Client Investment Letter January 2023

“[Interest rates] act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull.” – Warren Buffett


The path towards normalizing interest rates in 2022 reasserted the force of gravity on asset prices.  Since 2008, the Federal Reserve and other central banks have engaged in extremely low interest rate policy and purchasing bonds for the central bank balance sheets, known as quantitative easing. When it became clear that inflation expectations had firmly taken hold, eventually spiking to as much as 9.1% by June, central banks who are responsible for ensuring price stability had little choice but to act aggressively to raise rates and undo quantitative easing with the hope that slowing the economy will reduce demand and cause inflation to come back down to acceptable levels of around 2%. The Fed’s seven interest rate hikes totaling 4.25% were the most aggressive in 40 years, and all assets felt higher rates pull down their valuations. Even long-term government bonds, which many people (but not us) count on as a safe haven during volatile times, had their worst year since the 18th century according to one historian analyst.

The so-called “risk-free rate” is a key component of the discount rate investors use to determine the present value of future cash flows for all investments. Investors in stocks, bonds, real estate, collectibles, and even privately held businesses rely on the risk-free rate in determining their value.  A higher discount rate mathematically means values today must be lower. Most investors use the 10-Year United States Treasury Bond as an approximation for the long-term “risk-free rate.” The thinking is that the U.S. controls its own currency so it will always be able to come up with (print) dollars to pay the coupon and principal on those bonds.  Basically, the future cash flows are known with virtually 100% certainty. On the last day of 2021, the recently issued 1.375% U.S. Treasury bond maturing 11/15/2031 was trading at $98.75 per $100 of face value. At year-end 2022, that same bond traded at $81.46.  The cash flows haven’t changed one bit except for the $1.375 bond holders received in interest during 2022. Yet, that bond is worth 18% less than it was at the start of the 2022. The same should basically be true of any business or real estate project with long term cash flows that haven’t changed at all. In this context, the 19% fall in the S&P 500 for the year isn’t too surprising since businesses also produce their cash flow over many years, just like longer term bonds. We would note that most of the declines, in fact, are due to the reduction in valuation across all assets; corporate profits have yet to decline meaningfully.  We are grateful that our positions in energy, health care, and defense companies, where earnings outlooks improved this year, helped to lessen the decline in our portfolios relative to the broader markets.

In 2023, we are unlikely to experience nearly so much pain from rising interest rates. Sure, the Fed may keep hiking, but there are already signs of slowing in the economy and the Fed has started to moderate the size of its rate increases.  Gas prices are down substantially. Existing home sales are nearly as low as they were in 2008 as higher mortgage rates have taken buyers out of the market. Used car prices, which spiked coming out of the pandemic, are on the decline.  Nonetheless, certain aspects of inflation will be more stubborn, including rents, food, medical expenses, and education.  With inflation trending lower in recent months, we believe most of the Fed’s tightening has already been achieved.

However, we expect the true impact of the interest rate hikes the Fed has already implemented to continue to work their way through the economy. Presently, short-term rates are well above long-term rates (commonly known as an inverted yield curve). Given that an inverted yield curve has been an accurate predictor of prior recessions, combined with a Fed that has promised to err on the side of taming inflation, we view a recession in 2023 as quite likely.  We aren’t alone in this view, as most economists have come to expect one too.  A recession driven by an interest-rate cycle is normal cyclical behavior, a necessary cleansing before the economy resumes its growth.  And a recession that is widely expected should be somewhat reflected in stock prices already.

The depth of any contraction will likely be determined by how long inflation remains elevated and the strength of the labor market.  If inflation comes down relatively quickly, and with China finally reopening to unsnarl supply chains, we are hopeful the Fed won’t be forced to stay restrictive in the face of a slowing economy.  But, if inflation persists, the Fed’s hands will be tied, and it will be forced to keep rates high for longer, perhaps prolonging a downturn. There seems to be an ever-narrowing path to a soft landing where inflation declines rapidly, and the economy slows but doesn’t contract meaningfully.  While possible, the likelier course is that the Fed will remain tight until it is certain that inflation has been tamed.  Since the inflation data is backward looking, the Fed will probably wait too long and be forced to move aggressively to address a significantly weaker economy by the time it feels confident it has stamped out inflation.  If this scenario plays out, it could be a rough first half of the year as we wrestle with cuts to earnings estimates, but the market will respond aggressively in anticipating brighter days ahead as soon as the Fed gives even a hint of loosening policy.  In our estimation, the risk of trying to time such a transition isn’t worth it. No one has a crystal ball and the only thing we know for sure is that good companies will be worth more in the years ahead if they are purchased at a reasonable price.

With all this uncertainty in mind, we have remained mostly defensive.  The closing of the acquisition of Nielsen by private equity in the fourth quarter has provided us with an additional cash cushion at a time of market weakness.  While we are beginning to see more attractive valuations in growth industries, we have yet to find valuations compelling enough to make significant new commitments beyond adding to some of our favorites for underinvested accounts.  We still think quality companies at reasonable prices provide the best chance to preserve and grow your purchasing power in the present environment.  While it may not happen overnight, companies can raise prices to pass cost increases through to their customers.  We retain dry powder invested in short-term U.S. Treasuries (under 12 months to maturity) that can easily be exchanged for shares of companies as opportunities arise.  The 4.5% return on such securities makes waiting for better opportunities a little bit more tolerable.  Though the risk-reward on longer bonds has made them untouchable for quite a while, some bonds may also eventually become attractive enough to make good investments, particularly if we get a full-blown credit cycle where many companies are forced to restructure their debts.

The irony of the current environment is that for years the Fed induced both companies and governments to take on more debt by depressing interest rates. Savers were punished through diminished income and borrowers rewarded through lower financing costs. It was looking like that huge pile of debt would be difficult to pay off, but with the outbreak of inflation, the burden of that debt will be more manageable over time.  While we hope the Fed succeeds in taming inflation, prior periods of excessive indebtedness have been “solved” through inflation; it looks like history is repeating itself.  In our opinion, the best way to protect against inflation in the long-term is to own quality companies that have enough financial flexibility and wherewithal to manage through the transition.

The return of higher interest rates has made fundamentals like high free cash flow and earnings important in the evaluation of investments again.  This is a welcome change from when the stories about the future – be it electric-vehicle makers with promises of becoming self-driving taxis, cryptocurrencies that would replace fiat, or renewable energy companies that would render oil and gas obsolete overnight – were all that mattered no matter how much money the companies were losing in the present.  Though the transition has been uncomfortable, the return of the impact of “gravity” through a normalization of interest rates is one we welcome.

We have been keeping our feet patiently on the ground waiting for traditional opportunities that we can measure with cash flow to come our way, and it seems like they are closer than they have been since Covid-19 closed the economy. The seeds sown during this downturn should provide a bountiful harvest in years to come.  We appreciate the trust you place in us and look forward to updating you as 2023 progresses.  As always, please call with any questions or come see us in person.


Penn Davis McFarland, Inc.
January 2023