Patiently Leaning into the Opportunities from a Position of Strength

This is a longer-than-usual quarterly letter from our Investment Strategy Team! We may be entering the most exciting and promising prospective investment opportunity set we have enjoyed in over a decade. Thank you for your indulgence as we err on the side of providing more detail than we typically do.

During the third quarter, stock markets finally faced up to the reality that a recession was around the corner — if it had not yet already started. We wrote last quarter about the ominous signals that the capital markets were already sending about this likelihood before taking additional steps to prepare portfolios for this eventuality. After entering “bear market” territory, stock markets spent most of the late summer months rebounding, propelled by the hope inflation rates were peaking, which would have enabled smaller interest rate increases by the Federal Reserve (the Fed). Many also wondered aloud how the economy could be close to a recession if the labor market continued to be so strong with a very low unemployment rate.  

By the time early fall arrived, we believe it became clear that those views were too optimistic. While food, energy, and other commodity prices had begun to fall significantly from their peaks, “core”[1] inflation appeared to be broadening out across many sectors in the economy, showing no signs of abating. The labor market, a backward-looking indicator reflecting more about where the economy has been than where it is going, has also been roiled by the pandemic, creating an inefficiency in matching those looking for work with job openings.

In the face of accelerated underlying inflation and an artificially tight[2] labor market, stock market investors realized that the Fed was going to have to ramp up its campaign of interest rate increases and couple that with decisive action in an effort to reduce its bloated balance sheet of $8.8 trillion of bonds. We believe that without these measures, inflation expectations over the medium term ran the risk of becoming unmoored, far away from the Federal Reserve’s target of 2%. As a result, the U.S. stock market corrected in September by approximately 10% to end the quarter down over 5%, its third consecutive quarterly decline, the longest losing streak since 2008.

At the same time, bond markets extended their losses for the year as interest rates surged. The 2-year Treasury bond rate ended the quarter over 4.2% — driving the yield curve to invert further, a condition it first reached in early summer[3]. This has occurred despite a record rise of over 2% for the 10-year Treasury bond in 2022. Spreads of corporate bonds widened further to an above average 5.5% and mortgage rates have surged to their highest level since 2007. Significantly, the U.S. dollar has surged across all major currencies, leaving many worried about the ripple effects of tighter money in the U.S. on fragilities in the global economy, such as the energy crisis across Europe, concerns about pension fund solvency in the United Kingdom, pressure on the emerging markets, and the continued fallout from the war in the Ukraine.

In summary, stock markets reconfirmed the signals that the bond, currency and credit markets have been suggesting consistently since early summer: the economy is slowing rapidly, and corporate earnings expectations would have to adjust to reflect the reality of a likely recession[4]. Moreover, unlike the last 12 years, the Fed is not going to do anything about it, with Fed Chair Powell more or less explicitly acknowledging that a recession is the price to pay to keep inflation expectations in check and to avoid returning to the “stagflationary” malaise of the 1970s.

Public Markets

Proactive changes to protecting capital means we are entering this period from a position of strength

Before examining where the future opportunities may lie, let’s review the proactive steps we have taken over the last 18 months to prepare portfolios for this period: 

• May 2021: We shifted from Large Cap Growth to Large Cap Value, with a small allocation to a Pure Value construct, a selective basket of stocks that exhibit the strongest value characteristics in the market based on price as compared to book value, sales, and earnings.
• July 2021: We eliminated our Emerging Markets position.
• January 2022 and May 2022: We shifted to the Momentum factor only after waiting for the factor to rebalance away from Growth and toward Value.
• May 2022: We doubled the percentage of Pure Value within our overall Value allocations.

In early 2021, we were at the top end of our ranges of exposure to stocks and emphasized Growth over Value, as detailed over the last few quarterly letters. The moves listed above gradually lowered the inflation and interest rate risk to which portfolios were exposed. Along this journey, we have continued to take advantage of the volatility for taxable clients by generating tax losses to protect future gains.

