Dear Friends,

We trust you have been well and had a pleasant summer.

The storms of the past month reminded us of the precariousness of life and the old quote from radio broadcaster Paul Harvey: “despite all our accomplishments, we owe our existence to a six-inch layer of topsoil and the fact that it rains”. We have friends and acquaintances in the Asheville, NC area who have lost homes and had their lives upended. It is clear that man-made climate change has made weather events much more powerful and capable of dropping enormous amounts of rain far further inland than previously imagined. We saw a very similar set of floods in the mountains of Vermont after Hurricane Irene. As we write this, Hurricane Milton has just torn through the western coast of Florida after record-high water temperatures in the Gulf of Mexico fueled it to become the fastest hurricane on record to reach category 5 level.

We have witnessed decades of inaction on climate change by American lawmakers in both parties, who are largely captive to domestic fossil fuel interests. Thankfully, the other large global economies, Europe, China, Japan and India do not have large, domestic fossil fuel energy reserves. Over the past few decades, these countries have begun to treat fossil fuel imports as a national security issue and prioritized a transition to renewables (and nuclear energy in some cases). This has dramatically changed the energy consumption mix of the world. Over the next 10-20 years, we expect to see fossil fuel use begin to drop in many large economies. Let us hope it isn’t too late to prevent enormous suffering.

As widely anticipated, the Federal Reserve began cutting interest rates in September with a 50 bps initial reduction.  This comes on the heels of continued softening of inflation data as the Fed has now determined that higher rates are unnecessarily restrictive on the economy. We expect a slow, steady pace of rate cuts going forward, and, absent extraordinary circumstances, we would expect the Fed to aim to stabilize at around 3%. This is good news for bond investors who have had to muddle through roughly 20 years of near-zero interest rate policies.

That said, there are significant tail risks that could drive markets and rates in extreme directions. The Israeli bombing and invasion campaigns in the Middle-East, and unwavering US support for them are contributing to a change in long-term political alignments in Asia and much of the global south.  When coupled with the US’s active sanctions policy and actions like the Biden administration’s ban on Chinese electronic components in cars, the potential exists for a dramatic shift in global trade. 

The US currently imposes some form of sanctions on roughly 20% of the world’s economic activity. Successive US administrations have increased the pace of sanctions, viewing it as a convenient policy tool. The result is that the US now imposes hundreds of sanctions each year.

This is rapidly isolating the US, and it is becoming increasingly difficult to claim sanctions are driven by a moral imperative when the US supports questionable, but pliable regimes on multiple continents. We can easily imagine a future where China and Russia establish, or re-establish parallel technology, trade and industrial systems to protect themselves from US sanctions. We can also see a future where Asian, Latin American and African industry shift to these alternative trade, industry, technology platforms. Such a move would not be unprecedented. We have seen such shifts in trade and industry during the Industrial Revolution, the rise of the US and Soviet Union in the 20th century, and throughout human history. This change is made possible by the trajectory India and China are on to recover the positions they occupied as industrial powerhouses prior to the 19th century. Within the US, such changes can exacerbate a difference in views between the East and West coasts, with elites in the west looking towards Asia, while those in DC and the east continue to look towards Europe as their primary partner in trade. Whether these tensions are resolved, or lead to breaks, may determine the long-term health and state of the US economy.

Despite increased geopolitical tensions and the specter of a potentially chaotic presidential election on the near horizon, markets have continued to remain remarkably resilient this year  

as risk assets have scaled new highs over the past month, in spite of a short-lived correction during the summer. Long term measures of equity market value (Shiller P/E) are at near record highs (37x times earnings).  The last time we saw multiples at these levels were briefly in 2021 and before that in 1999/2000 during the run-up to the dot com bust.  During that period, the Shiller P/E level reached the low 40’s before falling precipitously with the stock market in 2001/2002.  It’s possible markets revisit those stratospheric valuation levels, but if they do, it’s likely the aftermath will be particularly unpleasant for equity investors.

With the Fed launching into their easing campaign, we think dividend stocks, bonds and precious metals continue to look compelling as interest rates come down and the USD weakens in response.  For now, economic data has been holding up relatively well, but if we see signs of a slowdown, we would expect the speculative growth tech stocks that have been fueling the rally of the past two years to sputter.  So far that has not been the case, but we are keeping a close eye on the data and will look to reduce risk when appropriate.

Let us know if you’d like to discuss any of the above.

Best,

Subir and Louis   

As we head into spring, we are reminded of new beginnings. Like most people of a certain age in the northern hemisphere, we have been pottering about in our gardens. Pulling out old growth and planting the new. It seems to us that the American economy has been in the throes of a decades-long process that mirrors spring planting, in a way, but that this process has been lacking clear direction.
 
In the middle of the last century, American industrial might reigned supreme. Most competitors had seen their industrial capacity destroyed by the war, and it took decades for them to recover. American enterprise had almost no meaningful competition in certain sectors. The US built an extensive network of roads, airports and ports that helped transport goods across the country and the world.
 
Since the 1980s, these advantages have steadily eroded. Transportation policy has been mired in a morass of special interest jockeying by the oil industry and suburban communities. No meaningful public transport project has been undertaken in the US since the mid 20th century. The contrast with other wealthy economies is staggering: Europe, Japan and China have each managed to build extensive high speed rail networks. Meanwhile, transport policy discussions here revolve around adding lanes to aging urban roads. The decline of our transport infrastructure and how unsuitable it is for today’s needs was brought to dramatic light recently with the collapse of the Francis Scott Key Bridge in Baltimore. This is not the first bridge collapse in the country’s history. The cause in this case is complex and has as much to do with deregulated shipping as it does with US infrastructure. Tellingly though, it will take years to rebuild the bridge with estimates much longer than they were for the bridge’s original construction. 
 
We were also reminded of the decline in American industrial capability by a recent report on the installation of industrial robots. Chinese plants are installing five times as many industrial robots as Japan per year, and the US is even further behind. The fact is that most industrial supply chains are now centered in Asia. US industry is at a significant disadvantage in many segments, except in certain specialties such as electronics and weapons manufacturing. Even the advantage previously enjoyed in very complex industries such as commercial aircraft manufacturing appears to be fading. Though manufacturing has grown in nominal terms, it has become a much smaller portion of the US economy in terms of overall contribution to GDP and employment. In the 1950s, over 35% of the US workforce was employed in manufacturing, today that number is under 10%.
 
What has replaced it of course are service industries. This includes IT, financial services, healthcare, hospitality etc. This re-alignment has had an impact on the relative success of communities. Former industrial powerhouses such as the mid-west, have seen declines in wealth and well-being. Service industry focused regions, such as the North-East and West coast, have enjoyed remarkable growth. The advantages that accrued to US manufacturing centers from dominating global trade, have steadily migrated to US service centers which play a major role in global services, whether they operate in capital markets, or data center software. 
 
This realignment has already had a major impact on US politics, and will likely continue to. The lack of industrial work opportunities will continue to have a material impact on communities previously organized around such economic activity. 
 
