The Fed’s War On Inflation: Q3 2022

Table of Contents

Fed Wages War Against Inflation

Equities

Fixed Income

US Treasuries

Investment Grade Bonds

Municipal Bonds

Closed-End Funds

The Fed Wages War Against Inflation

In the third quarter, the Fed made it clear to market participants that they will fight inflation by raising interest rates, even if it comes at the expense of an economic recession. Their actions have reverberated throughout capital markets, as well as the economy, and have caused a correlated fall in equity and bond markets. It seems like the only asset class that had a reasonable, positive return was cash.

Source: Bloomberg

Against this backdrop, we see compelling opportunities in the equity of online marketplaces and enterprise SaaS companies (while we remain wary of “defensive” stocks trading at high multiples).  In fixed income, we are most bullish on short-term bonds (treasuries / highly rated municipal / some investment grade) but are wary of long-duration bonds.

Equities

Equity Performance by Indices

Source: Bloomberg

Valuation: S&P 500 P/E

Source: Bloomberg, SPX Index P/E

Forward Price Earnings Multiples (PEs) peaked at 30x for the S&P 500 in April 2021, and have since declined ~40% to 18x at the end of Q3, 2022.

The S&P 500 has traded at a 50-year average of 17x P/E. At the aggregate level, we believe equities are probably reasonably valued now.

That does not mean the recent volatility will end.  We came across an interesting statement, “Fair value barely gets waved at as assets go from undervalued to overvalued.   Or the reverse.”  

We believe valuations could compress further, or they could rise quickly. We do not make market predictions.

Instead, our strategy is to invest in companies with competitive edges, strong unit economics, wise management, and secular growth tailwinds. We aim to invest in these companies at reasonable multiples of their future profit potential to improve our chances of a satisfactory return on investment. As the interest rate environment changes, our yardstick for “reasonable multiples” also shifts, and we’ve lowered our multiple expectations by ~25% this year. 

We believe that many internet-enabled marketplaces and enterprise SaaS companies fit our criteria. The online marketplaces have improved their margin profiles during the pandemic, jettisoned non-core efforts, and are trading at reasonable valuations despite high growth trajectories.

The software space (which includes enterprise SaaS) has de-rated from a peak of ~20x EV/NTM Revenue multiple in Q4 2021 to 5.5x, with many companies declining >70% in price since that point in time. We believe certain businesses in this vertical have robust business models characterized by high gross margin profiles (70-80%+) and strong top-line growth bolstered by sticky relationships with their customer bases. 

Source: https://cloudedjudgement.substack.com/p/clouded-judgement-93022?utm_source=profile&utm_medium=reader2  - Sept. 30, 2022

On the flip side, we believe that there are many mature businesses with low expected revenue growth that still trade at high multiples, not justified in the current interest rate regime. We believe that investors positioned in those “defensive” securities are likely to have unsatisfactory forward returns.  We mentioned Costco in our previous quarterly update, and we think it still fits in this low growth, high multiple, low return category. 

Fixed Income

Source: Bloomberg, HY Bond: LF98TRUU, IG Bond: LBUSTRUU, Municipal Bond: LMBITR. Tax Rate Assumptions: Federal (37%), State (10%)

US Treasuries

Cash vs. 10-Year US Treasury Yields

In September, the Fed raised interest rates by 75 bps as the Fed Funds rate is between 3-3.25%. The market expects the Fed to breach 4% by the end of the year.

Source: Bloomberg, World Interest Rate Probability (WIRP)

The rise in interest rates is favorable for short-term fixed-income securities. The September 30th yield on money market securities was ~2.5% (source: FDRXX yield) and the market expects it to be ~4% by year-end. 

 The 10-Year US Treasury ended the month at a 3.6% yield and carries a ~ nine duration (a measure of sensitivity to interest rates, a 1% rise in interest rates should cause a ~9% drop in the price of the bond).

 We believe that the rise in interest rates has created a reasonable return on cash, which has an equivalent forward yield to 10-year treasuries with a far superior risk profile.

HY Credit Spreads: Additional yield received above US Treasuries for debt of riskier companies

Source: Bloomberg, BarCap US Corp HY YTW 10-Yr Spread (CSI BARC Index)

The above chart displays the recent increase in credit spreads for high-yield bonds issued by companies with riskier balance sheets. While HY spreads widened modestly in Q3, it’s not yet high enough to justify allocating significant capital to the space. 

Investment Grade Bonds

IG Credit Spreads: AAA 10-Yr premium received above US Treasuries (in bps)

Source: Bloomberg, BASPCAAA Index

Investment Grade bonds are debt instruments issued by companies that rating agencies deem to be high quality and have very low risks of defaults. Compared to last quarter, these debt instruments are trading at lower spreads to underlying treasuries and are less compelling. In addition, these instruments are fairly tax-inefficient and their absolute level of post-tax yield is still quite low.

Municipal Bonds

Municipal Bond Index (YTW):

Source: Bloomberg, LMBIYW Index

Municipal bonds are becoming more interesting and can be a tax-efficient way to generate yield. We recommend allocating exposure to the short end of the curve (maturities <1 year) as long-duration bonds do not give adequate additional yield to compensate for interest rate and duration risk.

Closed-End Funds

We are evaluating publicly traded Closed-End Funds that hold liquid fixed income securities, trading at significant discounts to NAV.  We’ve seen good opportunities to buy closed-end funds in Q4 2008, Q4 2018, and Q1 2020.  We believe we may see another opportunity in the next few quarters.