Quarterly Letter

The New Norm (?)

Company Updates

Our focus over Q3 was intently on client portfolios as the evolving economic landscape continues to impact market volatility. With client accounts being priority number one, we encourage you to schedule a meeting with us to review your portfolio and discuss what we see over the coming period. If you haven’t had the chance, feel free to explore our new website, www.cordhavencapital.com where you can find quarterly letters, thought pieces, and updates to the firm.

Market Perspective

Key Metrics

As expected, inflation and interest rates captivated markets for the entirety of the third quarter. The Fed had risen rates to 1.50% by the end of Q2 and had no intention of slowing down, citing entrenched inflation at extreme levels and an excessively tight labor market. Their rationale was supported early in the third quarter as the headline and core CPI readings in July marked 9.1% and 5.9% year over year. This gave the Fed the statistical ammunition they needed to raise rates another 0.75% in their July meeting, bringing the Fed Funds rate to 2.25%. Commentary from Chairman Jerome Powell coming out of the July meeting was opaque, stating another 75 basis point hike was on the table but remained “data dependent.” Eluding to the Fed’s hawkish stance up to that point, he went on to say inflation was still beyond their expectations and they didn’t feel the economy was in a recession. In other words, the Fed felt they were still behind the inflation curve and there was room for higher rates because the economy could withstand further monetary intervention. They pointed to the strong labor market (3.6% unemployment rate in June) as their rationale for believing the economy was strong.

Our viewpoint after the meeting was the Fed’s view of the economy was myopically focused on labor. Due to this, Powell was underestimating the economic environment and over-estimating the economy’s ability to absorb successive rate increases without a significant impact to overall growth. Our opinion gained credibility a few days after the Fed meeting when Q2 GDP notched its second successive quarter of negative growth of – 0.6%. This marked a technical recession which would be debated by many government officials as the administration attempted to save face on the declining economy. This point would be further debated days later when the July labor report showed unemployment tightening further to 3.5%. Following the July labor report, CPI recorded 8.5% year over year versus the 8.7% estimates. The core CPI figure however, remained unchanged at 5.9% which the Fed has reiterated countless times is the main measure of inflation that drives policy decisions. For a moment, the market rejoiced as the report gave hope the worst was in the past. A month later however, CPI registered 8.3% increase year over year and a 0.1% increase month over month. This was taken as a bad sign, especially given the core CPI number rose year over year to 6.3%.

Powell was underestimating the economic environment and over-estimating the economy’s ability to absorb successive rate increases without a significant impact to overall growth.

Following the CPI reading, the Fed raised interest rates another 0.75% to 3.0% during the September meeting. Commentary from Chair Powell after the meeting reiterated the hawkish points made during his speech at the Fed’s Annual Jackson Hole Symposium. He made clear the Fed’s opinion was the labor market’s strength (3.7% unemployment in August) would continue to push inflation higher if aggressive monetary measures are not taken. The Fed also pointed to consumer confidence and manufacturing as indicators of an economy that could withstand future rate hikes without going into recession. Through the quarter, consumer confidence remained soggy, keeping within a range of ~95 – ~103. For reference, consumer confidence pre-pandemic was around 130 and in the trough of COVID sunk as low as the upper 80s. The Institute for Supply Management Producer Manufacturing Index (ISM PMI) remained in expansion territory (50%+) for the quarter but just slightly from 53.0% to 52.8%.

The future of inflation and successive rate hikes is anyone’s guess. The Fed themselves are half sure at best, on where they will end up on the rate hike path. Investors have called for a range of possibilities from a Fed pivot where they reverse course and cut rates due to a severe recession, to scenarios where the Fed blindly raises rates without regard to the economic impact in the name of taming inflation. Based on Fed commentary, our view is they will raise rates through the end of the year and potentially into the beginning of 2023. At some point, as stated by Powell, they will pause hikes and allow time to observe the impact of previous rate increases. When that pause occurs, how much economic damage will have taken place and how much of inflation will be subdued, are valid questions. We are preparing for an environment where rates will be around 4.0%, lingering inflation near 4-5%, and an economy showing little to negative growth.

We expect the labor market to be further impacted by previous and future rate hikes as we are already seeing layoffs occur in pockets of the market. One major reason we aren’t seeing the unemployment rate spike yet is due to small businesses hiring to a neutral staffing level. The pandemic caused a labor deficit which is now narrowing and thus will only suppress the unemployment rate over the short-term. Where the unemployment rate ultimately settles will be determined by rate increases. This makes it hard to pinpoint where we will be, but we are confident it will be significantly higher than where we are today. Similar negative impacts can be expected for other key metrics: consumer confidence, ISM PMI, and consequently GDP. To reiterate, our expectation is the Fed will continue down the path of rate hikes, likely overshooting and causing more damage to the economy than necessary. That said, if they do pivot or stop hikes earlier than expected, all bets are off. We are in a highly fluid paradigm where market components and participants are in a state of reshuffling. It is possible we are entering a new macro regime where new winners and losers will be minted.

