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Quarterly Letter

The Market is Molting

Company Updates

Closing out our first full year as Cordhaven Capital Management, we want to thank you for trusting us as a steward of your capital – it is our privilege and honor. We place you, the client, above all else and look forward to continuously refining your experience and investment strategy through the new year and beyond. In alignment with the new year, we encourage clients to schedule a meeting with us to review your portfolio and discuss what risks and opportunities we see over 2023.

Market Perspective

Key Metrics

With two Federal Reserve meetings in Q4, investors keyed in on inputs that might impact the Fed’s decision on rates. Early in the quarter, the unemployment rate decreased to 3.5% showing a persistently tight labor market. This was concerning to investors who were optimistic that previous rate hikes would slow the labor market. Following the unemployment data and a high CPI reading of 8.2% in October, the market priced in a 0.75% rate increase for the November meeting. The Fed confirmed these expectations and raised the Fed Funds Rate to 3.75%. Fed Chairman Jerome Powell reiterated his commitment to taming inflation in the post meeting press conference by saying “there is still ground to cover.” He also addressed market participants’ interest in the successive speed at which the Fed would hike when he provided the following groundwork for how investors should be thinking:

  • When the Fed realized inflation wasn’t “transitory” at the beginning of the year, the pace at which they raised rates was important because they were behind the curve and to get ahead of inflation at that point required an urgent response.
  • Now, with rates rising to 3.75% from 0% in a matter of months, and feeling they were closer rather than further to peak rates, the pace of rate increases was no longer relevant.
  • What mattered from that point on was the eventual height and duration of rates.
  • Given this framework, he made clear it was “very premature” to think about a pause or reversal of rate hikes at this time.

During November, investors narrowed their focus further to data on the labor market and CPI. The unemployment rate remained at 3.5% in November, remaining largely unchanged since March while the CPI showed some improvement. The CPI and Core CPI for October, declined to 7.7% and 6.3% year-over-year, respectively. With this incrementally positive data in hand, the Fed slowed the pace of rate hikes at their December meeting, raising rates by only 50 basis points to a rate of 4.25%. The initial decrease in pace was welcomed by the market, but optimism quickly dissipated when Powell said the labor market remained out of balance and progress on inflation had been slower than expected which led to an upward revision of the target range of rates. Powell’s best assessment at the time was that peak rates would be 5% or higher, with no projections for cuts during 2023.

Powell’s best assessment at the time was that peak rates would be 5% or higher, with no projections for cuts during 2023.

Over the quarter, persistent inflation and the likelihood of higher rates continued to affect consumer sentiment, as demonstrated by the Consumer Confidence Index. The index declined for two consecutive months, from 102.5 in October to 100.2 in November, before spiking to 108.3 in December. It is worth noting that prior to Covid, this index was in the 130 range and has not reached those levels since. The Institute for Supply Management Producer Manufacturing Index (ISM PMI) also faced pressure during the fourth quarter, falling below 50% and indicating contraction for the first time since May of 2020. The Federal Reserve monitors this index as a leading indicator of GDP which registered 3.2% in the third quarter.

In the coming year and into 2024, the Fed Funds Rate will be a central focus for the market. If the Fed sticks to previous tightening trends and follows the 2-year treasury note yield, which ended the year at approximately 4.2%, then it can be assumed the Fed will either continue to raise rates past 4.2% shortly before cutting them back down in 2023, or they will stop increasing rates immediately. If the Fed deviates from this model and continues to raise rates past 5%, then there is still significant ground to cover. While the situation remains dynamic and uncertain, our general view is the Fed is showing its hand and rates will rise beyond 5% and remain at that terminal level into 2024. It is even more difficult to predict what will occur beyond that point, but if we trust the Fed’s statements, it is likely relief from peak rates will be provided at some point in 2024.

Given the challenges of predicting the Federal Reserve’s actions, our view of the economic landscape remains fluid. If the economy were to experience a significant recession, we would expect the Fed to adopt an accommodative stance in response. While it is possible that the economy will experience some form of recession in the next two years, the severity of the recession remains uncertain. Some well-known investors, including Michael Burry, who was popularized in the film The Big Short, have suggested the possibility of an environment in which inflation slows but does not come to a halt, leading to a deflationary scenario. According to Burry, this would result in the Fed cutting rates significantly in order to eliminate deflation, thereby restarting the inflationary cycle. While we do not currently subscribe to this idea, we acknowledge that there are a range of potential outcomes and leave room for all possibilities. The Cone of Potential Outcomes, which refers to the many different paths that the future can take at any given moment, is currently at its widest since the beginning of Covid. It would be imprudent to assert a high level of certainty at this time, particularly when capital is at risk.

The Cone of Potential Outcomes, which refers to the many different paths that the future can take at any given moment, is currently at its widest since the beginning of Covid.

