SECOND QUARTER 2023
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NEWS & INSIGHTS | SECOND QUARTER 2023
July 3, 2023
By Mark Oelschlager, CFA
Music star Taylor Swift has taken the country by storm this year, selling out large football stadiums in every city lucky enough to have her perform. Generally, she puts on two or three shows in each city, in some cases more, such as the six shows in Los Angeles. You would think that with all this supply the tickets would be affordable, but a recent check on some seats on the secondary market showed a price of $2,000 for one ticket – and those were for the poor seats. But her devoted fans – known as “Swifties” – have been willing to pay up and, in many cases, make the long drive to see and sing along with the icon.
We don’t know where she invests her money (we’d be happy to meet with her), but Swift has proven to possess some financial savvy. When crypto exchange FTX recruited her as an endorser, she asked some critical questions that led her to decline the deal. Other celebrities that signed on with FTX have since been embroiled in legal problems in the wake of the collapse of the exchange.
The market’s mega-cap “love story” continued in the second quarter, with a handful of stocks carrying the major indices higher while the average stock was relatively flat. This time the catalyst was the excitement over generative AI, or artificial intelligence. AI is an advancement in technology that allows a machine to learn and produce new content based on inputs. The most well-known play on AI is semiconductor company Nvidia, whose chips are the brains of many AI systems. Management’s recent extremely bullish forecast sent the stock dramatically higher, and it became one of the few US companies to break the $1 trillion market value barrier.
AI, which has applications across various industries, appears to be a real trend with plenty of growth potential. That said, as with other burgeoning technologies in recent memory (e.g., Internet, cloud computing, electric vehicles) the market may be getting carried away with the valuations of the companies associated with the theme and overestimating the number of long-term winners. Nvidia, which we do not own, seems like the most obvious winner, but it’s also trading at more than 40 times sales – an astronomical multiple that requires the company to grow profits at an exceedingly high rate for many years to come.
The other big news in the quarter was Congress reaching a deal to raise the debt ceiling, thereby avoiding default. There is a theory that the recent strength in stocks has been partially driven by liquidity, and that this liquidity will decline significantly as it is sopped up in the coming months by the US Treasury’s issuance of new debt. This wave of new Treasury bonds will refill the federal government’s coffers, which had been drawn down because of the inability to issue new debt (borrow) before the agreement. On June 2, Treasury’s cash balance was $23 billion, a very low number given all its obligations. As we write this it was on pace to have refilled the “blank space” in its checking account back above $400 billion by the end of June.
The federal debt is now approximately $32 trillion. For perspective, if every tree on Earth had a ten-dollar bill stapled to it, and you went around and collected all of those bills (take a minute to visualize how many trees there are in the world), you still wouldn’t have enough to pay off what our government owes.
That $32 trillion figure is up from $23 trillion at the end of 2019. In 2007 it was $9 trillion, and in 2001 less than $6 trillion. The remarkable aspect of this ascent over the past two decades is that it occurred largely during a time of low interest rates, meaning Treasury’s interest costs were low, which meant that it had to borrow less than it would have otherwise. Not only did Congress squander this gift by ramping up spending, but in addition it failed to take advantage of the low rates by locking in low borrowing costs for the future. When rates were low, we wrote about the failure of the government to extend its maturities – in other words, to borrow more at longer terms, such as 15 years than at shorter terms, like 2 years. When it did this it saved a little in in the near term because interest rates on short-term bonds are usually lower than they are on long-term bonds, but it failed to lock in the generally low rates that existed at the time. Now, with interest rates having risen dramatically, its borrowing costs are much higher. In fact, 3-month Treasury bills are above 5%, a far cry from the 0% at which they spent much of the past ten years. 10-year rates, which had spent much of that time below 2 ½%, and even most of 2020 below 1%, are now 3.8%.
