Q2 2023 Commentary from Andorra
“If you’re going to invest in stocks for the long term, or real estate, of course, there are going to be periods when there's a lot of agony and other periods when there's a boom. I think you just have to learn to live through them.”
-- Charlie Munger, long-time investment partner of Warren Buffet
In summary, central banks have participated in a coordinated interest rate increase post-pandemic. This rise in rates has been the sharpest and fastest in 40 years and the impacts are still yet to be fully felt. As mentioned in last quarter’s newsletter, stress in the banking and crypto sectors was fairly widespread in the first quarter. Things have calmed down somewhat in the banking sector, but many market participants are waiting for further dislocation in the real estate and corporate debt markets due to substantially higher interest rates. The chart below clearly illustrates that we are in a very different interest rate environment post-pandemic.
It is likely that we are nearing the peak in interest rates and discussion is now focused on how long rates will stay at these elevated levels. Many are predicting that inflation will be “sticky” and rates will stay higher for longer to ensure inflation meaningfully declines. Regardless, the cost of money (expressed by interest rates) is wildly more expensive versus the last couple of years.
It bears repeating that rates have moved up quickly and the stated objective from the Fed is to bring down inflation which may limit economic growth. The rapid rise in interest rates from the Fed has caused turmoil in many areas of financial markets. This, coupled with the rapid increase of short-term rates has caused the yield curve to invert. Typically, we’d like to stay away from such a technical discussion of financial markets, but an inverted yield curve has predicted future recessions with about 90 percent certainty since 1955. An inverted curve simply means that short-term rates (1-3 years out) are higher than long-rates (10-30 years out). Basically, the bond market is telling us that the economy is going to slow down.
The question facing us as investors is, how much of this is “priced in” to the economy and financial markets? Many sectors of the bond market have already had a substantial correction (as previously mentioned values have come way down). Where this will likely impact the economy is financially sensitive areas like real estate, the mortgage industry, consumer finance, and construction. We have already witnessed massive layoffs in the mortgage business. But importantly, the labor market remains tight due to a myriad of factors which might imply we will only experience a mild recession. This is another area of much debate with some saying “it’s different this time” and that a looming recession is not guaranteed. Clearly the jury is still out, but we would direct you to the following chart showing the relationship of recessions and inverted yield curves.
While it should be stressed that an inverted curve likely signals a coming recession, it doesn’t necessarily mean poor performance in financial markets. Last year’s negative return in the bond market has led many to predict that higher bond yields are a great entry point for investors to lock-in higher yields. Some sectors of the bond market are more attractive than others, with the municipal market and government bond market likely to be a safe bet, while commercial property and floating rate debt may have further downside. High rates may continue to negatively impact areas of real estate, particularly commercial property in the office market due to extreme vacancy rates.
As the economy slows, many are predicting a mild or shallow recession due to overall low-levels of financial leverage and persistently tight labor markets. Unemployment continues to be at multi-year lows, while only recently showing signs of weakness due to layoffs announced by large corporations. Due to a general aging of our workforce, early retirements across all sectors of the economy and a lack of productivity growth, unemployment should continue to stay at relatively low levels. This, in turn, will put the Fed in a difficult position, as low unemployment has a direct impact on price levels. So, we will see how much more pain the Fed is willing to inflict on the labor force. Many are saying that we (the economy) have yet to adjust to a higher cost of capital and executing a “soft landing” with radically higher interest rates will be a difficult task.
As we have seen adjustments in asset values from higher interest rates; mega-cap technology stocks have led much of the gains in the last six months. Some have attributed 80-90% of this year’s stock market gains to eight mega-cap stocks, while the broader market is down or flat. The large majority of portfolio managers view this as unsustainable. This could mean either of two things; some tech stocks are overvalued and/or at the same time there are many parts of the market that are undervalued. Specifically, valuations across many stocks are very reasonable with many companies still substantially off their 52-week highs and have fairly strong future earnings guidance.
Risks to the economy and markets seem to be many of the same that have been in plain sight for many years. Debt-to-GDP levels have been rising for decades in the United States. Recently we just avoided a debt ceiling showdown and basically kicked the can down the road until 2025, when real cuts in federal spending may have to be made (or taxes must be raised). But this has happened before, last-minute deals will be struck and financial markets have overall marched higher. The chart below illustrates the substantial growth in national debt that we have witnessed over the past decades.
Where will substantially higher interest rates, low unemployment, and inflation that is “still too high” lead us in the coming months and years? We may have seen the Fed’s last interest rate increase, which could end up supporting both stocks and bonds at these levels. With mortgage rates now over 7% it is likely that some parts of the economy will experience some pain. But, since COVID many households have paid down debt, have either built substantial equity in their home or may not even have a mortgage, and unemployment is at 50-year lows. Due to these factors, we have rebalanced into a portfolio of stocks and bonds, as bond yields may have peaked and stocks still offer some good relative value. The real risk from here is that inflation remains hot, and the Fed continues to raise rates.