From an investor’s perspective, this means investors focused on the US will have fewer profitable opportunities to invest in sectors where the US does not have a competitive industrial policy and is losing ground to industrial sectors based in Asia or Europe. Investors focused on US markets will find better opportunities in services focused industries that have a larger footprint and where American companies remain globally competitive.
 
In terms of near term and broader factors that affect the market, despite the Fed’s rate hikes, inflation remains stubbornly high. The US yield curve now suggests rates may remain where they are for another 6-9 months, with rate cuts occurring in late 2024 or possibly 2025. This is in stark contrast to the beginning of 2024 when the prevailing market view was for 6 rate cuts beginning in the spring.
 
With long term rates drifting higher again and inflation appearing remarkably sticky, investors have shifted back towards what worked last year – growth stocks, particularly tech companies in the AI space, despite increasingly stretched valuations.  This has come at the expense of value/income stocks which have been pummeled yet again to start the year.  We expect this trend of growth over value will reverse if/when the Fed begins easing interest rates.
 
Investors have also recently started to diversify into commodities as oil prices move higher again and precious metals, most notably gold, are attracting increased attention.  Gold’s surge is likely a result of several recent trends: central banks diversifying away from bonds, Chinese investors seeking stability in a slumping economy where the real estate market is imploding and macro investors sensing the beginnings of a possible paradigm shift towards commodities as a hedge against entrenched inflation.  When looking back at the 1970’s (the last time inflation was this pervasive), gold outperformed equities and bonds.
 
While it’s difficult to know for sure whether we are entering an environment similar to the 1970’s, we can’t rule it out so long as the economic data shows inflation re-emerging.  The next few months of data will be important in shedding light on where things are headed.  While growth stocks continue to be favored in this environment, we believe value stocks will have their due and it’s important for investors to maintain a diversified portfolio with exposure to bonds and commodities.
 

 Best,
 Subir and Louis

We hope you’ve enjoyed a restful holiday season and a wonderful start to 2024.

The fourth quarter saw heavy volatility across nearly all asset classes as inflation and the Fed’s response continued to be the main driver of market direction.  October began with long term interest rates continuing their upward trajectory as the “higher for longer” narrative took hold and investors expected the Fed would need to raise rates considerably higher in order to rein-in inflation. Due to the projected increase in borrowing costs, this move in rates put considerable pressure on stocks, particularly stocks in capital intensive industries. From the end of July to the end of October, the S&P 500 suffered a 10% correction despite near-record corporate earnings.  But following a cooler than expected inflation print for October–3.2% vs. 3.3% expected in the Consumer Price Index–and dovish commentary from Fed Chairman Powell, both stock and bond markets reversed course in November and rallied strongly into year-end, with the S&P 500 ending within striking distance of all time highs.

As discussed in previous letters, our expectation was to see a sharp rally in risk assets once the Fed signaled a pause in rate hikes and inflation looked to be under control.  And markets responded accordingly in November and December.  The key question for investors is will this rally have follow-through into the New Year? 

For 2024, like 2023, we think market direction will continue to hinge largely on inflation and the Fed’s response.  The market currently expects the Fed to begin cutting rates this year as inflation cools (as signaled by the Fed Board of Governors).  However, as we saw in October, market expectations don’t always jibe with how things eventually play out. 

Going forward, there are three paths the economy can take this year with regards to inflation and Fed response:

1. Soft landing:  In this scenario, inflation continues to cool, reaching the Fed’s target of 2% in a gradual and controlled manner without triggering a significant spike in unemployment or an economic recession.  The Fed would slowly ease rates and we would expect to see stocks and bonds continue to perform well.
2. Hard landing:  In this scenario, the Fed’s rate hikes cool the economy too much, triggering an economic recession and a significant spike in unemployment.  This would lead the Fed to cut rates aggressively in order to re-stimulate the economy.  We would expect to see stocks (particularly growth stocks) perform poorly while investment grade bonds and treasuries would perform well (acting as a safe haven).
3. No Landing:  In this scenario, inflation would reignite and remain sticky, settling in at a rate 1-2% points above Fed target with continued economic overheating.  This would cause the Fed to keep nudging rates higher.  We would expect floating rate bonds and commodities to perform well while longer term bonds would perform poorly.  Growth stocks would likely outperform value stocks.

Which scenario is most likely?   A no-landing scenario is very uncommon (and somewhat controversial) – one could argue the last time the US economy experienced anything like this was in the late 1970’s/ early 1980’s.  This period also coincided with the last time the economy encountered a similar spike in inflation, so, while unlikely, one can’t rule this scenario out entirely.

A soft landing, which is the ideal scenario for the Fed, policy makers and investors, has more historical precedence.  The most recent clear example would be in the mid-90’s, where the rate hiking cycle ended in April of 1995 and there was no subsequent economic recession.

The end of the last three rate hiking cycles arguably resulted in hard landings: Jan 1999-July 2000 culminated in the Dotcom bust, May 2004-July 2006 preceded the Great Recession, and Nov 2015-Jan 2019 preceded the Covid crash.  Some current and former Fed officials argue that Fed interest rate policy was not directly responsible for the Great Recession and the Covid crash and that the economic contraction following the rate hikes of 1999-2000 was mild.  There may be some credence to this argument, but as investors we believe it’s important to consider that the end of the last three rate hike cycles (cycles in which the Fed has had an increasingly influential role) presaged significant market corrections.

All that said, if market expectations are correct and the Fed is done hiking and we eventually see a hard landing, does that mean it’s now time for investors to run for the hills?  Not necessarily. If we look at the end of previous rate hike cycles since 1974, the S&P 500 averaged an 8.1% return over the 12 months following the last hike.  Four out of the last five cycles saw double digit positive returns (the exception being the 2000 cycle).

If we are to assume the Fed is done raising rates for this cycle, the S&P 500 has returned 4.75% from the last hike date of 7/23/23 through 1/12/24.  This is below the 8.1% average, implying there could be further upside for equities.

But what happens when the Fed starts cutting rates? 

Things look decidedly less rosy.

Looking again at rate cycles from 1974, once the Fed begins cutting, the S&P 500 has returned an average of 3.4% in the following 6 months.  However, when considering the S&P 500 cycle low from the date of the first rate cut, the average return is -20.5% with a duration of 276 days to the cycle low from the first cut date.

When looking at the data, you can see the gold standard for soft landings occurred in 1995, when the S&P 500 returned 12.6% over 6 months following the first rate cut and saw a cycle low of just -0.5% 13 days after the first rate cut.  On the flip side, the hard landing of the Great Recession saw the S&P 500 return  -15.1% 6 months after the first rate cut and saw a cycle low of -55.5% 538 days after the first rate cut.

So what conclusions should investors draw?  When the Fed concludes its rate hiking cycle and pauses, historically on average, equity markets tend to perform pretty well over the following 12 months.  However, once the Fed begins to cut rates, near term upside for stocks is muted and downside risk increases significantly after the first 6 months.  So, in our view, investors should view a rate cut as a signal to reduce risk across all assets.

