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October 13, 2022
3rd Quarter 2022
A Strange New World, Revisited
In our 2nd Quarter 2019 Commentary we discussed the ever-changing environment in which we assess public securities. As part of that discussion, we listed a number of fiscal, monetary, market and economic outliers that were either rare occurrences or had never been present previously. Towards the end of the discussion we stated, “many of the items listed above have and will generate future financial system instability.” Below we will review several of the atypical fiscal and monetary issues that are still present. We believe these abnormalities enhance the persistent inflationary pressures in the economy and are likely to continue to exacerbate volatility in the public securities market.
These outliers include:
• $30,900,000,000,000 in U.S. government debt and counting – an increase of $8,417,000,000,000 or 37.4% in just over three years since our 2019 writing (see chart beside): An astounding increase! U.S. debt as a percentage of Gross Domestic Product (GDP) has actually decreased from the all-time high of 134.8% as of the 2nd quarter of 2020 (see chart on next page which cites the year end 2021 figure). However, it is still well over the 100% level where many economists believe it begins to negatively impact economic growth.
• Negative real (after inflation) short-term interest rates in the U.S. for more than a decade and counting: Even after raising the Federal Funds Rate to 3.25% on September 21, 2022 from 0.25% in March of 2022, the real rate is still deeply negative (see chart below). This qualifies as continuing accommodative monetary policy in classical economics.
• Modern Monetary Theory (MMT) is losing any credibility it ever had (we hope!): The prominence of the idea that the government should create all the money it “needs” has led to inflation, as measured by the Consumer Price Index (CPI), at levels the U.S. has not seen in 40 years. Many headlines have pointed to CPI decelerating from its high of 9.1% in June 2022 to 8.3% in August 2022. As we have mentioned many times before in our commentaries, we do not know what CPI will be next month or a year from now. Nor do we think inflation can be as precisely measured as CPI portends, especially when the measurers have a history of removing highly inflating items as they wish to reduce the headline CPI figure. We do think the current inflationary environment has the potential to be with us for some time, mainly because approximately 30% of all the U.S. dollars in existence were created since March 2020. Much of this money printing was encouraged by MMT-touting economists.
The speculation around the Federal Reserve’s actions on interest rates at the next meeting or what level CPI will be over the next month has contributed to much volatility in the public securities market, both upward and downward volatility. In part, this is driven by the very real pressures on the Federal Reserve policy makers. The rapid increase in interest rates this year is showing signs of putting pressure on many overly indebted parts of the economy, while at the same time, possibly not being high enough to actually bring CPI back down to the targeted 2% level. If that conundrum reminds any of you of the Federal Reserve’s challenges during the stagflation of the 1970’s, there is good reason. We do not know the timing of nor how much higher the Federal Reserve will raise interest rates; however, we are confident the public securities market volatility will continue.
A Time of Opportunity
As we reminded you in our last quarterly commentary, “there are reasons to be optimistic as an equity market investor, particularly as an equity market investor who has hired a firm that thinks independently.” While we believe the broad stock market remains at overvalued levels, your portfolio’s prospect for future returns remains bright as we will review below.
Currently FRM’s composite equity portfolio (which represents all of the equity portfolios managed by FRM combined) trades at one of the most attractive levels relative to its intrinsic value during the 10 years we have been tracking this figure (see chart above). As you know, our process for evaluating businesses begins by analyzing the historical performance and future business prospects for each company to arrive at our estimate of the worth of a company – the “intrinsic value.” Then we set our “buy price” at a discount to that intrinsic value. The only time in the last decade that FRM’s composite equity portfolio had as much upside to our conservative appraisal of intrinsic value was in March of 2020 during the beginning of the COVID-19 pandemic. Our returns from that point over the last two and a half years have been very good on an absolute basis and a relative basis outperforming the broader market. We never know when the market will recognize the value we see for each of the holdings in your portfolios, but we continue to have confidence in our valuation discipline and process. We also believe that the patience to wait for that recognition will be rewarded. As a reminder, we are working for our own families in exactly the same manner as we are for you.