These higher interest payments are an extra cost for the government. For the current fiscal year, interest payments on the debt are expected to be about $660 billion. In 2016 the total was $240 billion. Remember: this is just interest payments; it does not include any outlays for Social Security, Medicare, military, etc. This interest burden should continue to climb, which will cause the debt to climb as well.
Even when we look at figures as a percentage of GDP, they are extreme. The federal debt is about 120% of GDP; it spent most of the last 60 years in the 40%-60% range. The picture is similar for the country’s income statement - the only time in the last 100 years that federal spending was higher as a percentage of GDP than it is now was during Covid and World War II. As we have said before, it is impossible to know when all this will matter to financial markets, but we think it’s important to be aware of the dynamics and to bring the staggering numbers to light.
Back to the stock market. There are two major questions on investors’ minds: how long will the Fed continue to tighten monetary policy, and will there be a recession?
The Fed finally paused its rate hikes in June. However, Chairman Powell emphasized that, given the persistence of inflation, further rate hikes are likely necessary, which was at odds with what the bond and stock markets had been projecting. Nonetheless, the market has decided to “shake it off.”
One possible explanation for the strength in stocks is that investors are growing increasingly convinced that we will avoid recession. The economic data hasn’t deteriorated much (the commercial real estate market notwithstanding), and of course unemployment remains low. But we believe this conclusion is likely a mistake. Declaring that we won’t have a recession because unemployment is low is a bit like concluding it won’t rain because the ground isn’t wet. Employment tends to follow the economy, not lead it, though certainly in an expansion or recession it can have a self-perpetuating effect. A low unemployment rate precedes recession, though it doesn’t directly cause it. The point is that low unemployment doesn’t tell us anything about the likelihood of a recession. Incidentally, and to add further illustration to the lagging point, the unemployment rate typically rises in the early stages of an economic expansion.
In addition, as we have mentioned before, an inverted yield curve (brought on by Federal Reserve rate hikes) has been a reliable harbinger of economic downturns. As experienced investors know “all too well,” with each inversion there have been many that have dismissed the curve’s relevance, and today is no different. Is it possible it will be different this time and the economy will avoid a contraction? Sure, but we don’t believe that’s the right bet.
It may be that market participants are being emboldened by the fact that we have had 16 months of tightening monetary policy and the economy is still healthy. They may be concluding that if we haven’t seen it yet then we aren’t going to see it. But monetary policy works with a long lag. Its effects aren’t felt until a year or two later. This wait-until-I-see-it philosophy might be fostered by the increasing short-term focus of those trading stocks.
The Fed is often seen as an “anti-hero,” and some of the criticism is deserved, but the lag in monetary policy is what makes its job so difficult. It sees inflation is high, so its inclination is to raise rates, but these measures work with a long lag, so it doesn’t yet know the consequences of some of the actions it has already taken. If it knew that price growth were going to come down in six months and the economy falter, it wouldn’t be talking about more hikes. But it doesn’t know, so it has to continue to profess a willingness to tighten.
Given all this, we have positioned our portfolios more defensively than normal, and as valuations and/or interest rates rise, we feel compelled to move even more in that direction. One of the advantages for a defensive investor today as opposed to a couple years ago is that, with short rates at 5%, we can get paid to wait. We look forward to becoming more aggressive when conditions change.
Mark Oelschlager, CFA
Total Return as of 6/30/23
Towpath Focus Fund
Russell 3000® Index
S&P 500® Index
Fund returns are net of fees.
Gross Expense Ratio: 1.12%, Net Expense Ratio: 1.12% (Contractual until 3/31/2024)
Since 12/31/19 Inception
Since 12/31/19 Inception*
Total Return as of 6/30/23
Towpath Technology Fund
Morningstar Tech Category
Fund returns are net of fees.
Gross Expense Ratio: 2.48%, Net Expense Ratio: 1.12% (Contractual until 3/31/2024)
Since 12/31/20 Inception
Since 12/31/20 Inception*
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