Of course, each market cycle is unique and past performance is no guarantee of future results.  Also, 2024 is a year in which there is a presidential election and what looks to be a pronounced uptick in geopolitical conflicts.  These types of events of course can and will influence markets and upend prior narratives.
We continue to believe a well-diversified portfolio with exposure to US and international stocks along with bonds and commodities is a prudent approach to the current market environment.  Should we see a slowdown in economic growth that leads the Fed to begin cutting rates, our approach will be to reduce equity exposure and increase exposure to short term treasuries.

Let us know if you would like to discuss any of the above in more detail.
 
Best,
Louis and Subir

We hope the end of summer and beginning of fall have been pleasant for you and those close to you.

The third quarter saw the emergence of several market dislocations, driven primarily by the impact of rising interest rates on various parts of the economy. Long-term rates in the US jumped in Q3 and are now higher than they have been in over 15 years. The speed of this move has taken many market participants by surprise.  While 2023 has seen the Fed continue to raise short term rates to over 5% (albeit at a slower pace than 2022), the long end of the curve remained well below this level as the market expected rates would go back down in short order once inflation had been tamed.  Q3 saw the market shift away from this view to a “higher-for-longer” thesis, where the expectation is that rates may not be cut for several quarters, or at least not until durable progress has been made on inflation or the economy begins showing signs of slowing.  This reversal in thinking was evident in the move in the 30-year treasury bond.  At the start of Q3, the 30-year was trading at a 3.86% yield (after starting 2023 at 3.975%).   By mid-August it had run up to 4.45% and then, after a brief lull at the end of August, ran through 5% by early October, and has traded in that area since. 
 
This move in long-term rates has had a wide-ranging impact on investment decisions across credit and equities markets. For years, investors seeking income had been forced by very low interest rates to look further afield, in riskier segments of the market.  Traditional income investors could not rely on savings accounts, treasuries or CDs for meaningful yields, but instead ventured into income securities like preferred stocks, high yield bonds, and dividend-paying equities including REITs and utilities.   Now that yields on bonds have returned to meaningful levels, some income investors have switched back to the safety of treasuries and other highly-rated bonds.  This move has put selling pressure on income securities — September saw a notable pullback in defensive sectors like utilities, consumer staples and healthcare stocks.  We expect this pressure will likely continue until it is evident long term yields have peaked.
 
Higher interest rates and wage inflation have hit capital intensive industries particularly hard.  Renewable energy stocks have seen a sizable sell-off as the market expects higher capital costs, material costs and specialized labor costs to eat into profit margins.  While these concerns are warranted, in our view the recent selloff has created opportunities for investors who recognize that the shift from fossil fuels to renewable energy sources is a long term trend.
 
In addition to the impact on investor sentiment, higher rates have also begun to shift consumer behavior. The average interest rate on credit cards stands at 21%, and consumers have responded by trying to pay down balances. Outstanding consumer credit fell by 3.8% in August. All credit-linked markets have been impacted, including real estate, with existing home sales dropping to levels last seen in 2008 (as housing supply wanes and mortgage rates reach 8%). This change in consumer behavior is what the Fed desired when it started raising rates. The Fed Board of Governors were clear that they were taking this action to staunch inflation and reverse what they saw as an associated asset bubble. The risk to investors is that materially higher rates will stall economic activity in a manner that impacts asset prices dramatically. We believe the Fed is determined to control both inflation and limit asset price speculation. This suggests investors should be cautious and the Federal Reserve (for the first time in about 15 years) does not appear to be supportive of a booming stock market.
 
Though there have been several important geo-political events over the past several months, in our view, the most consequential to financial markets is the deterioration in the relationship between China and the US. For the past 30 years, the Chinese and US economies have become ever more tightly coupled, with commingled supply chains across every conceivable industry, from iPhones to rubber duckies. The past several years have seen a steady change in the political relationship between the two countries and this has impacted their economic relationship as well. China remains the US’s largest trading partner, and it has developed several industrial specialties that cannot be easily replicated, including battery technology and certain portions of the semiconductor manufacturing industry. Unwinding the close trading relationship between China and the US will take decades, as it has taken decades to develop. The more acute and immediate risk is that political relationships deteriorate enough to drive a trade stoppage. Such an event would reverberate through markets, creating worse supply chain and production challenges than we saw at the beginning of the Covid pandemic.  Due to the symbiotic nature of their relationship, neither side necessarily wants this outcome, but there could be circumstances that make it unavoidable (an invasion of Taiwan, for example).
 
While inflation has trended downward over the course of 2023, it has not dropped at the pace the Fed, policymakers and investors were hoping.  We expect inflation will continue its downward trajectory, although the wars in Ukraine and the Middle East will likely place upside pressure in the immediate term (war is often inflationary).  We think the Fed may opt to raise short-term rates one more time before the end of the year, depending on how they interpret recent economic data.  Either way, we think the Fed is likely at or near the end of their hiking cycle. 
 
Once long term rates do peak and start to reverse lower, we expect to see those asset classes that have been under the most pressure start to outperform: defensive stocks, small cap stocks and intermediate/long term bonds.  In recent weeks, commodities, and gold in particular, have seen buying as geopolitical tensions have escalated.  We expect gold will continue to perform well if rates fall and the USD weakens. Floating rate bonds, short term treasuries and CDs have been a strong safe haven during recent volatility as yields exceed 5%.   We expect these yields to remain compelling until the Fed begins to cut short term rates, likely sometime later in 2024. 
 
Let us know if you would like to discuss any of the above in more detail.
 
Best,
 
Louis and Subir

We hope you are having a pleasant start to summer. 

Over the past three months, financial market commentary has been driven largely by a focus on changes in interest rate policy and inflation data, with a sidebar on Generative AI (artificial intelligence). We believe interest rate and inflation dynamics will be the primary driving force in determining market movements in the medium term. 

Most Central Banks in the US and Europe have taken decisive action to control inflation. Interest rates in most of these economies are now at 5%. In Canada, the 5% benchmark rate is higher than it has been any time since 2001. In the UK, EU and US, the last time rates were this high was in 2008. Central Banks have signaled the intention to maintain these rates till inflation is brought in check. Though some of the recent readings for inflation look promising, they are still quite high compared to the prior 25 years.

The interest rate environment we are now seeing is good news for savers as CDs and money market accounts are seeing yields much closer to the historic norm in years prior to 2001. Since the mid-90s, most developed country Central Banks have maintained very low or zero interest rate policies for extended periods in response to the tech wreck of 2000/2001, the financial crisis of 2007/2008 and the Covid crash of 2020. An entire generation of home buyers, business executives and investors has spent over 20 years operating in an environment with very low or zero rates. This era is ending and the changes will have wide ranging impacts.

In the UK, Canada and several EU countries, fixed mortgage rates are uncommon. Most home-buyers obtain variable interest rate mortgages with a short fixed period. Millions of home-buyers are beginning to see their monthly housing payments creep up with interest rates. This will have the effect Central Banks want, to reduce the amount of spending in the economy, and therefore tamp down inflation. It will also impact the discretionary income and spending of millions of homeowners.