Rather than forecast, our best bet is to understand what is happening today. At the moment, labor markets remain tight showing little signs of weakness beyond select segments of the economy such as tech. Consumer confidence is shaky but has yet to fully break down to levels typical of recessionary environments. ISM PMI is flashing yellow and should be watched closely as an indicator for GDP. CPI and Core CPI are trending down and will likely continue decreasing until something structural, like rates, change course. As a whole, the economic metrics we watch closely, are on unstable foundations. There are larger, more secular shifts occurring, which will impact the readouts on these data points for years to come. Below is one example of the magnitude at which the environment is changing as seen through the number of rate hikes occurring across global central banks. This is all to say, we have our ear to the ground and continue to question our viewpoints constructively.

Source: The Economist, World Bank
Market Sentiment

Q4 is a unique quarter for most institutional investors. In addition to the tactical moves common over the course of any given quarter, it is also a time when they step back and view the playing field from a higher vantage point. This allows them to stretch the investment time horizon and look at secular movements in the market. As these moves are secular and long-lasting, it is inherent that there is little to no change year to year in the collective perspective of investors. That said, when there is a shift in sentiment, it is usually tectonic. This past quarter calcified the beginning of such a move and is no surprise considering the market had its worst single year performance since the Global Financial Crisis. While we will analyze the cyclical market views that occur regularly, we would be remised not to mention the growing belief among investors that the next decade may differ significantly from the previous one. Below is a great summation by Macro Ops of the year through a list of economic events:

Source: Macro Ops

Following a small bear market rally in the third quarter, investors were examining the Federal Reserve’s commentary to determine if the Fed Funds Rate would continue to rise. Some market participants believed inflation had peaked and the Fed would be compelled to shift course in the coming year due to the prospect of a recession. Others believed the Fed would continue to raise rates, eventually settling at an elevated level for an extended period, as stated by the central bank. During the fourth quarter and up to this point, negative economic news has been construed as positive for the market and vice versa. This phenomenon occurs because if economic news, such as unemployment and wage growth, is positive, indicating a healthy and growing economy, the Fed may need to further increase rates to curb inflation, which is detrimental to the market.

Using this logic, it can be understood why the market rallied through the first part of Q4. A series of reports was released early in the quarter, suggesting a recession was imminent and thus, a potential reversal in rates. In October alone, the following was released:

  • U.N. report warned the Fed and other central banks raising rates further risked pushing the global economy into a recession and potential prolonged stagnation.
  • IMF (International Monetary Fund) cut global economic growth forecast.
  • Bloomberg Economics predicts recession will occur with a 100% likelihood.

Despite the Federal Reserve’s assertion that a reversal in rates is not currently on the table for 2023, market sentiment continued to be driven by the narrative of an impending recession and a potential shift in monetary policy. This narrative was fueled by the central bank stating they were willing to accept a “sustained period of below trend growth” in order to corral inflation back down to their 2% target. In alignment with that stance, Fed Chair Powell said bluntly, he would prefer to overshoot rates and curb inflation with a recession rather than ease policy too early risking entrenched inflation. Investors’ optimism was flamed further after Powell announced the Fed would likely slow the pace of successive rate hikes. He cautioned this announcement by saying a slower pace had always been apart of the plan and market participants should not place undue emphasis on the statement. Instead, he emphasized investors should focus on the terminal level of interest rates and the duration for which they are expected to remain elevated.

Fed Chair Powell said bluntly, he would prefer to overshoot rates and curb inflation with a recession rather than ease policy too early risking entrenched inflation.

The market dismissed his comments until he provided further color during the Fed’s December meeting press conference. Powell stated they had made less progress on inflation than they expected and a terminal Fed Fund’s Rate was in the range of 5% with no consideration of rate cuts in 2023. The market digested the information and sold off through the end of the year despite the CPI reading in mid-December coming in below expectations. While the Fed and the economy likely played the majority role in the bearish sentiment seen at the end of Q4, investors may have also been spooked by a building rhetoric around a potential secular change in markets.

Whispers among institutional investors regarding a transformation in market dynamics began to circulate during the latter half of the year. These whispers garnered our attention, leading us to address the topic in our Q3 letter, entitled “A New Norm(?)”, in which we examined the possibility of a new investment paradigm. As the fourth quarter progressed, the idea of a shifting landscape became widely accepted. Investment luminaries such as Stan Druckenmiller and Howard Marks have characterized the forthcoming period in investing as a “post asset bubble” and a “Sea Change”, respectively. The fundamental shift in dynamics can be summarized as follows:

  • Following a decade of near-zero interest rates and low inflation, and a longer trend since the early 1980s of steadily declining rates and inflation, investors had grown accustomed to a golden age of investing.
  • Under these conditions, growth stocks significantly outperformed value stocks, as sky-high valuations were justified by the “free” availability of capital and the ability to apply minimal discount rates to valuation multiples.
  • However, the dynamic has changed, and the factors that once propelled markets forward have come full circle, dramatically altering the prospects for the next generation of winners and losers.

In Howard Mark’s, “Sea Change” article, he compares the last decade to what we are seeing today in a summarized table:

Source: Howard Marks, Oaktree Capital Management

Investors who subscribe to this perspective believe that the next secular trend will shift towards traditional value investing, prioritizing companies with robust balance sheets and predictable cash flows. The rationale behind this belief is in an environment where capital is more scarce and the minimum required rate of return (the discount rate) for investments is higher, investors will be less inclined to take on additional risk in pursuit of higher returns from growth assets. Instead, they will aim to achieve reasonable returns with a lower level of risk. As a result, growth companies that require significant financing in order to expand may struggle due to the increased cost of borrowing.

