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Next Stop: New World Order
While fall foliage and “pumpkin spice” foods have come and gone, the rest of the world has become far less stable. Not since we moved to a fully industrialized society and national borders redefined cultural affiliations have we seen so much change. The political tendency towards extremism is as much a reflection of prosperous citizens terrified of losing something as it is a battle of ideologies. Sadly, we are seeing a repeat of all the worst aspects of twentieth-century historical developments: the resurgence of totalitarianism, a denial of fact for myth, and the sacrifice of young men’s lives to satisfy the ambition of desperate leaders. In an echo of Stalinism, it was reported this week that Russian soldiers are shooting suspected deserters. This is a redux of the worst parts of modern history.
On the brighter side — yes, there is a bright side — there is an opportunity to harness technology and advancement. I would not go as far to say that there will be a second or third industrial revolution, but we are on the brink of change that can have massive and long-lasting positive ramifications. At its core, the U.S. economy is quite stable and in fact extremely robust despite the abysmal performance of the markets. The Inflation Reduction Act (IRA), passed this year, has the potential to be the fundamental framework for a new wave of investment and innovation in the broad field of climate change. For comparison, the technology sector today represents 28% of the total stock market and over twelve million jobs in the U.S. alone. In 1990, it was only 6% of the stock market capitalization, and in 1950 it was zero. Put another way, in 1980 no one could have imagined how the nascent internet and yet-to-be-invented PCs would so radically change the economy.
Even if the IRA doesn’t reach its full potential, there is no turning back climate change. The United Nations estimates that poor countries will need from $160 billion to $340 billion per year in aid for adaptation to climate change, rising to $565 billion by 2050. As we have seen over and over again in a capitalist society, need drives invention, and with invention comes jobs and prosperity. It isn’t how one would hope to create a silver lining — through destruction, pain, and despair — but these are the realities that we face today.
We have begun to see some of these benefits. Water funds, virtually unheard of five years ago, are now thriving in this new economy. As one example, our private water fund holdings have surpassed our expectations in just the three years that they have been in existence. Furthermore, ESG is quickly becoming an assumed starting point for portfolios, allowing for capital flows to drive positive change. And on the streets, we see folks invest small fortunes into electric vehicles in an individual attempt to stem the damage to the climate. [That said, I am perplexed as to why EVs have gravitated to the luxury car sector so pervasively… we don’t need EV tanks driving down the road].
Markets have reflected much of this uncertainly over the past year. What we are seeing is nothing short of a massive hangover that was postponed for many years. Fed monetary policy created such a flood of cheap money for so long, we lost sight of what it is like to suffer losses with risky assets and what we should be able to earn from safe assets. Put more bluntly, no large cap company can justify a price that is 215 times future earnings (Tesla on January 1st, 2022), nor can the Fed justify nominal interest rates that are 1% for the next ten years (the 10-year Treasury rate in 2021). Things needed to change, and while it has been an abysmal year in most markets, it could have been much worse had our economy not been so strong at the start of the year; and it continues to be so today.
Inflation was the first byproduct of these conditions. With a mixture of aggressive fiscal stimulus at a time when our monetary stimulus was already in the trillions of dollars, we created the perfect conditions for market-clearing dysfunction. In layman’s terms, what people pay for a good or service should reflect what it cost for that good or service. That relationship got heavily skewed when simple issues like the cost of shipping large quantities of items far outstripped the cost of those items, or landlords found it easy to quickly raise rents since tenants were not able to move with the same ease as they had in the past. The dislocations caused by Covid, however, should be temporary, based on the data we are seeing today as well as the way that the markets are pricing future inflation. The risk is that the massive flood of cheap money through recent monetary and fiscal policies does not unwind in time for inflation to become a self-enforcing dynamic.
With regard to the portfolios, it has been a difficult year. Our stocks are down with the major indices almost lock-step. Given that we have a growth-oriented, global portfolio, we are down more than the S&P 500 but significantly better than the growth indices. Our fixed income is a mixed story. The asset-backed holdings we have for many folks are doing great in this environment, with minimal losses if any. As a reminder, we hold CMBS’s for some accounts backed by office, commercial, and retail real estate holdings. Our corporate bond ladders also continue to outperform the market; and while they are down with the market, they are doing considerably better than the corporate bond indices.