In the US, a popular Covid-era relief program is set to expire on Sept 1st as 45 million student loan borrowers will once again see interest accrue on their loans.  This policy was put in place three years ago, during the Covid lockdowns, in an effort to give borrowers some budgetary flexibility.  Like the variable rate mortgage payments in the UK, the end of this program will likely have a measurable effect on spending as households with student loans will again need to budget for interest expenses.  While this is bad news for the budgets of these households, this resulting reduction on discretionary spending will likely contribute to the cooling of inflation.

Similarly, business loans and investor margin loans have had very small carrying costs for almost two decades, Businesses looking at investments for growth now have to contend with higher financing costs. Higher margin rates will make some investments unattractive for a group of investors. All of this is designed to reduce the rate of economic activity and its inflationary impact. This will eventually be reflected in the market prices of risky assets.

Despite all this news, the stock market has been steadily rising, shrugging off the market volatility that came after the failure of three notable regional banks in March and May.  Much of the stock buying has been driven by investments in technology companies (a sector that had sold off significantly last year), and more specifically those that have anything to do with the current generation of AI technology. We believe AI is a misnomer for the technology in question. In most instances, it is the next evolution of search and natural language processing, aided by statistical analysis of documents and data made available on the internet. Intelligence, in the sense of critical thinking, is not really a part of the current generation of models. That is not to diminish their usefulness or impactfulness. We have seen very powerful results from some of the generative AI models. The ability to process documents written in human languages and synthesize information from them, has implications for every corner of human activity, including all economic activity.

As with the internet, mobile phones, cloud computing and smartphones, it will take several years for the Gen-AI market to mature. Some of the newer players will not survive, and some existing, larger entities will catch up. We are watching this space, both the core technology and its application quite carefully. However, as is often the case with market trends, the sudden rush of buying has driven valuations far higher than what is warranted and we’re seeing that again with AI-related companies.

As we’ve written in previous letters, if/when inflation is contained and the Fed signals an end to their interest rate increases, we expect risk assets to move appreciably higher.  The Fed elected to pause their rate hikes in June.  While the general market consensus is that they will raise rates again in July, most market prognosticators believe we’re in the later innings of this rate rising cycle.  If inflation data continues to cool, it’s possible that July may represent the last hike.  This, of course, remains to be seen and is dependent on the data.  However, the rally in stocks implies many investors are anticipating this regime change.  

While the Fed’s policies appear to be working to combat inflation, there are often lags in how quickly a change in rates works its way through the economy.  With the unprecedented pace at which the Fed has raised rates (a pace not seen in the 1980’s), it’s likely the Fed risks overshooting and a byproduct of taming inflation could potentially be sending the economy into recession.  There’s no certainty this will happen, but it’s been clear the Fed’s priority has been getting a handle on inflation at any cost before it becomes entrenched.  The thinking being if the economy does go into recession, the Fed can always cut rates to stimulate growth (which has worked in the past), but it has far fewer tools to handle entrenched inflation.

The second half of 2023 should provide a clearer picture on where inflation and rates are headed.  We will continue to monitor the data closely and look for investment opportunities that come as a result.

