Second Quarter 2023 Client Newsletter

The first half of 2023 has been a breath of fresh air compared to the first six months of last year. We’re optimistic that the trend will continue in the second half, though we’re not taking anything for granted. Earning decent income on short-term bonds and cash-like securities has been nice, yet it’s unclear how long that will be a feature of the investing environment.

We trust you’re enjoying the start of your summer, wherever you’re taking it. Here in Kansas City, this is about the time we start thinking about Chiefs training camp. It seems like the 2022 season just ended, yet here we are, on the verge of yet another Super Bowl run.

In this quarter’s newsletter, we put on the professor’s tweed and get back to basics on the mechanics of investing in stocks and bonds. We also look at some topics swirling around financial news outlets and try to provide some context and maybe some peace of mind.

We hope you enjoy our note. As always, if you have any questions about the content or would like to schedule a portfolio review, please do not hesitate to reach out.

Best,
Kyle

The Case for Stocks

Owning a stock can work out well for you in one of three ways:

• The underlying company will earn more and become more intrinsically valuable.
• You can find somebody else willing to buy your shares at a higher valuation.
• You can collect on a return of capital in the form of share buybacks and dividends.

Ideally, all three drivers would benefit our equity holdings positively. Let's review where things currently stand on each catalyst:

From 2019 through the end of 2021, S&P500 index earnings grew at a blistering 13.1% annualized rate. Fiscal stimulus, rising wages, and corporate pricing power were potent. Throughout 2022, earnings growth consistently regressed: from a +11% y/y rate in the first quarter to an outright -1.6% y/y decline in the fourth quarter. Cue, the 'recession is coming' chant from pessimistically inclined strategists.

Some estimates went so far as to predict a more than -20% decline in FY23 earnings. That outcome would be on par with the Dot Com earnings decline of the early 2000s.

And who could blame them? Economic prognosticators were sure a recession was right around the corner. To state the obvious, recessions (vertical shading below) are bad news for corporate earnings.

Of course, if you’re keeping up with financial news, you’re aware that the elusive recession of 2023 remains stubbornly unaccounted for. Contrarily, ‘23 earnings estimates have stabilized at or slightly above ‘22 levels (blue labeled lines). Barring a collapse in the next six months, analysts’ attention will increasingly shift to 2024. Market participants typically have a hard time living in the present; in this case, that’s a positive, especially since economic data confirm the turn higher.

Bloomberg economic surprise data has vaulted higher (yet again) as incoming data proved far more resilient than economist forecasts.

Despite the somewhat average year of S&P500 earnings growth in 2022, markets fell sharply. And as proof that markets have an innate sense of humor, the first six months of 2023 have been the exact opposite – earnings are set to be flat to down, and markets have leaped higher. Though, all the wounds from 2022 have yet to heal.

The equally weighted S&P500, the market cap weighted S&P500 and rip-roaring NASDAQ100 are all still about 8% below their all-time highs. Be my guest if you’d like to call this a Bull Market. Many folks use the up/down >20% as the measuring stick for bull/bear markets. Call it whatever you like; we see a range-bound, tortured market.

Over the past 18 months, equity valuations for the median S&P500 never got outright ‘cheap.’ Instead, they’ve gyrated between average and expensive. As of 2Q23, the median price/earnings ratio is back at the high end of its historical range. Interestingly, the 100 cheapest stocks in the index are on par with the lowest readings on record. That’s a good indication that the market isn’t trading as a monolith and that, despite index-level torture, there are values to be had.

Companies returned a near-record $1.5 trillion to shareholders in the form of dividends and buybacks over the past 12 months. If you relate that value to the market capitalization of the S&P500, you'll find a total shareholder yield of roughly 4%. It’s a good deal, though, in this interest rate environment, you can secure >5% in Treasury bills or FDIC-insured CDs. If you prioritize income, stocks are a hazardous destination relative to fixed income and money markets. 

The Case for Bonds

Bonds are supposed to be the boring sibling of stocks. Stocks need all sorts of things to go right for you to get a return (see above). On the other hand, bonds require the absence of a negative. So long as the entity you lent your money to remains solvent, you get paid the contractual rate.