‍In July this year, the stock market finally appeared extremely expensive relative to bonds on the criteria we use to measure its relative value. This precondition is a precursor to a sustained “bear market” in stocks, so our unemotional, model-driven process called for us to take an additional step to preserve capital. As a result, we lowered our equity exposure to underweight our long-term neutral targets, putting the proceeds into short duration (1-3 year) high quality Treasury bonds that are less sensitive to continued rising interest rates than the broader bond market. Within our equity portfolio, we also: sold our position in the US Energy sector, which had outperformed the broad market since we had initiated the position; sold our Momentum factor position; and bought the Low Volatility factor index, a broad basket of stocks concentrated in defensive, less economically-sensitive sectors, such as Consumer Staples and Utilities.

As a result, our public market portfolios have weathered the storm of 2022 very well. While it is never easy to digest portfolios that are down in value, our strategies have corrected by less than half of what an unmanaged index of the broad stock and bond markets have experienced this year. We believe we are entering the recession from a position of strength, affording us the patience to lean into the opportunities as they continue to develop.

‍Where are the possible opportunities?

Rising inflation and interest rates pose significant headwinds to stock market valuation levels. The S&P 500 index’s approximately 20% correction in 2022 has come from a 25% decline in its P/E multiple to 16 times trailing earnings, offset by approximately 5% underlying earnings growth. If history is a reliable guide, that multiple should fall further to around 15.7 times if inflation is going to run between 4% and 6% over the next year (where consensus inflation expectations currently are).

Though multiples have mostly adjusted to the reality of persistently above average inflation, earnings expectations may not yet have fully adjusted to the likelihood of a recession. Current consensus has only priced in a 3.8% downward earning revision for 2023. A 10% decline is still less than the typical median decline in earnings during a recession, but that may be justifiable given the higher operating margins that corporations have been able to generate in a post-pandemic world[5]. Our models are alert to any further deterioration in credit (further widening in credit spreads) and bond (deeper inversion of the yield curve) as leading indicators of whether we need to take additional action to reduce more significant downside risk from here.

In the meantime, we will wait for our models to confirm when a more aggressive stance is warranted again based on future fundamentals. We will also monitor indicators to signal if sentiment has capitulated before then, typically an indication that the stock market has made a durable bottom before embarking on a new cyclical bull market. Capitulation occurs when sentiment is so washed out that investors irrationally no longer care about fundamental justifications for price levels, leaving volatility, uncertainty, and sharp price swings to characterize market movements[6]. It is a signal to us to at least eliminate our underweight to stocks before moving overweight again.  

‍For now, we reiterate our counsel to clients that if they have 18 months to 2 years’ worth of spending needs net of portfolio yield in cash (which, for the first time in many years, is paying an acceptable return), they stick to their discipline of averaging into markets over a period of six months to achieve our underweight equity target. Markets do not necessarily have to reach a point of capitulation before beginning to rally in a sustained way again.

Our models are closely monitoring potential opportunities. Will credit spreads widen to a point that high yield bonds become an opportunity again, even if not as spectacularly as 2008? Will the strength of the dollar cause such distress abroad that international markets become an opportunity to capitalize on after many years in the wilderness? Will high Quality stocks pick up the baton from Value stocks as earnings expectations adjust to reality? These are just some of the many candidates our discipline is monitoring every day.  

Finally, how has the opportunity set evolved in private markets to supplement what we do on the public market side of portfolios?

‍Private Capital

The private capital markets will not be immune to the impending economic recession. The venture capital market has been most impacted so far — few deals are being done and new deals are being repriced lower as the need for a greater cash runway to survive a slowing economy has become paramount. The once-hot Initial Public Offering market for technology software companies has frozen.

