Third Quarter Review and Outlook
“Ain’t it funny how an old broken bottle, looks just like a diamond ring.”
– John Prine, “Far From Me”
The economy today is not the same one as before the pandemic. It feels similar to those of us who have the same job, live in the same home, and eventually settled back into the same basic routine. Pandemic and war nevertheless rocked the building blocks of the global economy. We have detailed these changes over the past two years, while emphasizing the immense difficulty in forecasting what the ultimate result will look like once the temporary effects fade.
Economic fundamentals are always shifting, of course, but the pandemic shook the labor market like a snow globe. Based on prior trends, the US labor force would have grown by about four million since 2019 through a combination of organic growth and immigration. Instead, the number of workers is unchanged. Recent research suggests this gap is largely from retirements, which sparked a movement away from low-skilled service jobs as workers moved up the job ladder. With no net immigration over that period1, labor markets may remain tight for some time.
Meanwhile investment demand appears to be shifting into a higher gear. Vital manufacturing can no longer rely on China. European gas supply can no longer rely on Russia. What were once considered risks are now reality. Policy-makers in the US and Europe have responded with plans to invest significant sums over the next decade into natural resources, military, transportation, power generation, and infrastructure.
Investment is disinflationary…eventually. We have to build the bridge before we can drive across it. For now, the developed world is trying to do more with less. Interest rates may stay higher for longer as a result. It is fashionable to say the Fed will keep hiking until something breaks, but what breaks is unlikely to be the same as last time. Banks have de-risked, household balance sheets are solid. The risk today is in companies or strategies overly engineered to thrive in a low investment, low interest rate, cheap labor world.
Markets have been adjusting to this new environment. From here, we believe investors with a multi-year time horizon have rarely seen forward-looking returns look so attractive. The tradeoff is higher volatility. War and disease are unpredictable. A Fed pivot toward lower rates may not be warranted anytime soon. Time is the biggest obstacle to long-term returns right now—building a good portfolio is only half the battle, holding onto it is the other half.
The S&P 500 grew earnings at an above-average pace through the pandemic on the back of large government deficits—one person’s spending is another person’s income. The flip side is that lower deficits will weigh on corporate earnings. As discussed above, though, developed countries are not shifting to austerity, so a broad collapse in earnings is unlikely.
More likely there will be winners and losers. The US cap-weighted index is dominated by the winners of the last decade, and it is not unreasonable to think those same technology platforms can still thrive. Microsoft and Amazon together command a majority share of cloud infrastructure spending, and every two years the world doubles the amount of data produced. Still, we remind ourselves that, in 2006, the financial sector similarly earned record profits, traded at rich valuations, and dominated the S&P 500 Index. Humility is a perennially undervalued feature of a sound investment strategy.
We believe fixed income now offers a range of opportunities. Treasuries are yielding around 4% across the curve, with higher yields available in short-term high quality corporate bonds. Forward looking returns in the high yield bond market are now in double digits. Only a small fraction of the high yield market matures in the next three years, so we believe default rates should be contained even in a recessionary period.
We also believe a period of higher sustained interest rates will lead to new opportunities within private markets. We prefer strategies that generate attractive unlevered cash flows that are secured by tangible or intangible assets. We believe this profile complements traditional public markets and is resilient to extreme periods of inflation and recession.
We are also seeing an uptick in the number of opportunities to buy good assets at attractive prices from sellers that are in situational distress. Areas like direct lending and real estate use significant amounts of leverage and saw massive capital inflows in recent years. We are confident that in the rush to deploy capital, not every deal was properly structured to succeed in a high interest rate environment. We work with a number of managers who seek out these situations. In our experience, the best deals are never listed on an exchange. Sourcing requires deep relationships, domain expertise, and the ability to move quickly.
Now is the time to think about how to invest for the next several years, not the next few days. We believe true fundamental diversification is vital. A concentrated portfolio offers the allure of high returns but, in our opinion, comes with unacceptably high failure rates. CNBC only interviews the survivors. By finding many differentiated sources of return, we aim for resilience through market turmoil so that we can take advantage of opportunities during periods like today.
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