At least, that’s the mechanics for an individual bond – you buy it at the prevailing market price, with a fixed periodic interest payment (coupon), and it matures at $100/bond. The price at which you could sell that bond throughout the holding period may fluctuate. But if you hold it until the bond matures, the math is straightforward and rewarding.

We’ve been using individual bonds in client accounts over the past year, and it’s been a great addition to our arsenal. For over a decade, we had to rely on bond funds, which are acceptable in many situations, but they have one potentially harmful caveat.

Since bond funds don’t have a fixed maturity date, there’s no endpoint to your holding period. The fund price constantly adjusts to the prevailing interest rate environment.

So, if you bought a fund when it yielded a 2% interest rate, nobody would want to buy your bond if they could now secure a 5% rate. Your bond is now unattractive relative to prevailing rates. You’ll have to take the loss of the difference (3%) to sell it. In this case, we’re analyzing a one-year bond.

If it were a two-year bond, you’d have to make up that 3% difference twice, once for each year – a 6% capital loss. Not fun! The farther and farther you go out in maturity, the more dramatic this magnification gets. Once you get out to a 10-year bond fund, a 3% change in the interest rate environment would cause a near -30% capital loss!

Bond funds wreaked havoc on risk-averse investors worldwide in 2022 as interest rates shot higher. The longer out the fund went (duration), the more significant the losses were. Bonds are boring, but they’re anything but safe.

So, what to do now? Luckily, higher rates now mean that we can earn some considerable income. And if you are one of the folks that got bit by bonds last year, that higher rate is helping to salve the capital loss of 2022. But is the risk of another reset higher now past? Let’s take a tour of the fixed-income sector:

We always want to start with the most generic and safe bond class – U.S. Treasury bonds. They set the tone for the entire asset class and typically comprise a substantial portion of available funds. The yield curve below shows what the U.S. Government can borrow for at any given term. I’ve circled the one-year rate (5.41%), a 10-year (4.05), and a 30-year (4.04) as well.

You'll note that the U.S. government is paying a higher rate for very short-term debt than for longer-term debt. That's counterintuitive and owes itself to the Federal Reserve's fight against inflation. The logic is that by taking short rates dramatically higher, they'll be able to stifle economic growth and, by extension, inflation. Expectations for slower growth and lower inflation in the years ahead weigh on long-term rates, thus the lower yields farther out.

But, what if inflation recedes and growth expectations surprise to the upside? That would sound a lot like the late 1990s. Let’s compare today’s yield curve with that of 1997.

The faint yellow line represents where rates were in 1997; the solid green line represents today. The short end of the curve is already nearly identical. Yet the long-end would have to move another 3% higher to match 1997 levels. That would be extraordinarily painful for holders of long-term bond funds. Remember our rough bond math from before – multiply that 3% times the years to maturity. Yikes!

To hold a positive view of the appreciation potential of long-term government bonds, you have to believe that either pandemic monetary policies will return or that geopolitical risks are imminent.

Corporate bonds trade with what's called a 'spread' to Treasurys. The spread represents compensation for a company's default risk (credit risk). Investment grade bonds typically have a small/tight spread. And speculative credits trade with larger/wider spreads to compensate for the elevated risk.

Due to the economy's strength, investment and speculative grades yield roughly the same amount on 3-month bonds. But that spread widens dramatically past one year to maturity. Investment-grade corporates and Treasurys begin to get widest about four years out.

In both cases, that's partly due to companies' initiatives to lock in longer-term debt during the pandemic. Maturities in 2023 are nearly a third of that in the coming years. A lack of debt coming due means a lack of financial stress. Although that will change the farther down the road you look.

As we build additional fixed income into portfolios, we’re balancing credit risk with duration risk. It has been great to earn 4% and 5% returns on cash, but those short-term rates could disappear overnight should the Fed’s war against inflation suddenly conclude. Yet, we’re also aware that yields in the middle to the long end of the curve have only barely reached historically average levels. Dramatically higher rates are still possible should inflation remain sticky and growth resilient.

A Commercial Real Estate Storm?