There is a more nuanced story with structured notes. The individual holdings are generally intact: aside from minor holdings in Credit Suisse, none of the underlying credits have shown any sort of default stress, and many continue to pay their full interest amount. Some of the notes, however, are not paying interest for the time being because of the unprecedented shape of the yield curve, driven by the inflation conundrum and Fed policy. We expect that to change next year as Fed tightening peaks and we tip into a recession. We believe that, by design, this part of the portfolio will thrive in a recessionary environment.
The market for these structured notes, however, has disintegrated. In short, if we need to sell yield-curve indexed structured notes there are few buyers. As a result, there are few good price reference points for most of our holdings, and as such the pricing services have stopped providing market prices. They instead have reverted to “best available bid”—which in many cases involves nothing more than a scavenger trader looking to make a quick profit. Citibank is the credit most impacted by this dynamic, and this is reflected in the statement price of those notes that we hold.
That said, we are positive on our structured notes portfolios, and see them as the key to portfolio growth in the next two years. As we have seen in past crises (2008 and 2020), these prices quickly reverse, with many pieces getting called out at par value. Because of this dynamic, we have purchased additional notes at these depressed prices for most portfolios, increasing the gains potential in such a reversal.
For those who hold private fund positions (Private Equity and Venture Capital), it has been a strong year. Almost all of our positions are up for the year, some by small amounts and some quite substantially. It is a great counter to public market positions as we advocated for over the past few years, and bearing substantial fruit today. We also have good news to publish on Vodia Ventures Fund II, with two of our portfolio companies raising new money on substantially higher valuations, leading to a doubling of the Fund value. An investor update on all the Funds will be coming out shortly.
On the following pages you will find slides from our October Live Market Update which exclude events in the crypto world of the past few weeks. It will take crypto years to regain the credibility the promoters were trying to establish as a legitimate asset class, if ever in the eyes of some. The collapse of crypto is unfortunately an important lesson in the need for structures and regulation in any market that involves retails investors and their own money. It isn’t a new story — the history of finance is littered with such examples. The story here is that with all the potential benefits of crypto, people cannot help themselves from believing that they are somehow immune from the lessons of the past.
Since October the equity and bond markets have shown some modest improvements, albeit minor in the overall picture of this year’s market performance. Inflation’s rather muted numbers from October helped considerably, although we are nowhere near from being out of the weeds. We believe it will take several more months for a true inflation trend to emerge and take hold for the markets to recover from this year’s declines.
Finally, while you have all heard the news by now, we will be joining Robertson Stephens by the end of the year. It is an exciting move for us, and comes eighteen years after I founded the firm on the values of integrity and value-creation. The Vodia office remains intact, while giving us access to a broader platform of services and offerings. In short, it is the way we would have hoped to enter this next phase of the firm’s growth.
We are always here for questions or comments. In the interim, wishing everyone a wonderful Thanksgiving and the start to (hopefully) a pleasant winter!
– DBM
- Markets collapsed this year, torn down by high inflation figures and heightened anxiety around energy and the Fed.
- Equities declined extensively across the board.
- Interestingly, investment grade corporate bonds, which are considered “safer” compared to junk bonds, declined 21%! This is a function of not only heightened risk, but of an extraordinarily distorted yield curve as well.
- US dollar has performed extremely well this year, as a result of global flight to safety. Even gold, which is considered a major protection asset has lost value against dollar.
- Looking at five-year performances since 2018, the only asset class to take on risk and earn consistent returns was U.S. stocks. However, even U.S. stock market returns are not impressive given the amount of risk and volatility that in embedded in that asset class. Historically one should expect 11% per annum from stocks to justify the risks.
- Interestingly, the All World index performance is only positive if the U.S. is included.
- Bonds have been effectively flat since the multi-decade rally that began in the early 80s came to an end this year.
- Energy has been doing very well, driven by the spikes in oil and natural gas prices and the conflict in Europe.
- The contribution of the top five companies in the S&P500 Index has been disproportionate.
- All five of these are technology companies. And if we compare their returns to that of S&P500, only Apple has a slightly better return, demonstrating that growth companies have been hit the hardest in the decline.
- While technology represents 28% of the total U.S. market cap, it was just 6% in 1990 and zero in 1950. Climate change technology and adaptation could be the next driver of equity market growth.
