Client Investment Letter October 2024
“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith
While jokes about wrong-way economic projections almost write themselves – like the time inflation was confidently called “transitory” just before spiking to 9% – this quarter, central bankers both home and abroad reminded us of their power to shape economic outcomes.
The Federal Reserve’s intense focus on combating inflation appears to be waning, with Chair Powell indicating a historic shift in policy, a “recalibration,” he called it more than a dozen times. In September, citing weakness in the labor market and broader economic malaise, the Fed lowered interest rates by half a percentage point. Because the Fed typically moves in measured, quarter-point increments, the size of this cut came as somewhat of a surprise even if the action itself was well telegraphed.
Policymakers must worry that risks to economic growth warrant a more aggressive move as they turn their attention to the other half of their dual mandate: maintaining maximum employment. The Fed is now working to ensure that the previous rate hikes don’t cause further damage to the U.S. job market. While the unemployment rate has ticked modestly higher in recent months, in August, the number crunchers at the Bureau of Labor Statistics revealed the actual number of fully employed Americans was 818,000 fewer than reported over the prior twelve months, the largest revision since 2009.
Beyond the employment data, the bond market is providing some signals that corroborate concerns about risks to growth. Typically, when the 2-year Treasury yield is as far below the Fed funds rate as it is today, an economic downturn could be on the horizon. Additionally, the so-called inverted yield curve – when rates on short-term debt exceed those of longer-term maturities – has unwound. When yield relationships are first twisted and then flip back to normal, this often is a telltale sign of an impending recession (whether leading astrologists agree, we are not sure).
With that said, this seems like a good place to remind you that recessions are a normal part of the business cycle and cannot be repealed indefinitely. Recessions cleanse the market’s excesses, making for a more attractive prospective investment environment.
Meanwhile, the global economic landscape is already showing signs of strain, with Europe and China experiencing notable economic slowdowns. China recently announced a stimulus bazooka to pull its economy out of its slump and revive confidence in its growth targets. If successful, this could drive commodity prices like oil, copper and iron ore higher, complicating the Fed’s efforts to manage inflation.
As we move forward, the Fed’s ability to navigate these complex economic crosscurrents will be crucial. The challenge lies in striking the just-right policy balance between supporting economic growth and maintaining price stability, all while contending with global economic headwinds and potential market instability.
As a case in point, consider the dramatic dip in global markets around the end of July and the first trading day of August. Negative interest rates in Japan over the years caused the yen to be substantially weaker than peer currencies. This encouraged one of the largest carry trades ever as investors borrowed cheap yen to invest in higher-yielding assets in other currencies, profiting from the interest rate differential. The Bank of Japan’s July rate hike and hawkish rhetoric set off a rally in the yen, triggering a mad rush to unwind the carry trade that caused the sharp, almost 10% three-day selloff in the equity markets, which was entirely recouped within nine trading sessions.
The U.S. election cycle adds another layer of complexity. Both candidates have put out economic plans that look highly inflationary to us. One side is proposing grants for first-time homebuyers, price-control actions against supermarket “gouging” and maintaining tariffs on China. The other is planning even broader tariffs that will raise consumer prices on imported goods and reviving domestic manufacturing with a more expensive documented labor force. Neither candidate is talking about fiscal austerity or appears at all focused on the deficit.
While the election may contribute to short-term market volatility, we anticipate the impact to be temporary, and regardless of the outcome, on Wednesday, November 6, it will be in the rear-view mirror, the uncertainty will be removed, and we will carry on with whatever hand we’re dealt.
Whether the Fed’s approach will result in the much desired, but exceedingly rare “soft landing” remains to be seen. If the easier monetary regime and China stimulus reignites inflation, the Fed may need to recalibrate yet again. Though we will have many more economist jokes if such a policy flip-flop occurs, the market’s reaction won’t be funny. However, with ample cash and a disciplined strategy, we feel well-equipped to navigate any potential market instability and capitalize on emerging opportunities.
Turning to your portfolio, we have two brief updates.
As you may recall, last fall we initiated a new position in Fortrea, a contract research organization (“CRO”) that was spun out of Labcorp. In simple terms, a CRO helps drug companies design, run, and manage clinical trials. The thesis here is that we believe Fortrea’s best-in-class management team can turn the business around and get its industry-low margins more aligned with the peer group. If it’s able to do so, the valuation should be substantially higher than it is currently. Following a disappointing earnings report, the stock sold off and we used the weakness to build up our position. While industry trends appear to have softened since last year, we continue to have confidence in management and believe the turnaround plan may be postponed but is not derailed. We remain patient and like the risk-reward at current levels.
Since the end of 2020, we have held a position in a tracking stock that represents Liberty Media’s majority stake in SiriusXM, the satellite radio company. At the time, Liberty Media SiriusXM traded at a 35% discount to the underlying value of its publicly traded holdings and the rationale was simple: we’re buying good assets at a steep discount with catalysts to close it, controlled by the influential cable mogul John Malone, a legendary capital allocator. In December 2023, the companies announced an agreement to merge, effectively collapsing the discount entirely, and that deal closed in early September. So you will now see a position in SiriusXM in your account instead of Liberty Media SiriusXM.
Subscriber growth at SiriusXM has been challenging, but the company gushes cash and seems excessively undervalued. So much so that it’s caught the attention of Berkshire Hathaway, which is now the largest holder, owning almost a third of the new SiriusXM. We anticipate technical factors depressing the shares – like arbitrageurs positioning to take advantage of the discount – will soon unwind. In addition, with a larger float following the transaction, we believe the company will be eligible for inclusion in the S&P 400 Index, forcing passive funds tracking the index to buy it. But, that said, we have always considered this to be more of a special situation than a core, long-term position.
Finally, some exciting PDM news. On August 1st, Ben Brown joined our team. Ben had been managing his own firm since 1995 with exceptional results. With a shared investment philosophy and his decades of experience, we look forward to Ben’s many contributions.
As we enter the home stretch of 2024, we’re reminded that in the world of finance, today’s economic forecast can quickly become tomorrow’s cautionary tale. But unlike the immutable stars that astrologers rely on, we have the flexibility to adapt our strategy as circumstances change. We’ll keep watching the economic skies, not for signs and portents, but for real opportunities to protect and grow your assets.
As always, we appreciate your trust and confidence in us. Please don’t hesitate to reach out if you have any questions or concerns.
Penn Davis McFarland, Inc.
October 2024
