Investor Letter
Elevate Capital Management
Investor Letter
May 5, 2022
MACRO
The much-anticipated FED transition from expansionary to contractionary monetary policy has finally begun. The FOMC finished their quantitative easing campaign and raised the FED Funds rate 25bps in March and another 50bps on May 4th. Despite very clear communication of their plans for many months, the market still seemed to be caught somewhat offsides and we have experienced very high levels of volatility across both fixed income and equities. The Russian war in Ukraine added another layer of complexity and uncertainty to an already fluid situation.
Inflation is the hot topic of the moment at the now recently resumed cocktail parties in San Francisco. 2021 ended the year at 7% headline CPI and GDP growth about the same. The Omicron variant, which already seems like a lifetime ago, nudged the inflation number up slightly and GDP growth down slightly in January and February. The March CPI number hit a modern record of 8.5% (prior 12 months). The extra bump from Jan/Feb is mostly due to the Russian war in Ukraine. The continued COVID lockdowns in China are not helping either. The April number will be released Wednesday May 11th.
We recently wrote a piece on inflation on our blog, which can be viewed here:
The supply shock to energy markets, while very uncomfortable, is much smaller than that of the 1970s. I recently took a spring break skiing road trip. The fuel tab was surprising, yet much less painful than being in a car with 3 teenagers for several hours.
Before Russia invaded Ukraine, the bond market had been pricing 4-5 FED rate hikes of 25 basis points thru 2022. Now, the bond market is pricing in 7-8 hikes for 2022. This is a significant change. However, the forward curve tends to be a poor predictor of future rates. Unfortunately, it is the only empirical data that exists from the future. Other than our crystal ball, of course.
While the current inflation is uncomfortable for many US consumers; and has made our job more challenging; we do think a large portion of it will pass and relatively soon. Our base case is we see a marked decrease around late summer into the end of the year. Wage increases for the average worker have not kept up with the most recent inflation numbers. During COVID, prices seemed to be very inelastic. Now, we expect price elasticity and substitution effects to come back. Pricing power will be very important for individual companies. Both on the revenue side, and on the input cost side.
Importantly, mortgage rates have risen significantly and very quickly. A 30yr fixed rate mortgage rate was around 3% late last year and is now around 5%. This is a massive increase in just a matter of months.
Let those number sink in for a minute. First, that one could finance a mortgage at 3% or even below that for 30 years. Second, the financing cost of a mortgage has almost doubled in a matter of just a few months. A move of this magnitude is stunning. To put things in perspective, during the last FED rate hike cycle (December 2015 to December 2018), it took 3 years for a similar move to occur.
Housing is a large part of CPI as well as the follow-on elements (think home related items such as furniture, appliances, home repairs/renovation, yard items). Just this dynamic alone will have a strong ‘braking’ effect on the macro economy.
Sometimes, the market does the FED’s job for them. And while the FED arguably was behind the curve in terms of the timing of their transition from expansionary to contractionary policy, the market is making that transition happen faster than just the FED Funds rate could do by itself. Mortgage rates are one example.
The oil futures market is also sending signals that energy prices will come down in the near future. As we write, the June 2022 futures contract is trading around $106 while the June 2023 contract is at $88. This is a very steep backwardation of the futures curve.
Back on the institutional trading floor at Merrill Lynch, we had a saying:
‘There is no such thing as a bad bond, just a bad price’
This saying holds true for all asset classes, in our opinion. Sometimes a good price might be cents on the dollar. Or a good price could be at a premium. For most of 2010-2020, it felt like most bonds traded at a premium. Pretty much all assets are affected by interest rates at least to some degree. Some more so than others. Most valuation models contain elements of a dividend or cash flow discount model using some type of rate.
Volatile markets, while uncomfortable, tend to produce the best investment opportunities.
Our expectation is that equity markets will tend to trade ‘sideways’ for several months until we see the CPI numbers begin to move down. This means there will be volatility, but we won’t trend significantly in either direction. To top things off, midterm elections in the US tend to add incremental volatility as well. Further out, we likely will not get all the way down to the FEDs target inflation rate of 2% for some time. But we could get down to 4-5% much more quickly. Unemployment is now at 3.6%, well below the FED’s target of 5%
FIXED INCOME
Credit spreads have been very tamed given everything else that is going on. For example, IG (investment grade corporate) spreads traded around 100bps for most of 2021. Going into February they widened out by only 20-30 bps and then traded as high as around 150 bps in the first few weeks of the Russia war. This is very mild increase. During the last cycle, they traded at over 200bps shortly after the first rate hike.
High yield spreads are around 400s now after being in the low 300s for most of 2021 and hit a high of around 420 bps in the first few weeks of the Russian war. Also very tame and this tells us there is plenty of risk appetite in the market.
Importantly, default rates are low and below historical levels. Even despite a small forecasted increase in 2022 from 2021 levels by Fitch.
Early in my career, I remember Alan Greenspan comparing FED monetary policy to driving an aircraft carrier. With CPI at 8%+, the aircraft carrier is at full speed. We can’t stop on a dime and go in reverse quickly. I.e. the economic equivalent of falling into a recession.
