The Big Picture
Fed Chairman Powell’s speech at the annual Jackson Hole symposium is worth keeping on your desk. Powell was quite clear that addressing high inflation is the number one priority. Here are a few lines from the speech:
“Today, my remarks will be shorter, my focus narrower, and my message more direct.”
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.”
“Reducing inflation is likely to require a sustained period of below trend growth.”
“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”
“Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”
“Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.”
We firmly believe that the price of money is one of the most important macro drivers, and clearly it is going higher. Historically the Federal Reserve hikes rates until the real Fed Funds rate is positive (difference between the Fed Funds rate & inflation rate). Inflation is coming down, and we expect that to continue, but we are not believers that it is going to decline to anywhere near the Fed’s 2% objective anytime soon (perhaps it takes years). When the Fed Funds rate crosses above inflation is very unclear, and yet it is arguably an important determinant of when the Fed may pivot less hawkish. We’ve all heard the saying – Don’t fight the Fed. So, don’t.
We have repeatedly commented that the range of potential outcomes to equity and bond prices is wider than it has been in a decade, and thus confidence in the direction of markets (risk assets and rates) should be low. Our view hasn’t changed, and neither has our general bias for more volatility and a base case expectation of sideways choppy markets until the path of rates and inflation becomes more clear.
We have so often spoken about how we break investment strategies into two categories:
∙ Category 1: Short volatility, also known as convergent, or stability seeking investments. Examples are long stocks, long bonds, long real estate, long private equity, long venture capital.
∙ Category 2: Long Volatility, also known as divergent or dislocation seeking investments. Examples are pretty much any trend following strategy, long volatility / long convexity strategies.
We are strong believers that all portfolios need to have exposure to both categories, at all times. We also believe we are still in a great repricing of risk, a repricing of the price of money, and a changing of economic and geopolitical regimes. This has been, and still is the type of environment where Category 1 investments tend to perform poorly, and Category 2 investments tend perform well.
Equity Markets:
Equity markets went from massively oversold in June to massively overbought in August and back to oversold again on our multiple indicators. Treasury yields have moved 10 or more bps in multiple days past few months. These are not signs of healthy markets.
We continue to believe the rapid increase in the price of money, a very strong dollar, and pockets of material weakness already showing up in the economy will eventually show up in weaker company earnings over the next few quarters. In mid‐August, Wal Mart highlighted that they are seeing an influx of higher income shoppers (defined by them as earning more than $100,000/year), and many shoppers are more focused on buying generic goods. Wal Mart also announced that they cancelled billions of dollars of orders and are cutting prices of some goods to pare inventory. We expect more of these type of headlines from corporate America in the quarters ahead. Earnings (realized and expected) and multiple expansion the primary drivers of higher equity prices. It is tough to be very optimistic on earnings here, and history shows that multiples tend to contract in periods of very high or very low inflation. So again, more clarity is needed on the outlook for inflation, inflation expectations, and the Fed’s response to the inflation data before confidence can be high that equity markets are asymmetric to the upside.
We also believe that until there is a softening in the very hawkish stance from the Federal Reserve, the ultimate equity market cycle bottom is not in. Additionally, our previously stated view that the Fed has essentially “sold call options on the equity market’ remains intact. The wealth effect can be a powerful tool, and the higher the equity markets bounce, the more aggressive the Fed can be.
Our portfolio holdings in equities are always separated into two groups: tactical equity strategies (Category 2 above, for those wondering) and passive long positions (Category 1 above). The tactical strategies are all systematic in nature, and actively modulate exposure based on the overall trend along with very tightly defined criteria around owning individual stocks, while the passive long positions are long term holds. The combination is quite elegant as in constructive markets both groups are heavily invested, while in adverse markets, often characterized by downtrends, the tactical group tends to be lightly (or not at all) invested, which helps truncate portfolio drawdowns, and introduces some positive asymmetry to the equity portfolio.
Our tactical equity strategies are generally still very lightly invested (important signal to note on its own). Our passive always long positions remain at the low end of their target range as we just don’t see the current market environment as one that is constructive for equity markets overall.