Best Regards,

Louis & Subir

Dear friends,
The first quarter of 2023 was eventful, baffling and utterly predictable all at the same time. As with all manias, the bubble in crypto currencies finally burst last year and financial markets are seeing the repercussions. Unsurprisingly, the retrenchment in crypto currency prices exposed weaknesses and fraud. Crypto exchanges, service providers and investment funds have failed. Celebrities and others who promoted crypto-currency investments are being sued by investors who have suffered heavy losses. Regulators, who had previously seemed content to let crypto participants “innovate”, have suddenly discovered the virtues of regulation and enforcement, ostensibly their reason for existence.
The rot was deep enough to have impacted the ordinarily staid world of regional banking. Two regional banks associated with technology and crypto finance, Silicon Valley Bank and Signature Bank, found themselves the hapless targets of bank runs. The runs were a result of several factors: high risk lending practices, a large proportion of uninsured deposits relative to other banks, a balance sheet overexposed to long duration bonds and a savvy customer base that were quick to withdraw funds when rumors of potential failure spread. The FDIC placed both banks into receivership, and remarkably, extended deposit protection to all deposits, retroactively erasing the $250k limit on deposit insurance. This extreme step was taken to stem the flood of deposits fleeing regional banks, headed directly for accounts in banks believed to be Too Big To Fail.
The speed with which these banks failed was breathtaking and caught most depositors, investors, regulators and ratings agencies by surprise. On Wednesday March 8th, SVB announced it had sold $21 billion in long-dated bonds at a $1.8 billion loss to raise cash to meet depositor withdrawal requests. SVB also announced they would raise $1.75 billion in capital via common and preferred stock sales. By Friday March 10th, just two days later, the FDIC had taken over the bank and placed it into receivership. The stock never traded that day and was frozen at $106.04 per share, the price it had closed on Thursday. That day, the ratings agencies S&P and Moody’s, presumably blindsided by the collapse, promptly lowered their credit ratings for SVB from investment grade BBB and Baa1 to D and C (respectively). By Sunday March 12th, Signature Bank suffered the same fate as the FDIC placed the bank into receivership with the stock frozen at $70 per share. Moody’s and Fitch responded by lowering their ratings from Baa2 and BBB+ to D and C (respectively). In most cases, when a bank is at risk of failure, the market sniffs it out and there is time (weeks and in some cases months) for investors to position themselves appropriately. In this case, the failure was so swift the market and investors were largely unprepared (as evidenced by the levels the stocks were last trading at).
The banking crisis wasn’t limited to the US alone. Over in Europe, on March 19th one of the world’s most storied banks, Credit Suisse, was ignominiously sold to its chief competitor UBS in a weekend deal enforced by the Swiss government. This action broke all sorts of convention, shaking up the markets again.
Though we understand the reasons for some of the extraordinary steps undertaken by regulators and authorities, we do wonder whether some of this might not have been avoided. As anyone who has watched the classic “It’s a Wonderful Life” knows, no bank can survive a crisis of confidence. Once fleeing depositors reach a tipping point, a bank is no longer a going concern. Deposit insurance was designed to reduce the likelihood of runs and protect smaller
depositors who might lack information on the health of their bank and would be at a disadvantage to more sophisticated depositors. In SVB’s case, the bank’s business model had two Achilles heels. First, it relied on large depositors (tech startups and tech entrepreneurs), whose accounts were not covered fully by FDIC insurance. SVB also held a portfolio of long dated treasuries, which lost substantial value due to rising interest rates. Banks are allowed to carry loans and bonds at par on their books if they intend to hold them to maturity. Once the run started, SVB was forced to liquidate some of these bonds to meet withdrawal requests causing it to recognize the losses. This was the death knell, with the bank run accelerating as soon as SVB’s large depositors became aware of this dynamic.
On March 12th, in an effort to stabilize the banking system, the Fed took the unprecedented step of creating a new liquidity facility called the Bank Term Funding Program (BTFP) which allows banks to pledge longer dated treasuries for immediate liquidity at par. The hope is this facility should help prevent similar bank runs from occurring. In the subsequent weeks of this facility’s establishment, there have been no further failures in the US and the banking sector has shown signs of stabilizing. That said, while the cause of these bank failures is very different, we are reminded of the early days of the Great Financial Crisis when the prevailing wisdom was that the failure of a few smaller, over-leveraged financial institutions was an isolated incident that would not cause wider financial contagion. We’re not predicting a repeat of the 2008 cataclysms. However, ten years of zero interest rate policy has indulged a great deal of speculation in various markets, and we believe vigilance remains the prudent route.
Despite the current turmoil, markets have been remarkably resilient with both stocks and bonds posting positive returns for the first quarter. Large cap technology stocks, which took a beating last year, have rebounded and were the equity safe haven of choice for investors fleeing bank stocks in March. We’ve also seen both gold and silver perform well, which is to be expected when there is a crisis of confidence in the banking sector. Short term rates have crept higher as the Fed continues its ongoing battle to stop inflation before it becomes entrenched. This has created a great opportunity for cash investors as yields on short term CDs, treasury bills and money market funds approach, and in some cases eclipse, 5%. These are yields investors have not seen in over 15 years.
While 2022 saw a major correction in risk assets (with speculative assets taking the greatest hit), we don’t believe the asset bubble has fully deflated. We expect 2023 to be volatile as the Fed continues to grapple with inflation and maintain our preference for quality assets – highly rated bonds and equities with strong balance sheets in defensive sectors. With volatility comes oversold conditions and buying opportunities which we will look to take advantage of.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We hope you’ve had a chance to spend some time with friends and family over the holidays.
As we begin 2023, many investors are looking back at 2022 as a year they are more than happy to see come to a close. 2022 broke a multi-year streak of positive returns for equity markets with broad indices finishing in firmly negative territory. Speculative growth stocks were hit hardest as momentum investors reversed course and sold many high-flying tech and recent IPO companies. The S&P 500 finished the year down nearly 20% while the tech-heavy Nasdaq Composite was down almost 33%. International stocks didn’t fare much better as the MSCI World Ex-US Index was down nearly 17%. And the bond market, typically a safe haven during stock market selloffs, had one of its worst years on record as the Bloomberg Aggregate US Bond Index was down approximately 13%.
The immediate cause for this across-the-board drop is the trajectory of interest rates, as the world confronts inflation levels not seen in decades. US rates started 2022 at nearly zero and ended the year at 4.5%, a remarkable pace of increases in a very short time period. Several other central banks also raised rates in an effort to rein in inflationary pressures. Acting belatedly, but with determination, central banks have taken away the easy money punch bowl put in place in the aftermath of the Great Financial Crisis, ending one of the longest bull market rallies in history.
Last year, we wrote about the risk in speculative assets and how many were trading at unsustainable valuations, appearing vulnerable to a market correction. The rapid rise in interest rates created an environment ripe for mean-reversion as investors bailed on these assets almost as quickly as they had bid them up. The ARK Innovation ETF (ARKK), a much followed barometer for speculative growth stocks, was down nearly 67% in 2022. Cryptocurrencies, rocked by several high-profile scandals and bankruptcies (FTX, Block-Fi, Voyager and Celsius) also saw steep losses. The Bitwise 10 Crypto Index (BITW – a fund comprising the 10 largest cryptocurrencies) fell over 68%. SPACs (special purpose acquisition companies) – quasi IPO companies taken public via mergers that had become popular in recent years – were also clobbered. The AXS De-SPAC ETF (DSPC) was down over 73%.
So what did well in 2022? Despite the broad carnage, there were a few bright spots. Defensive sectors did ok, with healthcare and consumer staples down slightly, while utilities were up slightly. Rising energy prices boosted energy stocks and commodities, with both asset classes posting their strongest returns in years. Rising interest rates benefitted floating rate bonds, money markets, and cash. The USD, riding the wave of higher interest rates, was up nearly 8%, its best return since 2015. Gold and silver also held up well, posting slightly positive returns.
And while investors are hoping 2023 brings stability to markets, the last two weeks have reminded us that several non-economic factors have the potential to create further turmoil. The Chinese government suddenly reversed its policy on Covid isolation, leading to a sharp increase in the number of cases. This has placed stresses on the Chinese health care system that are similar to those experienced in the US in 2020 and 2021. It has also impacted several industries within China, where a large number of workers are absent. The re-opening of the Chinese economy will also likely put renewed pressure on commodity prices, which only in