We think the probability of a recession is relatively low in the short term. My bigger concern is the possibility of the US economy falling into a stagflationary environment. This is where inflation is higher than nominal GDP growth. For example, CPI could come down to 3%. But what if GDP growth is only 1%? What does the FED do then, if anything? Do they let inflation run above target?
In terms of client portfolios, I have been positioned for an increasing rate environment for some time. All of my portfolios have low duration, i.e. interest rate risk, well below the benchmark. They do have credit risk and some mild liquidity risk within the underlying instruments. IG corporate credit is slightly underweight while HY corporate is overweight. Mortgages are overweight, specifically legacy non-agency bonds which have floating rate coupons. As rates have moved up, the investment vehicles have been able to buy new bonds at much higher yields than the frustratingly low interest rate environment of the last 18 months or so. I expect this dynamic to continue. Despite some price movement, the average portfolio yield for most clients will move up reasonably quickly providing higher income as bonds mature or floating rate coupons reset higher.
EQUITY
Equities have experienced higher levels of volatility. Not just in the last few months, but since the early days of COVID. With CPI at 8.5% and the 10yr US Treasury at just over 3%, something has to give. These numbers have an inherent gravitational pull to each other. They cannot stay this far apart for long. In fact, in a healthy economy, the 10yr should be higher than CPI. More on that later in subsequent writings.
The equity market is trying to figure out where these numbers will meet again. Will the 10yr move up to 8.5%? Or CPI down to 3? Probably neither, but rather somewhere in the middle. Will it be 4%? 5%? 6%? Only time will tell.
Why are we talking about the CPI and the 10yr in the equity section of this letter?
These numbers are critical to determining the inputs into equity valuation models. Investors are discounting equity valuations using much higher rates than they were 12-18 months ago. And some are probably adding a cushion on top just in case CPI moves even higher.
However, most equity valuation models are not built to accommodate a rapidly fluctuating inflation rate as we have experienced recently. In fact, most equity valuation models don’t even contain a variable for inflation at all. But rather, inflation is an assumption built into the discount rate, expected return, or required rate of return.
Pre-COVID, many analysts would assume an inflation rate of 2-3% in perpetuity and call it a day. Thus, their rate would work out to something like 7-10%. Now, with inflation at 8.5%, their discount rate might be in the 10-15% range, depending on who you ask.
The market is discounting certain parts of the equity market at a much higher rate, which in turn makes valuations attractive. Inflation and inflationary fears have a negative impact on the Net Present Value of an investment (and company earnings) since true profitability of an investment is determined by the amount earned over inflation.
Under the Discounted Cash Flow (DCF) model, higher discount rates mean lower present value and vice versa. If rates are about to go higher, then expectations for future profits must also be higher (same goes for real and nominal rates) and the opposite also holds true, as low rates are associated with low growth environment (think Japan). Street DCF models are accounting for higher inflation, when analyzing future cash flows, as they should but the market is accounting for a high and a lingering inflation rate within their models, which I believe has peaked or is at near peak. Also, most street models use Weighted Average Cost of Capital (WACC) in their DCF analysis, which will vary greatly across industries and sectors, depending on the capital structure of a firm. WACC is too simplistic, incorporates tax shielded figures and while it is commonly thought in academia, it omits critical qualitative analysis. One such analysis is opportunity cost.
The tech sector achieved two years-worth of growth in two quarters during the pandemic and current market conditions indicate that growth has come to a screeching halt. We see divergence between high discounted rates used by investors and disagree with this thesis. Assets can fluctuate greatly in price and not be risky so long they are reasonably certain to deliver increased purchasing power over their holding period. Current valuation methodologies used by the street are leading to serious depreciation of the tech sector. The valuation models aren’t built to accommodate different levels of inflation over time and by the time they adjust, investors can miss out on a serious, rapid appreciation of tech growth names.
My sentiment remains strong regarding our portfolio companies because they continue to track crucial metrics. Cloud, cybersecurity, fintech and broader technological disruption is far from being a saturated market. In fact, we are embarking on a new technological evolutionary era of web3, which will change the entire landscape of how we conduct business, how we protect our data, how state-of-the-art defense systems are made, how we pay for goods and services and how genomic revolution will change healthcare. High inflationary periods might slow down growth, but they cannot stop it and as long as our portfolio companies continue their march forward, we will have plenty of sleep at night.
Sincerely,
Jeremy and Garo
Disclaimer:
Investments are subject to investment risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principle invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time. Investments in foreign countries – Such investments may be in countries that proved to be politically or economically unstable. Furthermore, in the case of investments in securities or other assets, any fluctuations in currency exchange rates will affect the value of the investments and any restrictions imposed to prevent capital flight may make it difficult or impossible to exchange or repatriate foreign currency. Past performance is no guarantee of future results. All the information provided here and has been obtained from sources which we believe to be reliable, we do not guarantee its accuracy and such information may be incomplete or condensed. This communication is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security we manage or offer. The performance is not indicative of results that we may cheat in the future. This material is not intended to represent the rendering of accounting, tax, legal or regulatory advice. Please consult with your CPA for tax advice.