While we have been intentional in our efforts to avoid some of the riskiest sections of private markets over the last several years, we expect our strategies' valuations to be impacted in the coming quarters, at least temporarily. Second quarter “marks” on the portfolio may come in lower than the first quarter as managers and their valuation experts look to public markets and a slowing M&A market to value their holdings. We believe one advantage that private capital managers have is the ability to choose when to sell investments, allowing them to sell during more favorable exit conditions. We last saw this during COVID, as managers had companies ready to exit, but waited for the recovery before realizing gains. We have placed capital with managers that have demonstrated an ability to manage through an economic downturn before, and we do not have any reason to believe at this time that any of our existing private capital managers will not perform in line with expectations.

Many investors, especially those who are newer to investing in private markets, maybe tempted to pause or delay private capital investments during times of market stress we are experiencing today, especially given the length of the commitment involved. This is exactly the opposite of what they should be doing. Historically, some of the best private capital vintages have followed stock market corrections and recessions. Lower valuations and more selectivity[7] are two of the reasons for this. As such, it is important to stay the course in building up a private allocation in a disciplined way so that you do not miss out on above-average vintages.

While we are excited to have multiple managers with fresh balance sheets to invest in the coming months of potential further dislocation, we believe private capital is best invested in a disciplined manner, not trying to time the vintage. We instead look to manage expected capital calls to ensure client’s cash ands pending needs are not compromised and lean on our managers, relying on their experience to navigate the changing landscape and drive excess return through sourcing, operating, and exiting assets regardless of vintage.

‍Private Market Quarter in Review

After a quiet summer from our private capital managers, activity has picked up in the Fall, with three managers coming back to market and two co-investment opportunities. The first fund coming back to market is our leveraged buyout manager, J.F. Lehman. They will be in the market with their sixth fund focused on defense, aerospace, maritime, and environmental services. They approach these sectors with a deep value style, typically sourcing from broken deals or limited auctions. We believe their approach could be timely as many of these sectors are not as closely tied into the business cycle as the other sectors upon which private equity managers may be focused.

J.F. Lehman was also the source of one of our co-investments, which is a “take-private” airline logistics company. J.F. Lehman believes the market is mispricing this company due to valuing it as a passenger airline, not a logistics company. This co-investment was done alongside the Apollo group. The other co-investment was sourced through our venture capital manager Panoramic. This co-investment was a series C investment into a payment solutions provider and was done alongside FTV Capital, a global growth equity manager specializing in the global payments ecosystem. These types of co-investment opportunities are not appropriate for all clients given their higher risk, “rifle-shot” concentrated exposure to a specific deal. In addition, these opportunities should be scaled accordingly in a private capital allocation when appropriate.

The next fund we have coming back to market is Harbert U.S. Real Estate eight. We have been investing with Harbert since their sixth fund and both funds six and seven have performed well versus the public markets and their peer universe. This is the same team that invested through the global financial crisis and we look forward to that expertise as we enter what could be an opportunistic time to be investing in real estate.

The last manager we have coming back to market in 2022, which we are in the process of re-underwriting, is Fulcrum. Fulcrum is a growth equity manager that focuses on small but growing companies in the technology and healthcare space. We approved their third and fourth funds, both of which have outperformed expectations.

We would also like to take this time to give an update on our Decarbonization 2022 fund. Earlier this year, we created an access vehicle to allow clients to gain exposure to one of our intergenerational themes[8]: decarbonization of the world’s energy stack. Since then, we have completed our first close and called 18% of capital. The fund has paid its first capital call to our small-scale solar manager, Kendall. We will be paying our second capital call to Brookfield in October. This call to Brookfield will pay down the credit line they used to purchase the first investments in the fund. These investments include Cambridge Power, a UK battery storage developer, Sunovis, a vertically integrated German developer of solar power projects in Germany, and two solar distributed generation businesses, POWER and Solarity. We are excited to have this fund underway and to be making investments in what should be a multi-decade opportunity.