Growth companies that require significant financing in order to expand may struggle due to the increased cost of borrowing.

The reason investors believe that the current trend is a secular one rather than a temporary cycle is due to the expected imbalance between supply and demand for inputs such as oil and green energy commodities (such as copper, lithium, and cobalt). This disparity is anticipated to drive up the prices of these inputs, contributing to sustained, elevated levels of inflation. Additionally, the ongoing trend of deglobalization is another factor to consider. In recent decades, globalization has led to a decrease in labor and input costs. However, with the reversal of this trend, companies may now face higher costs for sourcing their supply chains locally or domestically, leading to increased prices for consumers.

Looking into the new year, we expect investors to remain guarded until there is clarity on the future of interest rates. While it is difficult to make definitive predictions, we can pair the Fed’s current rhetoric in conjunction with signals from the bond market to derive our best guess. It seems likely rates will reach their peak in 2023 and remain at that level into 2024. We have been saying for some time, when the Fed signals an end to rate hikes, the market will likely view it as the green light and look forward to recovery and potential rate cuts. Until then, sentiment will remain choppy and generally bearish. With an understanding the investment landscape may look drastically different than it did a decade ago, we are keeping a close eye on the forces driving markets and staying attuned to opportunities in areas previously deemed dead.

Performance Breakdown

The fourth quarter offered investors some respite from the bear market, albeit with elevated levels of volatility. Market performance during this period echoed that of the third quarter, as it rallied during the first half of the quarter due to unfounded optimism regarding interest rates. However, this optimism dissipated towards the end of November, leading to a sell-off that marked the worst annual performance since the 2008 Global Financial Crisis. Among the major indices, the Dow Jones Industrial Average performed the best in the fourth quarter and for the year, with gains of 16.0% and -6.9%, respectively. The S&P 500 fared worse, with a gain of 7.5% in the fourth quarter and a loss of -18.1% for the year. Given the rapid pace of interest rate hikes, it was unsurprising that the NASDAQ Composite finished well beyond the technical bear market limit (-20%), with a return of -0.8% over the quarter and -32.5% for the year. The energy sector was the clear winner in 2023, posting a return of 64.56%. Every other sector saw negative returns for the year, with consumer discretionary and communication services leading the way with losses of -37.66% and -36.23%, respectively.

Worst annual performance since the 2008 Global Financial Crisis.

For 2023, we anticipate that defensive positioning in value-oriented sectors will perform the best until there is a clear indication from the Fed that interest rate hikes are reaching or have reached their peak. Sectors that are sensitive to economic conditions, such as real estate and consumer discretionary, may struggle in the event of a recession. Conversely, sectors such as healthcare and consumer staples are likely to benefit in such an environment. The energy sector has the potential for another strong year due to constrained capacity and increasing demand for oil and gas, even in the face of a potential recession. To reiterate, we remain flexible during these fluid periods and remain alert for potential opportunities.

Investment Themes

Looking Back

During the quarter, we maintained our defensive posture and significant overweight in the energy sector. As markets remained in bear market territory, we took the opportunity to selectively deploy cash where we saw fit. While this represented our first modest reduction in cash positions, we continue to hold a significant amount of liquidity at the ready. We also began to favor certain healthcare positions in line with our outlook of a potential recession. When considering the entirety of 2022, our emphasis on energy proved to be a beneficial allocation decision that we made at the end of 2021. Our reduction in technology and consumer discretionary positions also contributed positively to portfolio performance over the course of the year. Below are charts that gave us perspective over the quarter:

Average bear markets with and without recession; we believe we are headed for a true recession (we are already in technical recession) with labor market deterioration; bottom line is we are likely heading for more pain.

Source: Macro Ops, Bloomberg

Economic risk categories reached all time highs while market liquidity approached Covid and Global Financial Crisis levels.

Source: Macro Ops, Bank of America
Looking Forward

As we enter a year in which a recession is more likely than not, our outlook is more bearish than bullish. We would not be surprised to see further market sell-off in the early part of 2023 as rates continue to increase against a deteriorating economic environment. However, if the Fed Funds Rate reaches its peak in 2023, we would expect to see a rally and potentially a more permanent market bottom. Once uncertainty subsides, we may deploy cash and take positions in areas that present opportunistic risks.

Looking further ahead, we maintain a bullish outlook on the energy sector due to the expected sustained imbalances between supply and demand over the next decade. We are also optimistic about the semiconductor industry for similar reasons, as the demand for these components continues to grow. Other areas that we are closely monitoring include nuclear energy, as a means of bridging the gap between current green energy capabilities and global sustainability goals, and battery storage to address the same issue. While value names may have a strong run over the next few years, we anticipate that growth and technology will regain favor once rates become more accommodative. 2023 is shaping up to be another year full of crosscurrents, and we look forward to assisting you in navigating them.

We look forward to speaking with you soon.

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