- The implied volatilities have been elevated, but not nearly enough for the VIX index to reach “panic” or “crisis” levels that we have seen in past market debacles.
- Currently, we seem to have effectively reached a ceiling around the VIX index, an overall positive. The market has been experiencing a steady unwind prolonged over most of the year, avoiding the sort of panic selling that we have seen in past crises.
- TIPS are a Treasury bonds whose income depends on CPI inflation rate. Traditional Treasuries have a fixed rate and do not adjust to inflation. Looking at the difference between TIPS and traditional Treasuries, that premium that reflects the investors’ inflation expectations and it is called the breakeven inflation rate.
- Over the 2-year horizon breakeven inflation rates suggest that inflation is expected to be under control next year and decrease to levels close to the Fed target.
- According to the Case-Shiller Home Price Index, the housing market has begun to stagnate. The index has declined slightly on a month-on-month basis, showing that house prices are no longer growing, and in fact experiencing a small decline. Given the delay in housing prices, we expect to see this trend continue and possibly accelerate.
- Although house prices have slightly declined in major US cities, rent prices do not reflect the same trend. Rent prices continue to climb and that is closely associated with supply-demand dislocation caused by COVID and work from home trends.
- Compared to a year ago energy prices are through the roof and while being a big input into food pricing. These two items, food and energy, constitute almost a quarter of the CPI index by weight and they are the major drivers of high year-over-year inflation.
- Interestingly, we saw medical care services spike last month and that may be a reflection of labor prices.
- Energy adjusted on a month-on-month basis however, -6.2%, is less of a decline than the economists expected.
- In terms of global real GDP, the outlooks are mediocre, but not terrible.
- China is expected to continue its growth, but the numbers are much lower than the past few years.
- Not surprisingly, the UK economy is suffering: energy prices are hitting hard at a time of political turmoil in the country. The energy crisis in Europe comes at a bad time for the UK as they digest the repercussions of Brexit.
- U.S. growth is predicted to be rather mediocre, but still on the positive side.
- The Fed policy is a major economic driver. We see a tapering and the balance sheet is shrinking in conjunction with quickly rising interest rates.
- The effects of tapering are reflected in all risk markets, from equities to high yield debt. More tapering is on the way suggesting that the trend will continue.
- At the same time the rates have been going up at a 75 bps monthly clip, which is quite extensive. The next rate hike should be around 50 bps, and declining in future months to zero and potentially rate cuts as we enter a recession.
- In December 2013 the yield curve was relatively straightforward and normal, with low short-term rates and higher long-term rates.
- Now the situation is reversed, where the short-term rates are high and long-term rates are low. It is usually the 10-year and 2-year yields that invert in a pre-recessionary environment. Currently, however, the 30-year and 2-year are also inverted, a rarity that we have not seen in forty years.
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The content above is for general informational purposes only and should not be acted upon without obtaining specific advice from a qualified professional. The information provided is not intended to provide any investment, tax or legal advice; in addition, nothing on this website should be considered a solicitation for the purchase or sale of any security. The information contained herein was compiled from sources believed to be reliable, but we do not guarantee its accuracy or completeness.
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Our portfolio characteristics and holdings are subject to change at any time and are based on arepresentative portfolio. Holdings and portfolio characteristics of individual client portfolios will differ, sometimes significantly, from those shown. The investments presented are examples of the securitiesheld, bought and/or sold in our strategies during the last 12 months. These investments may not berepresentative of the current or future investments of those strategies. You should not assume thatinvestments in the securities identified in this presentation were or will be profitable. We will furnish,upon your request, a list of all securities purchased, sold or held in the strategies during the 12monthspreceding the date of this presentation. It should not be assumed that recommendations made in thefuture will be profitable or will equal the performance of securities identified in this presentation. Our, orone or more of our officers or employees, may have a position in the securities presented, and maypurchase or sell such securities from time to time.
Not all investments presented are appropriate for all clients. Some of the investments presented, such as structured notes and private funds, are extremely complex, carry considerable risks, including significant loss of principal, and are are only available to qualified investors. Alternative investments include risks such as illiquidity, long time horizons and reduced transparency. Vodia Ventures funds are closed and are no longer accepting new investors.
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