Q3 2023 Compass Review
Expectations are hard to change. We expect certain things from our partners, our friends, an Amazon delivery, and a dining experience. When these expectations aren’t met, it’s hard to accept reality.
Here is the new reality; Lunch just got a whole lot more expensive. In previous letters we warned that the era of “free lunches” was over. It happened faster than we thought possible. While short-term bonds already reflected this reality, longer term bonds finally came to their senses. The 10-year Treasury started the quarter at 3.82% and finished at 4.57%, briefly touching 4.80% after quarter end.
4.80% was short lived due to Hamas’s invasion of Israel. Hopefully, the attack does not extend into a global war, but the possibility is now a reality markets must contend with. The threat of war in the Middle East adds more pressure to an undersupplied oil market, which is not making the Fed’s job any easier as it continues to fight stubbornly high inflation. None of this will help the US government deal with our massive $2 trillion budget deficit and $33 trillion in debt.
This all means that interest rates are higher than we’ve seen in a long time and are likely to remain elevated. Accepting this reality has been hard. Fifteen years after the Great Recession, the market expects (hopes) to return to “normal”. Unfortunately, this may be misguided amnesia from the Fed keeping short-term interest rates at or below 1% in part of 13 of the last 16 years. Prior to this period, the 50-year average was ~5.7%. It’s 5.5% today. Perhaps this is normal?
While savers are thrilled earning 5%, the bond market will continue to be pressured by the Fed no longer buying bonds, and many of the other major investors like China, Japan, and US banks caught dealing with their own financial stresses. As a result, the investments that worked during the low interest rate phenomena continued to crack this quarter. The biggest downdraft came in interest rate sensitive sectors such as utilities, real estate, and consumer staples, whose dividends and expensive valuations were much less attractive versus higher bond yields.
Debt and leverage didn’t matter when lunch was free, but the market is starting to punish companies and asset classes with significant refinancing needs. Even the tech sector experienced weakness, with only 3 of the Magnificent 7 in the green. Still, they continue to buoy the overall market, having gone from 20% of the S&P to 30% over the last 9 months. It’s anybody’s guess as to how much longer this discrepancy can last, but it won’t be forever. At some point the lack of growth at the big tech companies and the attractive relative valuation elsewhere will converge.
Despite these headwinds, we are breathing a sigh of relief. The transition back to a market with a real cost of capital is creating pockets of opportunity. Opportunity that won’t be driven by financial engineering, free money, or cheap debt, but through growing earnings and quality management.
We are finding opportunities in companies exposed to the broader trends of domestic manufacturing and onshoring, whose projects are built over long periods of time through market cycles. Although banks are currently out of favor, we think the ones with minimal commercial real estate exposure, smartly managed balance sheets, and cheap valuations, are compelling. While fintech or financial technology companies were all the rage over the past few years, slowing growth and heightened competition created carnage in the sector, but there are good businesses to be had.
We also couldn’t have a third quarter letter without mentioning Ozempic and its sister diabetes (weight loss) drugs. And although they have dominated the headlines, there are a lot of other exciting developments in healthcare that are still digesting the post Covid slowdown but have decades of growth ahead of them in diagnostics, precision medicine and gene and cycle therapy. Even a few of those hard-hit consumer businesses that have been able to increase volumes, not just raise prices, are coming into our sweet spot.
The interest rate induced volatility is likely to bring even more bargains our way. This makes our job a whole lot easier as we don’t have to guess who is going to win the AI chip wars or make speculative investments hoping that rapid sales growth can overcome insane valuations. A more normal environment means investor focus shifts back to what a company looks like today, not what it could look like in ten years.
In the same vein, the flip side to higher interest rates is that it becomes more compelling to lend money through bonds and loans. Thankfully, we’ve kept the average maturity on our bond portfolios short-dated, giving us ample opportunity to reinvest proceeds at these more attractive yields over the coming years. A balanced portfolio is finally a balanced portfolio again.
At the end of the day, if the new normal is just a return to normal, our core investment strategy of unearthing attractive value at reasonable prices will shine. In fact, we’ve invested our client’s money when interest rates were a lot higher. If we are wrong, and interest rates trend lower because of recession or global war, we are protected by owning a core portfolio of quality businesses with healthy balance sheets and a history of capitalizing on market weakness. Either way, our investments need to thrive in today’s reality, and that reality keeps us optimistic that value investing is alive and well.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.