Q2 Commentary
By Nick Fisher, Portfolio Manager
We have written in the past that all eyes are on the US Federal Reserve - and they are in quite the pickle. The Fed funds rate, or the rate at which the Fed regulates the overnight lending rate for the US banking system, is used to set the bar for the valuation of all assets around the globe. The Feds most important mandate is to hold inflation steady at 2% and there by facilitate the orderly functioning of the US (and global) economy. With this over simplified measure, the Fed has failed miserably having held interest rates too low for far too long.
The near-term scenario for inflation is not good, but inflation may have peaked and will begin receding, albeit to higher levels than we have historically been used to.
The problem in the short-term is each month’s 12-month inflation rate matches the previous month’s inflation rate, plus a new month, minus the corresponding month dropped from the previous year. We can’t know with any confidence what the new month’s rate will be, but we know with precision the rate of the month being dropped. The next three months to be dropped from 2021 will be 0.5%, 0.2%, and 0.3%, respectively. The Cleveland Fed produces an “inflation nowcast” which estimates what the monthly inflation would be if the month ended today. If inflation in each subsequent month through year-end 2022 matches the average inflation rate over the prior 12 months, we should finish the summer at 9.9% and finish the year at 10.8%. If, alternatively, monthly inflation recedes to match the trailing 36-month average, then the current 8.6% inflation rate would remain steady through year-end. This simple analysis leads us to believe that inflation measures will likely get worse before it gets better.
Markets are adjusting to this new reality. With rising interest rates, the federal reserve will slow down the economy. The question is, will it be a soft landing or a hard landing for the economy?
In a soft landing scenario, inflation is stabilized to a much lower measure, albeit still above what we have seen over the last 10 years. I wouldn’t be surprised if the Fed must adjust their view of “normal inflation” above their 2% mandate. In this scenario our emerging market, and commodity holdings will do well.
In a hard landing scenario, we will have a startling and abrupt recession, followed by more economic stimulus from the US Congress, additional Fed asset purchases and a rapid recovery. In this scenario our substantial cash and bond holdings will do well followed by a small cap value recovery.
Wildcard
China is emerging from their Covid lockdowns and has key political elections coming up in October and March. President Xi- Jinping should be highly motivated to stimulate and return China to growth. This could be very important for global growth and inflation. What if China is stimulating and loosening credit while the Federal Reserve is attempting to slow down the economy and tighten credit?
The above scenarios may be uncertain, but the emotions associated with each are not. It will be very important that we control our emotions and take a dispassionate approach. With the volatility we will inevitably experience, it will create opportunities to sow the seeds of future returns. I don’t believe now is the time to be overly aggressive though.
A lot of investors have taken huge losses in their portfolios with the worst 6-month performance in stock and bond prices combined in the last 40 years. We have certainly avoided the worst of it, but surely there will be more volatility before we have a clearer path forward.
Energy Markets
We own some energy companies, and they had a fantastic run during the first 5 months of the year followed by an extremely steep pull back during June and July erasing most of the 2022 gains (note we still have nice gains since late 2020). Many investors have incorrectly assumed that higher prices are primarily attributable to the war in Ukraine. Our thesis at this point remains unchanged: we have a structural undersupply of capital to the energy industry and therefore investors will experience significantly above average returns on capital.
In June we began seeing short-term demand destruction being priced in with markets expecting a near-term recession. Still, oil prices remain elevated. This does nothing to change the structural undersupply of capital and therefore the medium and long-term returns on capital.
In the meantime, Warren Buffett has acquired nearly 20% of Occidental Petroleum among other names bringing the total new investment in energy up to more than $40B, much of that acquired in the 1st quarter of 2022 and continued acquisition of Occidental making news in June and July. This should give us confidence. Again, we are owning the businesses and not merely the volatile stock certificates. Capital will flow back into energy companies and we will benefit with higher stock prices and society will benefit by having more stable oil and gas prices.
The Businesses We Own
I can’t emphasize enough; at the end of the day, we own businesses. A diversified collection of businesses owned and operated by management teams, the likes of Berkshire Hathaway, Fairfax Financial and Markel, to name a few. They will continue to manage their businesses and add value to all their stakeholders, just as they have over the last many market cycles. There may be more market wisdom in these three companies than the entire rest of the stock market combined.
Eric Cinnamond is another brilliant investment manager that works on our behalf. We have discussed Eric’s Palm Valley Capital Fund in late 2020 and just like in 2020 Eric and his team have done a remarkable job navigating this market dislocation. The fund is currently positive on the year despite having given back a few of their gains in the most recent few weeks.
We have cash and dry powder in portfolios. As this dislocation continues, you can expect us to allocate more capital to those who have the most experience in these market cycles and this will tremendously benefit portfolios as we emerge over the next several years.
We are grateful for you entrusting us with your hard-earned savings. We know that these are volatile times, but we are confident that this volatility will ultimately benefit portfolios over the next several years and we are excited to be on this journey with you. Please reach out with any questions and we look forward to meeting with you sometime soon.