Market Sentiment

Moving into Q4 will mark a year since investors first started raising the alarm on persistent inflation and potential rate increases as a response. Recalling back to the end of 2021, commentary coming out of the Federal Reserve and officials alike, was “inflation is transitory.” The term became mainstream and by October of 21’ you couldn’t read financial literature without seeing it. As mentioned in our Q4 2021 letter, “The Rotation has Arrived”, we highlighted how the transitory view was likely wrong and inflation was stickier than officials were leading on. Towards the end of the year, the Fed retired the word transitory and stated, “We will use our tools to make sure that higher inflation does not become entrenched.” Stated another way, the Fed and other officials realized they had made the wrong call on inflation and would now attempt to rectify their mistake through aggressive rate hikes. We viewed this as an issue early on because the Fed was singing a hawkish tune in the face of a naturally slowing economy and raising rates aggressively only exacerbates the rate of decline.

The Fed was singing a hawkish tune in the face of a naturally slowing economy

Fast forward to the beginning of Q3 2022, as investors shared our concern with one negative quarter of GDP already on the books while the Fed showed no signs of slowing rate hikes. With no end in sight, the market continued to sell off risk assets. Hiring freezes and layoffs in tech began spreading throughout the sector, raising yet another alarm for an economic slowdown. While a 75 basis point hike was expected by the market heading into the July Fed meeting, commentary regarding future hikes was unknown and would be the focus of investors. By the end of the press conference, the high-level takeaways were, the Fed was data dependent, they didn’t feel the economy was in a recession, the hikes already in place had yet to take hold, and they saw evidence showing their targets for labor and inflation starting to move.

The market construed this as a positive sign for the following reason: if the Fed didn’t think we were in a recession, then any evidence to the contrary would cause them to at least pause hikes so as to not push the economy further into a possible depression. Also, if Powell felt the previous rate hikes had not yet materialized in the economy and they were already seeing positive signs towards their targets, then successive hikes may not be necessary. That optimism led to a market rally with some pundits exclaiming the worst was behind us. Growth assets were back in favor as if economic worries never existed with tech and consumer discretionary leading the charge. The bull party continued into August after the CPI reading showed positive downward movement vs estimates. Adding a layer of distraction during this period was an escalation in Sino-American relations when House Speaker Nancy Pelosi visited Taiwan against China’s wishes. At this point investors felt they were over the hill and the path towards expansion was ahead of them. We can only speculate, but the proceeding commentary from Chair Powell at the end of August during the Fed’s Annual Jackson Hole Symposium suggested a vindictive temperament towards market participants, hoping to set them straight on the current situation.

At this point investors felt they were over the hill and the path towards expansion was ahead of them.

The quotes coming out of the speech from Powell speak for themselves as he presented his most hawkish stance to date:

  • “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against premature loosening policy.”
  • He warned there would be “some (economic) pain” ahead as these (rate hike) measures take hold.
  • “…use our tools forcefully.”
  • Related their stance to ex-Fed Chair Paul Volcker who famously raised rates in the 70’s to combat high inflation despite popular opinion.

If our concerns were warranted before, the speech in Jackson Hole validated them to the highest degree. It was made clear the Fed would not be deterred by a slowing economy but in fact, encouraged by negative GDP as they alluded to its necessity in order to tame inflation. If Powell’s intent was to scare the markets back to reality, or the at least the reality it wanted them to see, it was successful. In the blink of an eye, investors shook off their optimism and ran for the hills, sending markets to new lows. In hindsight, the rally was a typical bear market rally as defined by a short move up along the way of a longer move down. The Fed reiterated its position late in September after raising rates another 0.75%. The only variation in commentary was speaking to the duration of pain investors would have to endure. Chair Powell said, “sustained below trend growth will likely be necessary (to tame inflation)” and expected shelter inflation to remain high for some time.

