Everybody Is Looking for Something: Strategic Income Outlook Fourth Quarter
We doubt Annie Lennox had the investment community in mind when she sang these words in the Eurythmics’ hit single “Sweet Dreams” back in 1983, but they ring very true to investors today. As we look at the investment landscape, the impact that Covid-19 has had on all sectors of the economy is plain to see. It doesn’t require extensive experience or investment acumen to recognize the obvious damage that restaurants, theme parks, commercial real estate, airlines, and cruise ship operators have sustained over the past year and a half. However, looking in the rearview mirror rarely provides a clear view into the future when it comes to investing. Instead, as we look out at the economy and markets today and try to gauge where we are headed, we are faced with myriad potential obstacles that policy makers and businesses must navigate to keep the economy moving in a positive direction. Our friends in the media, those nattering nabobs of negativism (thank you, Mr. Agnew), are all very eager to tell everyone about the dire consequences that each of these situations poses. Inflation, China, supply chain problems, the Federal Reserve (the Fed), labor shortages, crypto, debt ceiling, energy prices, tight credit spreads, etc. How do investors filter out the noise from the things that actually matter?
“Everybody is looking for something” can help us frame which of these factors will have a meaningful impact and allow us to position portfolios to take advantage of the tailwinds while avoiding the potholes. While we do spend a lot of time thinking about the big picture, we feel it is also very important to marry this with a bottom-up analysis of the companies in which we invest. The challenge is to figure out which macro factors will have a real impact on our companies’ performance, and what the time horizon will be. Clearly if it is a long-term issue and we are invested in very short-term paper, it doesn’t matter much. For bonds where we have a longer-dated exposure, we need to gauge whether those changes to the business will be permanent, or merely a temporary speed bump. It all sounds straightforward, but there are many nuances to consider as we weigh the positives and negatives in coming to our conclusions. Here are some of the important macro considerations we are assessing today:
China — It is not surprising that China has a marked impact on just about every aspect of the U.S. economy and will continue to for the foreseeable future. It would be easy to become paralyzed with fear if we were to heed every warning that analysts and the talking heads proffer about what China’s policy moves mean. We are constantly working to filter out the hyperbole and pay particular attention to a few areas where their actions and policies are the driving forces behind global investment flows and prices. Recently, the big property developer Evergrande has been in the news due to their inability to make payments on their massive debt. Every investment bank on Wall Street has been hosting conference calls with experts to dissect the minutiae and prognosticate on where the impact of a blowup of this magnitude would be felt most.
The direct impact on our portfolio is negligible as we have long avoided investments in Chinese-owned companies. However, the ripple effects of Evergrande falling into distress could be more significant. The property market in China is a major driver of their economic growth, and problems at Evergrande will certainly damage confidence in the housing and construction markets within the country, likely slowing the flow of bank and retail investment into the space and possibly causing material capital destruction as weak or highly levered developers also run into liquidity problems. On a global basis, reduced building activity in China caused by waning confidence in Chinese property values would soften demand for commodities like aluminum, steel, and copper, which may affect global commodity prices. Consequently, we are monitoring the situation and the policy response (if any) from the Chinese government, but as far as our portfolio goes, it is mostly noise and we aren’t losing any sleep over it right now. However, we will continue to watch for signs of contagion in other markets and changes in investor sentiment.
We are paying closer attention to the activity levels in Chinese ports and the impact on global supply chains. At the beginning of the Covid shutdown, companies that were heavily reliant on Chinese supplies of both raw materials and finished goods got crushed. The pervasive discussions at that time were around the need to lessen reliance on China by creating parallel supply chains, which we have viewed as a longer-term solution that may come with its own hidden costs. While everyone talked about it back then, many companies today are still too heavily reliant on Chinese supplies. Rising prices caused by shipping delays might be “transitory” as the Fed would like us to believe, but this episode may likely lead to a more permanent shift in the development of new supply chains as the time that most consumers are willing to wait for goods they order has compressed from months or weeks down to days, or even hours in some cases. Consequently, companies that have successfully diversified away from a heavy reliance on Chinese goods will likely have a competitive advantage for the foreseeable future. While Evergrande may be garnering the headlines right now, we view energy and supply shortages as being far more relevant to our portfolio companies. We will be keeping a watchful eye for signs of easing as global supply chains and shipping backlogs return to normal.