Scary things begat scary premonitions. The banking crisis in March of this year rightly drew universal attention and concern. At its core, mismanagement of a rapidly rising interest rate environment was to blame. So, with one interest rate-catalyzed problem, we’d expect another right around the corner, right?

We were struck when we saw our hardcopy of Bloomberg Businessweek last week (very retro, I know). Finance publications frequently act simultaneously as reminders of what’s on the mind of Wall Street and as contrary indicators. For that reason, I keep some personal favorites framed on my office wall. But when a cover displays this degree of certainty and imminent dread, it’s time to discuss it in a newsletter.

So, is a cabin fever-stricken Jack Torrence headed down the hallway with an axe, ready to cleave commercial real estate values and, by extension, the US economy? Or is Businessweek being a bit extreme by invoking The Shining references? Let’s dive in.

First, let’s discuss the players and the field of play. At >$20 trillion, the commercial real estate market in the United States is as massive as it is diverse. Mortgage Bankers of America data shows that about $4.5 trillion, or 25% of that value, is subject to commercial real estate mortgages. The sector is sliced into the end-use industries as follows:

Each end-use has two things in common: renting to some tenant somewhere and having a mortgage to pay. But that's where the similarities end. What will make an industrial park in Santa Fe, New Mexico, successful has nothing to do with the outlook for a Duane Reade at 3rd and Broadway in New York. 

A review of each industry's rent growth and vacancy rates clarifies that the significant problems are neatly confined to offices. Work-from-home trends embedded during the pandemic wreaked havoc on metro-office building rents. At the same time, a growing reliance on e-commerce spending and expanding capital spending have sent industrial and logistics facility rents soaring. Multi-family rents speak to the housing shortage in the United States.

Again, offices stand clear in the pack concerning vacancy; it may come as news that office vacancies are now higher than in the darkest days of the financial crisis. 

No pricing power, no demand, and, like their residential counterparts, higher interest rates have dented property values. In the case of offices, some metros have seen building prices fall by as much as 30% over the last year. Typically, properties of this sort are lent at 50-60% loan to value. So, declines of much more than 40% in property values could eliminate all of a borrower's equity.

High and rising interest rates take no prisoners. And in this case, it's an insult to an already injured industry.

Additionally, over the past ten years, interest-only loans, where 100% of the principal is repaid at maturity, have become increasingly en vogue.

So, without any doubt, there is a problem here. Who will be left holding the bag, and when?

The leftmost bar chart below shows the total dollar maturity per end-use industry debt due over the next 10+ years. You'll note that much of the total office debt will mature in 2023 and 2024. We're officially in, or entering, what's likely to be the most acute phase of maturities.  

The right bar chart shows who's potentially holding the bag should mass defaults occur. Understandably, banks/depository institutions hold many outstanding corporate mortgages. Again, with a bias towards the next few years' worth of maturities.

Of all CRE loans, 85% are held by the following groups: non-bank entities (55%), Top 25 banks (14%), and $10-$160bn banks (16%). The largest banks have the size and scale to offset losses, and non-banks either have loss-absorbing characteristics or can raise funds to bridge shortfalls.

There's no sugarcoating risk to the depository institutions holding the loans to the wrong offices. Those banks typically fall in the total assets classification of $100mm – $10bn. They likely hold about 20% of their total assets in CRE mortgages, 10% of which in the office industry. So, call it about 2-4% of those banks' assets are tied directly to the success/failure of offices.

What is the likelihood that 100% of a bank's office portfolio loans will default? And then, what are the odds that those defaulted physical properties have precisely $0.00 in residual economic value?  

In a highly levered industry like banking, losing a few percent of assets is a big deal. Depositors would be loathe to hold their hard-earned dollars in a questionable institution, especially after the calamity this past March.

Deposit flight and eroded asset values are principally what caused the failure of Silicon Valley ($210bn), Signature ($110bn), and First Republic ($229bn). Noteworthy, though, is that each of those three failed banks was 10-20x larger than any in the cohort reviewed above. Somehow, despite $500bn worth of banks evaporating in a month, contagion didn’t break out; solutions were found.