In hindsight, the rally was a typical bear market rally as defined by a short move up along the way of a longer move down

This begs the question, are we entering a new norm? Esteemed hedge fund manager Stanley Druckenmiller painted an alternative future during an interview in June. He believes we are entering a new “post asset bubble” paradigm over the next decade where the markets experience sideways chop due to the “destruction of buying power.” The asset bubble he described was induced by the Fed and policy makers facilitating an environment of 0% rates and large rounds of fiscal stimulus. On top of that, the U.S. Dollar strengthened due to the global outlook. The conflict between Ukraine and Russia protracted beyond original estimates which impacted supply chains and created energy shortages. Because of this, U.S. markets experienced an influx of investment leading to weaker global currencies and in turn wreaking more havoc on those economies. Now, as the Fed reverses course on its previously dovish stance, the bubble is bursting, creating significant potential ramifications. At this point, the market believes navigating a soft landing of the economy is a long shot. If the market is correct, then we are left with a few options moving forward:

  1. The Fed overshoots rate hikes and pushes the economy into a recession but does not tame inflation which leads to stagflation.
  2. The Fed overshoots rate hikes and pushes the economy into a recession with inflation falling too much which leads to deflation.
  3. The Fed overshoots rate hikes and pushes the economy into a recession with inflation falling back into line with the Fed’s target range of 2%.
  4. The Fed reverses rate hikes in fear of economic damage and inflation remains high with the economy experiencing a less severe recession.

As mentioned last quarter, the market will be focused on getting answers to these questions because investors fear uncertainties more than anything. Our view is the Fed will continue to raise rates likely pushing the economy into a full-scale recession with negative GDP AND job loss. Beyond that, there are too many factors at play to place any sure bets on the course of inflation. Supply chain issues, Ukraine-Russia war, weakening foreign currencies, global recession, energy demand, to name a few, all play a part in inflation’s future. It goes without saying but a lot is in flux and unknown at the moment. It is prudent to remember that times such as these provide incredible opportunities to buy quality assets at distressed prices when markets are figuring out their next step. We, along with many other investors, will remain on our toes until the picture becomes clear. Until then, we anticipate more market volatility and downward pressure on risk assets.

Performance Breakdown

The third quarter encompassed the entirety of the bear market rally from beginning to end. To begin the quarter, markets rallied on the hopes of the Fed loosening its grip on interest rate hikes but by the end of September, fresh lows were marked. The momentum into the end of the quarter put the market on course for one of its worst years on record. The Dow Jones Industrial Average led the way down over Q3, shedding -6.2% followed by the S&P 500 and NASDAQ losing -4.9% and -3.9%, respectively. Consumer discretionary and energy sectors were the only two positive sectors for the quarter. Both real estate and communication sectors were down double digits as they were the biggest drags on the market. On the year, communication and tech are performing the worst, down -40.1% and -34.1% respectively.

The momentum into the end of the quarter put the market on course for one of its worst years on record.

With recession and continued rate hike fears holding the attention of investors, defensive sectors will have the best opportunity to outperform the rest of the market on a relative basis. Energy should also finish the year strong as Europe’s energy crisis worsens into the winter. We are still cautious regarding growth sectors such as tech and communication where we expect to see a drag on the market into year end. We remain opportunistic however, and expect growth names to come back in favor at some point.

Investment Themes

Looking Back

Our defensive posture expanded throughout the quarter as we saw recessionary indicators blinking red at the beginning of Q3. Due to these signals, we steered clear of companies with significant exposure to the economy. With the markets in a volatile state due to an aggressive Fed and persistent inflation, cash was an asset through the quarter. In tandem with these conditions, we maintained a lighter exposure to tech and consumer discretionary. Towards the end of the quarter we began to see valuations compress to a point where it made sense to begin slowly redeploying cash from the sideline. Below are charts that gave us perspective over the quarter:

One of the main reasons the labor market is tight is because the number of people looking for work remains low. This causes employers to raise wages in order to compete for applicants which in turn contributes to inflation.

Source: Labor Department via St. Louis Fed

This is a busy chart, but the main takeaway is the average PE ratio of the S&P 500 during secularly rising inflation periods is 13x vs 18.6x during falling inflationary periods. Over the quarter the average PE ratio was about 19x which tells us we have more compression ahead if history is any indication of the future.

Source: Macro-Ops
Looking Forward

Our outlook over next year still leaves us in a defensive position. That said, historically, in mid-term years, the market has a tendency to rally into the end of the year. Because of this, we wouldn’t be surprised to see relief in the selloff but over an extended period into 2023, we would expect further pain to the downside. All our expectations on the broader market are anchored by the path of inflation and the Fed’s successive reaction. We are awaiting the green light from the Fed indicating the end to their rate hike regime.

All our expectations on the broader market are anchored by the path of inflation and the Fed’s successive reaction

We don’t anticipate this will come soon but remain ready either way. If the market continues to selloff, we will likely take advantage of discounted asset prices. On the other hand, if light at the end of the tunnel is perceived through dovish commentary from Fed Chair Powell, we would want to lighten our defensive stance, moving towards market neutral. Beyond macro-level trends, we continue to look for compelling stories coming out of individual companies or niche sectors. History has shown that many quality companies emerge from recessionary periods and we believe this time will be no different. Our long-term view on client portfolios allows us to take advantage during these types of periods which leaves us guarded but optimistic.

We look forward to speaking with you soon.

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