The Fed and Inflation — It’s impossible to think about the Fed without also thinking about interest rates and inflation. We have talked about these in just about every outlook over the past few years. In the short run, the Fed continues to provide the safety net that is enabling the equity markets to hit new highs and the credit markets to approach all-time tight spreads, while keeping interest rates at historically low levels. We know (or at least we think we do) that Fed accommodation will end at some point – we just don’t know when. While others are searching for minute changes in the Fed’s commentary and studying the often discussed (and somewhat unhelpful) dot plots to pinpoint when changes in Fed policy may occur, we are more concerned with the markets’ reaction to those changes.
We can’t be certain if the stock market or the bond market will give us clear signals about shifting investor preferences in advance, but we are quite certain the shift may not happen concurrently with the taper. Once again, just about every Wall Street economist is publishing his or her opinion on when the Fed will begin to taper. The forecasts of the timing are so over-analyzed now that when it finally happens, it will likely be a non-event. We prefer trying to understand how the end of quantitative easing (QE) will impact our portfolio. There will be winners and losers when the tides turn, and investors should look at companies that will perform better without an ever-accommodative Fed. Reduced Fed bond buying should lead to slightly higher interest rates, which could cause valuations to fall (due to multiple compression) and could leave many investors that hold unhedged long-duration assets nursing losses if they are unable to adjust ahead of the crowd. We do feel that we have already seen the low in rates, and while markets have remained in “risk on” mode through most of the year, a shift from offense to some measure of defense may be warranted until we have a clearer picture of the magnitude and speed of interest rate normalization.
With global rates in most developed countries still extremely low and the U.S. remaining the safest market in the world, we believe that any significant uptick in rates ought to attract global capital in search of yield. So, while the taper will be in the headlines daily, and it may have adverse effects on asset prices, particularly those with longer duration, the likelihood of materially higher rates derailing the economy and sending us into a recession and a protracted bear market appears low to us. More likely, we prefer a long overdue correction where we could put some money to work buying bonds in good companies that go on sale for a short period of time.
Crypto — We have been actively avoiding all things crypto for a long time, including companies whose businesses are largely dependent on crypto prices or trading flows. Bitcoin and non-fungible tokens (NFTs) are unanalyzable as investments. They are complete speculations, and apt illustrations of the greater fool theory. Examples are MicroStrategy, which raised a few billion dollars earlier this year through the sale of multiple convertible bonds, which it then promptly invested in Bitcoin, and Coinbase, a large crypto exchange (which was recently hacked) that issued high yield debt earlier this year. These issuers do not present the type of risk/reward profiles we find attractive.
We do acknowledge that the crypto ecosystem continues to grow and attract more capital, for better or worse, as everybody is looking for the next Bitcoin or Beeple NFT. We still contend that at some point we will see significant destruction of capital among those who are investing meaningful amounts of cash into these purported assets and businesses. Yet, despite steering clear of investing in anything crypto-related, the broader acceptance and expansion of the crypto industry provides us with valuable barometers of investor sentiment and appetite for risk. We are carefully observing commentary and price action for crypto assets/companies for clues regarding changes in speculative fervor, which often parallels and sometimes presages sentiment swings in the stock and bond markets. So, while we don’t carry any direct risk linked to crypto in our portfolio, we do find the markets informative and helpful as a signaling mechanism to alert us to possible “risk off” shifts in investor sentiment.