recent months had started to fall. The recent US midterm election has left the House of Representatives in a very delicate balance. The possibility that a financial crisis might originate with action or inaction in the House of Representatives is distinctly higher than it was prior to this election (debt ceiling negotiations are already set to be a battleground). The political situation in several South American countries is quite tenuous, with Peru and Brazil in the headlines. Both countries are major producers of raw materials for industry and agriculture. The Ukraine war enters its second year without a clear path towards resolution. The potential for negative exogenous shocks to the global economy are higher than usual.
That has driven the World Bank to reduce its global growth forecast to below 2%, one of the lowest projections since the 1990’s. Most larger US-listed companies operate globally, and will be impacted by this slowdown in global growth. We have already begun to see businesses focus on cost reduction in a form that we haven’t seen for several years. While times were good and order books were brimming, weaker business models could limp along. We expect 2023 will be a year of reckoning for aging or obsolete product lines, with corresponding impacts on revenues and earnings, as well as an uptick in bankruptcy filings.
We expect the US Federal Reserve to continue its tight monetary policy through the middle of this year, albeit at a slower and more guarded pace. We expect rates to rise another 50-100 basis points, depending on inflation data. The impact of the past raises has not yet been felt by all enterprises, but it will reverberate through the entire economy over the coming year. Higher than expected rates will continue to place a drag on businesses for 2023, and we expect to see a visible impact on earnings, which have thus far been remarkably stable. This has the potential to lead to more selling of risk assets. That said, if we see inflation tamed and the Fed pause or reverse course on their interest rate policy, it’s likely markets will rally. It remains to be seen whether this rally would be short-lived or a sustained change of course for markets.
We continue to advise cautious allocations to risk assets as part of balanced portfolios. We have begun to see more reasonable valuations in certain sectors, notably technology. International and emerging market stocks with strong balance sheets are starting to look more compelling for long term investors, especially if we see weakening of the USD. After last year’s route, entry points for high quality bonds of short and intermediate duration look good. We believe gold and silver remain important components of a diversified portfolio in the current environment.
In general, though, froth and speculation remain in several sectors, and we aim to be selective in our investments, focusing on quality businesses that can weather an economic downturn and have long term potential for sustainable growth.
Let us know if you would like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
The 3rd quarter saw the US markets continue to be dogged by persistently high inflation with levels not seen since the early 1980’s. The underlying cause is partly lingering supply chain issues with a large contribution (over 60%) coming from energy and auto-related costs. Some of the supply chain issues (which began cropping up post-Covid lock downs) are now related to the on-going war in Ukraine. Dovish market observers and economists have vocally opposed the Fed’s aggressive interest rate policy response, claiming (not without merit) that the inflation figures are being driven by exceptional factors. Thus far, these arguments have not swayed the majority of voting members among the Fed board and 2022 has seen rates rise at a much steeper pace than the Fed themselves had projected just last year. The Fed has indicated a commitment to raising rates until they see inflation drop substantially from its current levels. Since unemployment remains at very low levels, there is little (barring a liquidity crisis) to stop the Fed from continuing on this path.
Elevated interest rates negatively impact credit-dependent businesses as well as stock/bond markets. They also impact public finances, since governments of all sizes have to pay more to borrow. Corporate borrowers also spend more on servicing debt, and marginally profitable projects get shelved when the cost of financing them rises. Consumers are also hurt as mortgages, auto loans and revolving credit lines become more costly, thus curtailing spending. All of this impacts corporate earnings, which will almost certainly drop from cyclical highs as the impact of rate rises is felt across industry.
In addition to inflation, we see several other signs to discourage aggressive risk taking. We have begun to see early indications of a drop in business activity. Certain US sectors such as real-estate, which are particularly credit dependent have slowed dramatically. US Job postings have dropped precipitously, though there continue to be far more job openings than in prior years. The IMF(International Monetary Fund) published a report indicating they now expect a global recession in 2023. The IMF’s Global Financial Stability Report indicates that the stability of global financial markets has “materially worsened” and markets face a higher likelihood of “disorderly pricing”. The US Treasury publishes an indicator of financial stress, which has been rising (albeit from very low levels) over the past few weeks. All of these indicators combine to raise risks for investors.
The lack of clarity around inflation as well as the potential for the Fed’s response to drive the economy toward recession has resulted in substantial selling in both stock and bond markets, with the bond market (through the first three quarters) posting one of its worst years on record. We expect to see continued volatility in both markets until investors see
definitive data suggesting a cooling of inflation and/or a pause/reversal of the Fed’s interest rate policy. If and when markets see a shift in policy, we expect stocks and bonds will rally sharply. However, there remains the risk that elevated inflation could become entrenched (which the Fed is aggressively fighting), in which case stocks and bonds would likely remain under pressure.
While market volatility can resemble a dizzying roller coaster ride, it often comes with opportunity. Bear markets can cause investors to act impulsively and sell assets indiscriminately in response to short term market conditions, without considering the long term. This leads to quality assets priced at discounted levels, levels much lower than an investor would typically find during a bull market. We continue to recommend a defensive allocation (due to the risks outlined above), but with an eye towards shifting money towards risk assets as prices fall further and entry points become compelling. Our long term outlook for the global economy remains positive and we expect patient investors will be rewarded.
Let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We hope you’re enjoying a pleasant summer with friends and family.
As we enter the third quarter of 2022, we are reminded of Lenin’s words on the Russian Revolution: “there are decades when nothing happens, and weeks when decades happen”. Events in the last three months have certainly fit into the latter category.
Earlier this year, the Russian invasion of Ukraine led to remarkable actions by financial and commercial institutions allied with the EU and US. As the war has dragged on, it is increasingly clear that the EU and US will not directly engage Russian forces, which reduces the immediate risk of this war drawing in many other actors. The tragic reality for Ukraine is that it is likely facing a loss of territory which will impact about half its population. The longer term lesson that all small/mid-sized countries will likely learn from this is that the only true deterrent for larger hostile nations is independent nuclear weapons capability. The treaty obligations made by Russia when Ukraine dissolved its nuclear weapons program in the 1990s aren’t worth the paper they were written on. The assurances made by the EU and US to Russia on the cusp of the breakup of the Soviet Union have been broken in both spirit and word.
In terms of impact to global markets, for now they appear primarily limited to the energy sector which has seen further supply issues. Equity investors exposed to Russia are directly impacted, but given Russia’s limited output and energy concentration, the short term direct impact remains minimal. Commodity prices have also been impacted, most notably oil/natural gas and wheat (Ukraine produces approximately 10% of the world’s wheat). This in turn has put additional short term pressure on inflation.
US financial markets have much broader issues to absorb and deal with. The weeks before the official start of summer saw every major US stock market index slip into bear market territory (defined as a 20% drawdown from the index highs). This was presaged by sharp, steep declines in the most speculative assets such as crypto-currencies and related tech. The onset of summer and a seasonal drop in trading has temporarily halted the declines, but the underlying causes have not disappeared and we suspect markets will continue to experience sharp volatility in the coming months.
We now have several months worth of inflation figures at levels we have not seen for decades. The Federal Reserve has telegraphed its intent to raise interest rates until inflation is under control. Their target rate for inflation is 2%, while inflation currently stands at approximately 9%. The risk of increasing rates too quickly is that it could drive the economy into recession. However, given where unemployment levels are (still historically low), it appears the Fed is more concerned with runaway inflation than recession risk. The thinking being they can always reverse course with rates once inflation is more manageable. Industries most sensitive to interest rates (mortgage origination and speculative new home construction among them) are experiencing sharp declines in revenue and canceled orders. In financial markets, speculators and corporate insiders who
