3Q2023 Investor Letter

Dear Investors & Friends,

At the halfway point of 2023, we are encountering strong but conflicting market signals.?On the one side we have the prevailing narrative force, and in the short-term, narrative often dominates. On the other, the fundamental market forces, and while the market can ignore fundamentals for quite some time, eventually those chickens tend to come home to roost.

The current market narrative is a positive one.?Inflation continues to fall (Figure 1) and while the Federal Reserve has been adamant that they are going to maintain an aggressive policy stance until they are sure the job is done, the light at the end of the tunnel is in sight for this hiking cycle and thus far, outside of the localized regional banking crisis this spring, the oft-forecasted stress on the broader economy has yet to materialize. The introduction of generative AI to the zeitgeist has added buoyancy to previously sinking technology stock prices and low inventory has kept housing prices elevated, the single largest contributor to household net worth.

Consumer expenditure remains healthy, corporate profits are declining but not yet significantly so, the unemployment rate continues to hover near record lows, and Covid is now firmly in the rearview.?The geopolitical situation is tense, but the world has largely acclimated itself to the notion of a prolonged conflict in Eastern Europe.?Congress has once again kicked the debt-ceiling-can down the road and we are firmly in the politically stable interlude between the mid-terms and the presidential election with a divided government.?In other words, there are unlikely to be any major changes coming out of Washington until at least 2025.?With the S&P 500 up more than 13% year to date and the Nasdaq up a dizzying 36%+ (as of 6/24) the positive market narrative can seem hard to challenge (Figure 2).

Figure 1: US Consumer Price Index continues to fall from peak of over 9% in 2022.

Figure 2: S&P 500 & Nasdaq 100 YTD Performance

However, beneath the seemingly cheerful narrative, ominous counterforces are simmering, threatening to disrupt the current market optimism as we move into the second half of the year. Several fundamental indicators are now signaling potential trouble. Let’s consider some of them.

Figure 3: Top: Annual bankruptcy filings through April each year in blue and rest of the year in yellow. Bottom: filings by month since January 2020.

Corporate casualties of the higher interest rate environment continue to mount at a pace not seen since the Great Financial Crisis. Although this statistic may be partly distorted as companies that would have perhaps gone under during the pandemic stayed afloat due to government stimulus.?The lower aggregate numbers in 2021 and 2022 is evidence of that phenomenon. However, the reality is that corporate life support has been turned off and bankruptcies are on the rise. This will be a critical indicator to watch in the coming months to determine if we are seeing a backlog or if this trend is indicative of a more sustained rise.

Figure 4: Top: Blue shaded area represents path of Covid era build-up of excess savings. Blue line indicates personal savings rate.

The excess household savings accumulated during the Covid pandemic are nearly depleted, and the personal savings rate has dipped below pre-pandemic trends. This trend, coupled with rising outstanding household credit, indicates that consumers are funding their pandemic-era lifestyles with savings and credit, an unsustainable trend.?As these sources of funding likely dry up in the second half of the year, we can expect corporate profits to be impacted as households tighten their belts.

Adding to the pressure of dwindling savings is the resumption of student loan payments, a burden that most borrowers haven't had to contend with for over three years. A recent survey of 2,000 borrowers conducted by Morgan Stanley found that 37% would need to adjust their spending in other areas to keep up, and a staggering 34% said they would be unable to make their payments at all. While only 1 in 5 American adults carry student loans, this additional financial obligation presents further stress on a consumer base already rattled by inflation.

Figure 5: Spread of 2-year minus 10-year Treasury yield plotted in purple. Shaded areas indicate recessions.

The U.S. yield curve is continuing to invert further, a situation where short-term rates are higher than long-term rates. This phenomenon has been a reliable predictor of a recession. The spread between the 10-year and 2-year Treasury yield hasn't been this wide since the 1980s, and history has shown that each time the curve inverted like this, a recession followed.

Figure 6: Blue line represents household allocation to Equities as a percentage of total household investments ex-real estate plotted against yellow line of subsequent 10-year forward S&P 500 returns. The implication is that as the household equity allocation reaches a peak, forward returns are lower.

This chart is a busy one, but the correlation is strong enough that I think it merits attention. Going back to 1951 there is a strong inverse relationship between the current “Equity as a Percentage of Total Household Equities, Bonds, and Cash”, vs the forward 10-year return of the S&P 500.?Recently, this relationship has started to diverge, which, if it were to converge back to its historical trend, would suggest lower forward returns. In fact, if we take this relationship at face value based on its historical pattern, it ominously suggests that the S&P 500 could deliver zero returns over the next decade.

Figure 7: Manufacturing PMI Index plotted in purple. Shaded areas indicate recessions.

Another reliable recession indicator is the US Manufacturing PMI (Purchasing Managers Index), a survey of domestic manufacturers that provides insight into economic activity. Readings below 50 indicate contraction, while those above 50 signal expansion.?The latest readings are trending downwards at an increasing rate, now firmly in contractionary territory. Like the yield curve inversion, this indicator has a reliable track record of signaling an impending recession.

The pattern emerging from these signals is a concerning one. While any one indicator can always flash a false signal, it is hard to ignore these concurrent facts all pointing in the same direction.

Yet, despite these warning signs, one crucial piece of fundamental data continues to support the positive narrative. There are still nearly 10 million open jobs! If the economy were to contract, we could shed more than a million jobs a year for the next two years and still be above the pre-pandemic all-time job openings peak.?While it's true that available jobs tend to evaporate rapidly in a recession, the considerable slack in the labor market should help cushion the impact of an economic slowdown.

Figure 8: Available US jobs openings 1973-2023. Shaded areas indicate recessions.

Additionally, employers across various sectors have reported difficulties in filling open positions with qualified candidates and will likely be reluctant to lay off employees they’ve just spent months, if not years, locating and training.?This robust labor market stands as the most substantial safeguard against a prolonged or damaging economic downturn. We believe this factor carries significant weight. However, we also anticipate that the delayed impact of the fastest rate-hiking cycle in history will ultimately have a negative effect on the economy.

Zachary S. Mineur, CFA

Chief Investment Officer

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The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

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