FRM’s portfolio remains diversified with significant allocations to companies in the energy and materials industries. Historically these industries have protected investors from the stagflationary environment discussed in the previous section of this commentary. We recently came across a study from The American Institute for Economic Research by Senior Fellow Richard M. Salsman titled “The Impact of Higher Inflation on U.S. Asset Class Returns.” This study reviewed the performance of various asset classes in three different CPI environments from November 1971 – November 2021 (see chart below). The study confirms that commodities, as represented by the Goldman Sachs Commodity Index (GSCI), historically protected against high rates of CPI growth. That has remained true in 2022. From December 31, 2021 to September 30, 2022, the GSCI is up 8.3% compared to the S&P 500 that is down 23.87%. We continue to maintain positions in various commodity producing companies because they remain attractively valued. The attractive valuations serve as additional confirmation to us that the market has a much more complacent attitude about the “transitory” nature of the current bout of inflation than we do.
The interesting part for many of the commodity markets to which our companies are exposed is the tightness of physical stocks combined with a lack of capital spending to drive future supply increases. We showed you oil inventories in our 1st Quarter 2022 Commentary, and these balances have continued to drop to very low levels (see chart on next page). It is interesting to note that this inventory depletion is happening in an environment with reduced Chinese demand due to their zero-COVID policy. We continue to believe we will be using fossil fuels for the forseeable future and believe the following quote from Jeff Currie, the Global Head of Commodities Research at Goldman Sachs, on CNBC on October 3, 2022 clearly states the case: “At the end of last year, overall fossil fuels represented 81% of energy consumption. 10 years ago, they were at 82%. $3.8 trillion of investment in renewables moved fossil fuels from 82% to 81% of overall energy consumption.”
Other commodities are faced with a similar set of circumstances: low inventories (see chart below), low capital spending for future supply and projections of growing demand. In the case of copper, rapidly growing demand spurred by the push to further electrify the world is increasing the risk that supply falls short of demand. We have reviewed two reports that were published in the last three months that point to the challenges of transitioning away from fossil fuels presented by the contraints in copper supplies, along with heightened demand for other metals and materials. Anyone that is interested in these challenges should review these reports, which are freely available: “The “Energy Transition” Delusion: A Reality Reset” by Mark P. Mills of the Manhattan Institute and “The Future of Copper: Will the Looming Supply Gap Short-Circuit the Energy Transition?” by Daniel Yergin of IHS Markit. Yergin estimates that copper demand will double between now and 2035 in order to achieve the current climate goals of various world governements. We believe that the modern economy will continue to rely on oil, gas, copper, steel, and fertilizers. Your portfolios should benefit from their exposure to companies that contribute to the supply of these vital inputs.
A Balm for Volatility
Last quarter we wrote about a balm for inflation woes, so we decided to highlight a balm for volatility this quarter. We’ve written extensively over the years about our emphasis on investing in companies that pay their shareholders dividends. Focusing on the steadiness of the dividends the companies in your portfolios are paying may help you look beyond the rise and fall of stock prices over time. Furthermore, dividends can provide a reasonably safe and growing income stream that has the potential to offset inflation’s erosive effects on your original investment. As of the end of the 3rd quarter 2022, FRM’s composite equity portfolio has a dividend yield of 4.05%, which is much higher than the S&P 500 dividend yield of 2.30% and even higher than the 3.80% yield of the 10-year U.S. Treasury bond on the same date.
Benefiting from Increasing Interest Rates
Speaking of bond yields, as we discussed earlier in this commentary, interest rates have increased rapidly during 2022. Because bond prices move inversely to bond yields, bond returns have been negative. The -14.61% year-to-date return for the Bloomberg Aggregate Bond Index through September 30, 2022 represents one of the worst nine months for bond returns in U.S. history. This is decidedly bad news if you own bonds with distant maturity dates. For FRM and our clients, this increase in rates represents a welcome reset. For all of our clients, we purchase U.S. Treasury bills in portfolios where we have sizable cash balances. We appreciate the safety of owning six month or nearer-term treasury bills due to their liquidity, and we generally receive a higher yield on treasury bills versus the cash and money market vehicles offered by our various custodians. Our last treasury bill purchase on August 11 yielded approximately 3%, much more exciting than our purchases have been for the past decade or more. For our clients who have fixed income and balanced portfolios, we have kept higher cash and treasury bill balances in anticipation of higher interest rates. We recently purchased a 2-year U.S. Treasury bond at a yield of approximately 4.3% (see chart below of historical 2-year U.S. Treasury yields). We have not yet gotten excited about yields in the corporate bond market, but if credit spreads widen further, we expect to become more active purchasers.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. “FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at email@example.com.