have borrowed against stock, find themselves exposed as prices fall and the cost of carrying margin debt rises. This is a vicious circle that can lead to rounds of forced selling.
Since inflation concerns are driving the Fed’s aggressive policy moves, if inflation slows meaningfully, we could see the Fed pause to take stock. In this scenario, we would likely see both stocks and bonds rally (though this may be a shorter term relief rally). Intermediate and long term bonds are pointing towards such a pause in rate hikes. The closely watched 10-year treasury is back under 3% after nearly touching 3.5% in June. This suggests bond investors don’t expect interest rates to remain elevated long term.
This bear market comes at the end of a nearly 40 year long secular decline in interest rates and sustained low inflation. These trends were coincident with very large labor pools in Asia being integrated into the global economy. The deflationary impact of adding hundreds of millions of workers across Asia to the global industrial and services labor market seems to have run its course. Anecdotally, we are seeing salaries for remote service workers approaching rough global parity. This is likely to mean better conditions and more bargaining power for workers in the long run. In the short term though, the inflationary pressures will likely mean higher labor market volatility, including elevated unemployment. Similarly, an improvement in labor conditions and wages will lead to more sustainable and better quality corporate earnings. In the short term, it means increased market volatility.
Corporate earnings remain at cyclical and all-time highs for large capitalization stocks. Despite the recent declines, price/earnings ratios are not yet close to past cyclical lows. When we look around for signs of a bottom, they are scarce and distant. Our expectation is that the markets will remain volatile and further declines remain likely. We continue to advocate for defensive portfolios incorporating high quality stocks, short term/floating rate/inflation protected bonds, commodities and precious metals.
On the other side of this bear market lies another bull market and we will continue to keep an eye out for investment opportunities as they appear.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
The first three months of 2022 have been very eventful in global affairs. The concerns surrounding the global spread of the Omicron variant have faded and been replaced with the surprising invasion of Ukraine by Russian forces followed by the unexpectedly robust retaliatory economic sanctions imposed by the US and EU. As with all such conflicts we hope it ends quickly with minimal further loss of life and suffering.
Russia’s invasion and the response it has engendered will likely have a long term impact on global finances. Within the span of days after the invasion, in a move that surprised many political pundits, Russian entities were shut out of the global payments systems. Credit cards issued on major networks stopped working and banks lost the ability to settle US dollar payments. The size and scope of the sanctions along with the widespread denunciation of the invasion (led by US and EU nations) seemed to have caught Russia off guard as prior Russian-led conflicts (Georgia, Donbas, Annexation of Crimea) had not been met with such unified opposition. Despite all this, EU markets continue to purchase Russian conventional energy, a position that appears increasingly farcical as other sanctions are strengthened.
In response to these measures, over the long run, we believe major economies outside North America and the EU will develop parallel financial systems to insulate themselves from any such punitive sanctions. The hand-wringing over the demise of the dollar as a global currency is probably exaggerated (that will likely not happen over the next two decades). But eventually we believe other currencies will play a larger role in global trade. This is to be expected and is a dynamic similar to the one that occurred over several decades when the British pound was replaced by the US Dollar as the primary means of international settlement in 1944. In the short term, there is no other major economy with a stable currency that can serve such a purpose since most aspirants (apart from the Euro) are either too small or have some form of capital control to limit currency fluctuation. The Swiss Franc has historically been a neutral alternative, but Swiss participation in the recent sanctions partly undercuts this role in the future. The Euro meets the size and stability criteria, but the Eurozone’s close alliance with the US is similarly likely to give other major countries pause when considering it as a backup. Physical gold has historically been a medium of last resort, but these sanctions have targeted Russian central bank gold reserve holdings as well as currency. This makes it less likely that non-allied countries will maintain large gold reserves in US/EU financial centers. It’s not unreasonable to say that blockchain concepts will play a role in any newly developed payment networks. We think it is unlikely that major central banks adopt one of the existing, independent crypto payment networks. They are far more likely to develop a new system/currency using the same technology as the early independent networks.
Both China and India have been moving towards developing independent payment networks for small and large transfers. We see this trend accelerating and the decades-long uncontested primacy of US/EU systems and networks will likely fade. This was, of course, bound to happen at some point as the locus of economic activity moves back towards Asia.
On the economic front, Q1 saw the US record inflation figures at levels not seen for decades. Some of this is due to a spike in energy prices and other dislocation in global supply chains. Regardless of cause, the hike in price levels likely spells trouble for both equities and bond markets. The Federal Reserve is poised to embark on a series of quick interest rate raises, coupled with a rapid reduction in its balance sheet. These moves would shift a virtually uninterrupted 16 years of easy money policies. The combination of inflationary pressure and rising rates are likely to have a larger impact on long-tenured instruments such as long-dated bonds and speculative growth stocks.
While the economic environment seems primed for rates to run higher, the Fed does have a recent history of pivoting on rate hike policy. 2019 saw the Fed reverse course after raising interest rates steadily over 2017 and 2018. The Fed made three rate cuts in 2019 (Trump’s trade war was referenced as a reason) and then slashed rates again to 0 in 2020 when the Covid-19 pandemic took hold. If inflation ebbs, the economy falters or demand slackens, we could see the Fed backtrack on their rate tightening plans.
While stocks and bonds have gotten off to a rough start in 2022, alternative assets such as commodities and precious metals have performed well. Value stocks in industries such as utilities and energy have shown positive returns on the year while speculative technology companies are deeply in the red. We continue to recommend a defensive, diversified
portfolio that is weighted towards value stocks over growth. With interest rates rising in anticipation of the moves from the Federal Reserve, we’re starting to see some compelling opportunities in the bond space. Tax free municipal bonds are starting to look interesting
again for the first time since the bond market upheaval in Q1 2020. While many speculative growth stocks have come down considerably in price, we still think there remains risk for further downside. We expect volatility to persist in 2022 and will continue to look for opportunities in stocks and bonds as they present themselves.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We hope you and your family have enjoyed a restful holiday season and a good start to 2022.
For investors, the new year comes with many continuing questions around trends in public health, government monetary policy and the rising cost of goods and services.
Perhaps weighing most heavily on investors’ minds is the recent surge in Covid Omicron cases. In the US, we are now seeing the highest number of weekly cases documented since the pandemic began. Globally, the US and EU appear to be the most heavily impacted in terms of case numbers. East Asian countries that have adopted immediate, effective lockdowns and mandatory isolation to reduce community spread are seeing smaller rises in new infections. Despite vaccines and various protective measures, this fast mutating virus remains with us and retains the capacity to cause widespread public health damage and economic disruption. Thus far, US markets have had a muted response to the new wave of infections, largely driven by the reluctance of state and federal governments to impose any form of lockdown to stall community spread.
The Covid crisis has, in many ways, made a lasting impact on the global investment landscape. Most white collar workers have now spent much of the past two years working from home. Technology usage in most businesses has accelerated, which has prompted investors to bid up prices for technology stocks to nose-bleed levels, with many trading at multiples of earnings not seen since the tech bubble of the late 1990s. There continues to be a long-term case for investing in technology stocks, but as with most investments, the levels at which you buy can often make the difference between profit and disappointment. At current levels, it is difficult to make a value driven case for most large, publicly-traded technology companies.
Tesla, in particular, is an extreme example. It is currently trading at a market cap that makes it more valuable than the 10 largest auto-makers combined. Those 10 automakers generate roughly 50 times the revenue that Tesla does, and each has an electric vehicle offering. Though Tesla has a devoted client-base willing to pay a premium for their product, it does not enjoy a meaningful technology edge, even in the premium car market, where German and Japanese car makers will offer stiff competition in the near future. Along similar lines, Zoom Communications offers a cautionary tale for speculative growth investors. When the effects of the pandemic were first being quantified, Zoom appeared unassailable and its stock price rose very quickly. In response, larger competitors strengthened their offerings, and as a result of this increased competition plus a decline in investor enthusiasm, Zoom is now 70% off its high from 2020. We’re starting to see similar trajectories for other high growth speculative tech names.