The Federal Reserve’s recently administered stress test of the largest, most systemically important banks included:

• A 40% drop in all commercial real estate (not just office).
• A 12% decline in U.S. Gross Domestic Product.
• A 25% decline in residential real estate prices.
• A 37% decline in stock prices.

The banks all passed. I hate to say that the mega banks can backstop the small banks. But they can.

I hate even more to say that regulators could step in and solve the issue. But, again, they probably can. The Federal Reserve, Treasury, and FDIC stepped in with breathtaking speed in the March 2023 edition of financial panic, which is to say nothing of the creative solutions they found during the pandemic.

There will be pain for some, of that there is little doubt. But so long as every office loan doesn’t default in unison, solutions are likely the better bet than collapse.

Labor vs. Artificial Intelligence Part I – For the Love of Irony

Is a budding revival in organized labor happening at the dawn of the artificial intelligence-driven path to human obsolescence? Wouldn’t that be ironic?

A sluggish and stubborn recovery marked the labor market in the post-financial crisis period of 2009-2019. The unemployment rate (blue line) peaked at 10% in 2010 and didn’t fully recover to pre-crisis levels until six years later. If you include those who became discouraged, dropped out of the labor force, or were forced to work part-time, the unemployment rate peaked at 17%. 

Workers were a dime a dozen, especially at the low end of the pay scale. And the damage to the economy was deep. Companies that survived the meltdown came away with scars that left them unable or unwilling to extend higher wages to workers. Expense rationalization, efficiencies, and deleveraging were the terms of the day.

Millions were out of work, and companies focused on efficiency above all else. Job openings per person fell to a record .15 job listings per unemployed person. 

Put another way, 6.5 unemployed people were fighting for each job opening. For nearly a decade, all the power was entirely on the side of hiring managers. Even in the shutdown economy of 2020, we didn't see levels quite that extreme. If you were demanding higher wages back then, you must have been acutely aware of your skills.

I'm sure you noticed each chart's most recent data point above. But take a moment, go back. Take in the polar shift that's taken place. Every record low/high recorded in the bad old days of the financial crisis has flipped to a record high/low in the post-pandemic period.

Just like the Somali pirate in Captain Phillips – workers are looking to managers and saying, 'Look at me – I am the captain now.'

Whether it's inflation-driven angst, a lack of appropriately skilled workers, or simply a 'life's too short' mentality, the flip in power dynamics is clear. And when workers feel emboldened, they tend to look towards unionization. They're looking and searching.

Whatever your personal feelings are towards unions, there’s no mistaking the increase in activity, even though membership rolls pale compared to the 1980s. Our news feed each morning seems to include at least one note of an ongoing negotiation, pending strike, active strike, or formation of a new union. Here’s a small sampling of significant union headlines over the past year.

Organized labor still mainly has its hold in the public sector (33.1% of employees), transportation and utilities (16.1%), and construction (12.4%). But recent efforts at Amazon facilities and Starbucks stores look to buck that trend. Foodservice and retail have less than half the union representation compared to the national average.

Given so-called ‘right to work’ laws and the political strongholds in the United States, it’s not surprising that union membership tends to be very regional. Here’s how things stood by the end of 2022.

The sustainability of the budding labor movement is highly uncertain. Collective bargaining laws are challenging to navigate. Federal Reserve's ambitions to slow inflation by any means necessary could come at the cost of economic growth and, by extension, workers' short-lived strategic advantage. And an onslaught of automation and artificial intelligence threatens to supplant the need for specific jobs and tasks.

We asked ChatGPT 3.5 about its opinion on how AI might impact organized labor. You'll be happy or maybe horrified at how diplomatic the response was.

So, how will AI impact all our lives? There is no shortage of opinions. But public companies have woken up to the buzzword and are seeing dollar signs. For now, the payoff for these companies is mainly to stake their reputation on future dominance. And they’re moving fast.

In the financial services industry, we already implement automation and natural language processing solutions to help streamline creative and analytical processes. More technologies that allow us to engage with clients more deeply and add efficiencies to our investment management are welcome. We're excited to see what comes next.

As developments warrant, we'll check back on this fascinating field and its impact on work in upcoming newsletters.