Labor Shortages — The CARES Act helped people replace (and sometimes more than replace) incomes lost due to Covid-related job losses. For some time now, almost every company we speak to is looking for bodies to fill job vacancies. By extending unemployment benefits and waiving some federal taxes on unemployment benefits, the U.S. government may have added to the inertia of staying at home for the unemployed. Also, recent reports show that many baby boomers have decided to permanently leave the workforce and enjoy a more modest retirement. However, companies can’t function properly without labor. Lack of available labor is one of the most often heard complaints on quarterly earnings calls. Companies in the transportation/distribution industries have reported having an extremely difficult time finding and keeping truck drivers, a problem with origins that predated Covid-19 and could take years to resolve. According to Winsight Grocery Business, two-thirds of food retailers say insufficient trucking and transportation capacity caused by a driver shortage has hurt their business. In addition, turnover of all food retail employees hit 58% in 2020 vs 40% in 2019. Raising wages to attract or keep employees can only lead to either slimmer margins or higher prices that the consumer will ultimately bear. Deep-pocketed employers have been quick to jump to $15, $17, or even $20 per hour to bring in much-needed workers. Those who don’t have deep pockets may have a hard time competing. It will make for a very interesting upcoming Christmas season to observe how delivery giants like FedEx and UPS handle the seasonal surge in volumes. FedEx recently reported an earnings shortfall in Q2 21 and cited lack of labor availability as one of the key components to its weaker operating results. The hourly rate for FedEx package handlers has risen 16% in the last year in its ground division and 25% in its Express group. These types of pay increases are tough to recoup through price increases, and rarely are labor price increases temporary when the problem is this pervasive. We are paying close attention to the companies and industries that are most impacted by labor shortages and are looking to see who has the pricing power to maintain margins and who does not. Companies in the food service, retail distribution, transportation, and hospitality industries seem to be having the most difficult time attracting and retaining employees. We are having frequent conversations with management teams to glean insight into possible solutions to the problem, but unfortunately there are no easy fixes at the moment. We are also being vigilant to make sure we don’t get blindsided by exposure to some of the weaker companies that are struggling because they are unable to address their staffing issues. That being said, having more business than you can fulfill is still better than the alternative.
Credit Spreads — You have to search pretty hard right now to find anyone in the media waving the flag in support of bond investments. With Treasury yields bouncing only a few basis points off the lowest levels of our lifetimes, everybody is looking for a reason to sell bonds rather than buy them. The high yield market has also seen a tightening of spreads over the past year, which critics once again suggest signifies a market top. As Morgan Stanley points out, however, all is not lost. The average leverage of high yield bond issuers declined 0.5x in the second quarter, driven by both debt repayment and strong EBITDA growth, and now sits at a level of 3.9x, which is lower than the pre-Covid level of 2019! And the interest rate they are paying on that debt is lower. We have often remarked that because of its heterogenous composition the high yield universe is a “market of bonds and not a bond market,” so we are careful not to get too excited about market averages. However, given the robust refinancing activity and ease of origination of new debt, companies have better access to capital today than ever before. Consequently, defaults are expected to remain very low, and companies should continue to de-lever further as economic growth persists. So, while we are earning lower yields on our bonds now, the financial metrics of our portfolio companies and the broader market should continue, in our view, to improve. Better overall financial health and ease of access to the capital markets remain key supports for bond prices throughout the high yield universe.
Given the unprecedented period we have experienced since the start of the pandemic, it is understandable that few have a crystal-clear view of what lies ahead. None of us have been here before. However, despite the numerous potential risks and problems that exist around the globe, there is much to give us comfort that U.S. markets are not heading into a maelstrom. Many businesses have done a remarkable job of cutting costs and have positioned themselves to come out of the Covid crisis stronger than they were in 2019. The capital markets have been functioning exceptionally well for the past 18 months, allowing companies to find capital to fund growth and to easily refinance debt obligations at attractive rates as they come due. Management teams are gaining experience and getting comfortable managing disparate organizations whose employees have been largely working from home for the last six quarters. So, while tight labor markets and supply chains present some near-term challenges, and a Fed taper could trigger some near-term volatility in the markets, corporate balance sheets are generally in excellent shape and companies seem well-positioned for growth as these temporary conditions work themselves out over the coming quarters. We do expect interest rates to rise a bit, so we are keeping a close eye on our duration while keeping a healthy cash hoard, per usual. However, we don’t see runaway inflation or significantly higher long-term interest rates coming anytime soon, and with corporate balance sheets strong, capital plentiful, and funding costs low, defaults should remain low, and we hope to use periods of volatility to add higher yielding bonds to the portfolio.
As always, we thank you for your confidence and welcome any questions or comments you may have.
Sincerely,
Carl Kaufman, Bradley Kane, Craig Manchuck
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A basis point (bp) is a unit that is equal to 1/100th of 1%.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
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