prospects were robust but in the new paradigm, investors are more weary of these companies due to their instability through a recession.

The biggest difference from investing in growth names moving forward, is the focus on free cash flowing companies.

The S&P 500 P/E Ratio is only slightly below pre-pandemic levels, leading us to believe the market has further room to move towards the downside especially given that full market capitulation has not been reached yet. Over the month of June, individual investors purchased a net $24 billion worth of U.S. stocks which was consistent with the average over 2021 and 2020. Although the selloff causes pain in many ways, we view these rare recessionary markets as an opportunity to buy quality assets at a discount. We encourage clients to take a long-term view on their portfolio and take advantage during times like these.

We look forward to speaking with you soon.

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