Yield Generating Strategies:
We continue to have extremely low exposure to traditional bond investments (Governments, corporates, etc.) however we do think front end yields (T‐bills) are again attractive. Our portfolio is relatively fully allocated to our yield generating strategies of choice including litigation finance, private credit, and commercial real estate with an emphasis on existing self‐storage facilities ready for improvements, conversions of legacy warehouses to self‐storage, and light industrial. The storage conversions are quite unique as they tend to be in northern
states that have existing warehouses with some curb appeal (i.e classic brick buildings) and are located in towns that generally don’t want modern looking self‐storage facilities developed. We are also actively exploring investments in short term rental properties (STRs), as they have many of the same tax advantages as other types of commercial real estate.
Trend Following & Inflation Benefitting Strategies:
Our classical CTA trend following strategies continue to have a solid positive performance in 2022. As previously mentioned, these strategies generally captured much of the commodity price increases early in 2022, and then systematically realized gains as the positive price momentum ended. These strategies with their “divergent” or “dislocation seeking” bias are critical components of any portfolio in our opinion, and we continue to add to existing positions on pullbacks. We would not be surprised if commodity prices re‐ accelerated higher or continued to crash lower, and these types of strategies that capture price trends are the best way to profit from these macro moves in our opinion. Allocations to these strategies are at the top end of our target range, and we expect exposure to stay there for a while.
Long Volatility / Long Convexity Strategies:
This category of investments is by far the most difficult to gain exposure to and adjust sizing as the best managers we have found are all private funds. Despite the significant equity market selloff in 2022, these strategies have not generated munch in terms of profitability, and numerous articles and Twitter posts have pointed out the reason is most likely because there has not been “a tail event” yet. We remain committed to these exposures despite their lack of contribution to portfolios as we previously stated – the range of potential market outcomes is quite wide. We generally agree with the view going around that holders of tail protection (i.e long S&P 500 put options) are growing tired of the negative theta. A plausible scenario is these tail hedges are allowed to expire, are not replaced, and market participants are not at all hedged right when the delayed impacts of Fed rate hikes and quantitative tightening ramp up and the market is most at risk of a move to the downside. How many times have we heard that monetary policy operates with a lag of anywhere from 3 to 18 months.
What Are We Watching:
∙ Credit card and many types of loan delinquencies are on the rise
∙ We are hearing from multiple commercial real estate developers that banks are firmly pulling back from lending. The Senior Loan Officer Surveys indicate a similar trend.
∙ Residential mortgage rates are roughly 6% and are at levels not seen since 2008. Housing is an important input to both GDP and inflation readings (investment, rents, OER, etc.) and also is one of the largest components of the US consumer’s balance sheet. A firm decline in housing may be just what the Fed would like to see with respect to a wealth effect driving a cooling off of aggregate demand.
Lastly, below are a collection of graphs and tables that we found interesting this past month.
Notable Charts & Tables
Inflation Expectations & Market Impacts
“The longer CPI inflation stays close to current levels, the greater the risk that PEs head back toward 15x. This chart is a reminder that both deflation and high inflation damage market multiples”
Source: Twitter @IanRHarnett
Equity Markets
The top 10 largest stocks in the S&P 500 have cheapened on a Price/Earnings basis, but they are still quite expensive relative to the other 490 stocks in the index.
Source: @MikeZaccardi
Goldman Sachs on bear market rallies:
"Between September and December 2008, the S&P 500 experienced six distinct 1‐6 trading day bounces of 9% or more, with some rallies as large as 19%. However, the actual market bottom did not occur until March 2009."
If you ask Wall Street Bank stock analysts, they will tell you earnings are going to go up, but if you ask Main Street Bank *loan officers* ‐‐ they will tell you a very different prognosis... @Callum_Thomas
Inflation
Inflation Weighing On Earnings Despite Nominal Wage Increases:
Housing
Housing Activity is Firmly Slowing:
Credit Card Asset Quality Summary
Disclaimers
This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities nor does it constitute tax advice. This information is for informational purposes only and is confidential and may not be reproduced or transferred without the written consent of Sundial. Past performance is not indicative of future results. Statements and opinions in this publication are based on sources of information believed to be accurate and reliable, but we make no representations or guarantees as to the accuracy or completeness thereof. These materials are subject to a more complete description and do not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees, and investment strategies of an investment.
This correspondence may include forward‐looking statements. Forward‐looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties, and contingencies. Forward‐looking statements are not a promise or guarantee of future events.
Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices are not available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments) than the Firm. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. We make no representations that any benchmark or index is an appropriate measure for comparison. The S&P 500® Index is a stock market index from S&P Dow Jones Indices. It is a market capitalization weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
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