‍Private Market Outlook

In the coming near-term environment, we think it is important to steer clear of non-secured lending strategies given their return profile of debt and risk of equity, such as second lien mezzanine debt. To supplement the successful senior-secured lending strategy of Monroe, we are creating a new access vehicle, Credit Opportunities 2023[9],which will offer what we believe to be a strong current yield component, but also a higher total return target than Monroe. In general, this fund will be comprised of balance sheets composed of first lien lenders in niche or opportunistic areas. We are already in advance stages of due diligence with a manager that has unique access and experience in this area of the market to anchor this fund. We are also considering strategies, such as consumer lending, asset based lending, and commercial lending in niche areas around this anchor holding[10].

Beyond the immediate couple of quarters, we continue to see the best long-term focus in private markets around our four intergenerational themes of decarbonization, the growth of the sunbelt in the southeastern United States, the explosion of productivity growth as a result of artificial Intelligence and machine learning , and the healthcare revolution.

‍Outlook

Having counseled clients through several market cycles over more than three decades, we know how difficult it is to navigate falling and volatile capital markets. It is worth repeating that there have been 108 “compelling” reasons to sell the S&P 500 since 1928[11], the most recent being surging inflation and interest rates in 2022. It can be tempting to succumb to the temptation to “sit things out until the outlook is better” when our discipline states it is better to spend time in the market rather than trying to time the market.

As the legendary investor Warren Buffett likes to remind us: “the time to be fearful is when others are greedy and the time to be greedy is when others are fearful.” As always, we believe our unemotional, forward-looking data-driven process will guide us to lean into opportunities patiently as we have entered this period from a position of strength. They will signal when the Fed’s job in taming inflation expectations is complete even if a recession is necessary to help them achieve that.

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_{[1] Core inflation refers to cost increases in goods and services excluding the food and energy sectors.}

_{[2] As we have discussed in previous quarterly letters, the labor market has been roiled by the COVID-19 pandemic in several ways. The economy is entering this period with approximately two job openings for every one person looking for a job. Historically, this relationship is usually the other way around. The Fed’s hope is that aggressive interest rate increases will destroy job openings rather than create higher unemployment, as in previous cycles.}

_{[3]The yield curve’s inversion measures the extent to which short-term interest rates exceed long-term interest rates, a condition that normally signals a recession is likely 12 – 18 months hence.}

_{[4]Often, a recession is typically defined as two consecutive quarters of declining Gross Domestic Product (GDP) growth, which we have already experienced in 2022. The official arbiter of recessions is the National Bureau of Economic Research (linked below); they cite a recession when their criteria point to “a significant decline in economic activity and employment.” Unfortunately, they work in hindsight – confirming recessions when they have already occurred. This year has been another reminder that capital markets lead the economy (and the economics profession), not the other way around.  National Bureau of Economic Research}

_{[5]We have discussed in previous quarterly letters the positive effects on long-run profitability from potential productivity growth arising from corporations adopting new game-changing technologies as they were forced to do more with less during the pandemic.}

_{[6] At a high level, we look for two of the following conditions to coincide to confirm capitulation: 1)Elevated levels of the VIX volatility index 2) Significantly highly correlated sector returns and 3) Daily price corrections of 5% or more.}

_{[7] During times of dislocation, General Partners in private capital markets can negotiate better terms, obtain a higher percentage of equity, or demand more covenants from the companies or assets in which they invest or to which they lend.}

_{[8] Balentine, 2022 Capital Markets Forecast}

_{[9]Like this our Decarbonization 2022 fund, this fund is a vehicle we will create to allow clients to access these strategies. Balentine does not receive any additional fees for doing so.}

_{[10]The last time we were able to pivot in a similar way to take advantage of distress in private markets was our allocation to the Peachtree Distressed Opportunities Fund in 2020 as COVID threatened many hotels with bankruptcy. Though the distress caused by the pandemic subsided quickly as the authorities injected record stimulus into the economy, we are hopeful that this fund will return 1.5 – 2x with very high internal rate of return.}

_{[11] Balentine, Reasons to Sell the S&P 500}

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