Client Investment Letter October 2022

“Inflation is running too hot. You don’t need to know much more than that.”

– Fed Chairman Jay Powell


The third quarter marked the beginning of a paradigm shift as investors began questioning the path of inflation and the resolve of the central bank in responding. Since the days of Alan Greenspan, the Fed’s track record of eternally supporting the stock market has created a moral hazard, conditioning investors to buy every dip. So, when the Fed told us as recently as last year that inflation was transitory and would revert to the 2% range organically, many interpreted it as a signal to continue the party. Later, even as the Fed began slowly raising rates, we were promised a soft landing, which is a growth slowdown that reduces inflation without wrecking the labor market and causing a recession, a feat often talked about but rarely achieved.


With the S&P down over 20% by June, and the December 2018 policy U-turn still fresh in everyone’s minds, the market began anticipating the Fed’s pulling of the rip cord, quickly pivoting to a looser policy more supportive of risk assets. Stocks rallied sharply during the summer on hope that the Fed would stop tightening soon. But inflation has remained stubbornly high, and by August the Fed had a no-nonsense message for the market: it would accept a recession as the cost of defeating inflation. At a highly anticipated speech in Jackson Hole in late August, Fed Chair Jay Powell said, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.” In fact, the word “pain” was used twice in the speech, and several more times during a September press conference. This is clearly not the easy Fed that the market has grown accustomed to since the 1990s.


Because the central bank was so late in recognizing the threat of runaway inflation, it now has to raise interest rates higher and faster. At the same time, there are plans to reduce its $8.4 trillion balance sheet by $95 billion per month, known as quantitative tightening, which will put additional upward pressure on interest rates. These policy tools impact the economy with long and variable lags, so the effects of the actions already taken have yet to be felt; there is a real risk that the Fed, late to act, stays overly restrictive for too long. To borrow from economist Mohamed El-Erian, policymaking has gone from a repressor of volatility, by always backstopping risk, to an amplifier of volatility with the erratic Jekyll & Hyde act.


Thus, the transition to a Fed singularly focused on price stability has been a bit bumpy across all asset classes. For example, the Aggregate Bond Index, a broad measure of the U.S. investment-grade fixed-income market, is having its worst year since at least 1977, down over 15%. The yield on benchmark 10-year U.S. government bonds briefly touched 4% at one point. The foreign currency market has gone haywire, with unprecedented U.S. dollar strength against virtually all major currencies as global central banks take divergent paths. The housing market, too, has clearly begun to feel the impact of a 30-year mortgage rate over 7%. In short, it has been a wild ride, but we will get through it.


The good news is that this reset will ultimately lead to a better destination, with less distortions, better price discovery, and a healthier allocation of capital. Long-term interest rates were even higher prior to the 2008 financial crisis, and the real economy did just fine. If more normalized rates mean the end of digital images of cartoonish monkeys selling for seven figures, or blank-check acquisitions of no-revenue businesses at billion-dollar market values, we are all for it. We welcome the return of some rationality and more traditional measures of value.


So, how does this all translate into our positioning? You have plenty of cash in your portfolio, and we expect to have opportunities that we have not had in over a decade to buy great companies at fair prices. You own a portfolio of high-quality companies with strong balance sheets and resilient businesses, and we expect they will navigate the current landscape relatively well. We are comfortable holding these positions through the cycle and may even look to add to some of them. Our exposure to health care, energy, defense, and companies receiving takeover offers has certainly helped. Everything in life is cyclical; market instability is always followed by recovery.


With that, we want to share a couple of third-quarter portfolio updates.


Nielsen and the private equity firms proposing to acquire the company at $28 per share reached an agreement with WindAcre, Nielsen’s largest shareholder. WindAcre, which owned 28% of the company, had previously attempted to block the deal. This settlement removed the last hurdle, and the deal is set to close in the coming weeks. When it does, that position will bring some additional cash into your portfolio.


In mid-September, we exited our long-held Gilead position. Covid-driven Veklury (remdesivir) sales have masked rather pedestrian performance of its core HIV franchise. With the pandemic behind us, the Veklury benefit is likely to turn into a headwind over the coming quarters. The oncology business that held so much promise has been underwhelming, and the company’s $21 billion acquisition of Immunomedics in 2020 has not panned out as well as we had hoped; indeed, the company took a $2.7 billion write down on it earlier this year. While the stock is arguably inexpensive and pays a nice dividend, the path to multiple expansion is unclear and risk-free Treasury bills now offer a comparable yield, so we are moving on.


Together, these positions will have increased your cash, which we can reinvest in short-term Treasury bills now yielding roughly 4.1% until we find a better opportunity (which should get easier if this market volatility persists).


Finally, we have a couple of updates on the PDM team.


After 45 years, John McFarland has decided to retire. While we miss having him around, we’re sure Linda is happy to see much more of him, and we know there will be many exciting international trips ahead for the McFarlands. The world awaits! Let us know if you would like John’s personal email or mobile number; he would love to keep in touch with you. We are also excited to announce a new addition to our team. Hope Robinson joined us in late September as part of the client relations team and will be getting to know you in the coming months. Hope joins us from RGT Wealth Advisors where she had been a financial planner for the past three years and was a CPA at Ernst & Young before that. Welcome, Hope!


Today’s environment requires patience, cautious optimism, and liquidity, all of which we have in abundance. These are certainly interesting times, with what seems to be an important inflection in many long-lasting trends. Thank you for your continued vote of confidence in us, as we steward your account through this challenging period.


Penn Davis McFarland, Inc.
September 2022