In general, equity multiples remain at elevated levels despite a remarkable surge in earnings during 2021. The broad S&P 500 index is trading at nearly 30 times the past 12 months earnings. The average multiple historically has been closer to 15. Corporate earnings are themselves at elevated levels, which implies even higher risk. If earnings and P/E ratios both revert towards the historic mean, prices would decline further and faster than if it were just one of these factors impacting markets.
In our view, it looks increasingly certain the Fed will follow through with its plan to raise interest rates this year. With unemployment under 4%, and the most recent CPI (inflation) reading for December registering at 7% –the fastest pace since June 1982– we see no conventional impediments to the Fed tightening rates. This of course means we will likely be entering a rising interest rate environment for the first time since late 2018. As a result, the support equity markets have enjoyed from rock-bottom interest rates will disappear. Investors holding long-dated bonds should expect some deterioration in the value of their holdings, as long-term rates generally rise alongside the short-term Federal Funds rate.
Underlining the anticipated rise in interest rates is the growth in debt issuance across the world. During the Covid pandemic, the US Federal government has added over 5 Trillion in debt. This is the sharpest rise in the past 30 years, though the trend has been steadily upwards. In 1990, US Federal debt stood at under 4 Trillion. 30 years later the US government has borrowed over 28.4 trillion. Debt as a percentage of GDP has risen during the pandemic as well, from 108% to over 120%. This is the highest it has ever been for the US. Other large economies have seen similar increases in debt levels during the pandemic, including China, the EU and India. Meanwhile, interest rates have remained below inflation in much of the world, minimizing the cost of servicing this debt. As rates adjust to more normal levels, public finances will need to be modified as well. In many countries this will lead to a search for revenues in the form of increased taxes. Higher tax rates would reduce corporate earnings, placing additional pressure on stocks.
We continue to recommend maintaining balanced portfolios, with a bias towards lower risk. Given the uncertainties we face and very high levels that equities are currently trading at, we advise investors to remain cautious and avoid the temptation to aggressively jump into what appears to be a very late-stage bull market. When bull markets break, they typically provide opportunities for investors to purchase high-quality companies at discounted prices.
With interest rates likely to continue rising this year, bond investors need to evaluate the maturities and duration in their bond portfolios. We recommend trimming longer term bond exposure and adding to shorter/floating rate bonds.
We expect 2022 will bring increased volatility in both the equity and bond markets. We think this volatility will also present compelling buying opportunities for investors in both markets.
Disclosure: Neither Subir nor Louis hold Tesla (TSLA) or Zoom (ZM) in their personal accounts. Tesla (TSLA) or Zoom (ZM) are not held in any discretionary portfolios at WSCM. Tesla (TSLA) is held in non-discretionary accounts at WSCM while Zoom (ZM) is not.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We hope you and your family have enjoyed a pleasant summer.
The third quarter began with risk assets continuing their relentless march upwards as US stock indices touched all time highs at the end of August. September, however, saw a bit of a reversal as the S&P 500 fell by approximately 5% on the month. Bonds also saw selling as the Bloomberg US Aggregate Bond Index dropped by approx 1% in September. A market where stocks and bonds sell off concurrently is a bit unusual (investors typically flock to the safety of bonds during times of stock selling), so what caused this to happen?
In our view, a shift in the Fed’s stimulus and interest rate policies are mainly responsible. The Fed has indicated they plan to begin raising rates next year and expect to taper their bond purchasing program later this year. Some market observers believe the Fed’s hand is being forced by recent inflation data, which appears to be more significant than transitory supply chain imbalances. If inflation continues to rise, the Fed’s accommodative policy response to the Covid-19 pandemic no longer seems prudent
(and may actually make things worse), warranting a change.
We believe these factors are primarily responsible for the recent volatility in stocks and bonds. The Fed’s bond buying program has provided ample liquidity, leading stock investors to rely on the Fed’s continuing support. In March 2020, the Fed’s announcement of a massive bond buying program signaled the market bottom. Conversely, if Fed liquidity goes away or is substantially reduced, stock investors would see it as a signal to reduce exposure to risk assets, hence the selling. Bond rates meanwhile have remained artificially low with the Fed’s 0% interest rate policy and monthly bond buying providing a constant bid for bonds. If the Fed’s bid goes away, then bond yields will revert to a market determined level which, given recent inflation data, could be considerably higher.
The threat of higher interest rates is also starting to drag on the technology sector, which has been the best performer coming out of the Covid-19 market correction. In recent years, Big Tech has become the juggernaut driving returns for the S&P 500. In fact, at the end of Q3, the top five companies by market cap were all tech names (Apple, Microsoft, Amazon, Google and Facebook) comprising nearly 25% of the index. This is an enormous number, illustrating how an index of 500 components has become top-heavy and concentrated. The last time the S&P 500 was anywhere close to this level of concentration was in 2000, at the height of the tech bubble, when the top five companies represented 18.2% of the index. You’d have to go back to the 1960’s, when the US economy was a very different animal, to find a number higher than 25%. While high concentration doesn’t necessarily portend a market correction, it can lead to a shift in investor sentiment. And the Fed’s change in interest rate policy may stoke that shift. Big Tech companies, like other growth stocks, are more sensitive to rising interest rates since their high multiples are based on the growth of future cash flows. When rates rise, the value of that cash flow is discounted. As a result, investors may lose their appetite to speculate on high multiple tech stocks and instead reallocate to value stocks which are trading at more reasonable valuations.
Shifting now to international markets, a story that made headlines in the third quarter was the emerging crisis in Chinese real estate. For the past 20 years, China has enjoyed tremendous growth in the construction and property sectors. Much of this is underpinned by real need as a large population migrated from rural areas to cities. But as is often the case during times of rising asset prices, the real growth has been supplemented by pure speculation. For years, we have observed these excesses without any real sense of whether they might come to a head. In the past month, two major Chinese real estate companies, Evergrande and Fantasia, have defaulted on debt obligations. The assumption among foreign investors has always been that the Chinese government would not allow such a critical sector to suffer widespread failure. That assumption is being tested. The response from China’s financial authorities so far appears to be to retreat behind the veil. The domestic listed securities of both companies have been suspended and there is no indication as to when they may resume trading. As China’s real estate sector has ballooned, various financial instruments have grown in its share to fund the enormous level of investment. A significant portion of this is held by households. All of which makes for an explosive situation, not dissimilar to classic bank runs. It remains to be seen whether this crisis spills over to China’s larger economy and impacts global markets, so we’re monitoring the situation closely.
As we head towards year end, we continue to maintain a cautious outlook and recommend moderate allocations to risk assets. While growth stocks look overvalued to us and could be at risk if we see interest rates continue to rise, we do see opportunities in value stocks. We think if inflation continues to run hot, commodities, inflation-protected bonds and precious metals will be prudent portfolio diversifiers. For long term investors, we think renewable energy stocks and emerging markets offer good risk/reward.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We trust you and your family have stayed healthy and are enjoying the summer thus far.
The second quarter saw major stock market indices maintain an almost uniformly upward trajectory. In our view, this expansion has been driven by three primary factors:
1. A recovery in business earnings
2. Accommodative fiscal policy
3. Expansionary monetary policy at the Federal Reserve
Earnings of large American companies have indeed rebounded over the past few months, almost retracing the steep 35% decline in earnings seen during 2020. Consumer and business spending have made up for lost time during the gradual reopening of the US economy. The future path of earnings though, is far from certain, as are the long term prospects for several companies, and even entire industries. This has not stopped investors from pouring money into the stock market at a record-shattering pace. According to data compiled by Bank of America, 2021 US equity inflows project to annualize at $1.178 trillion which would blow away not just any previous year, but the cumulative equity flows for the past 20 years ($777 billion). Other measures of equity market frothiness are also flashing major warning signs, including the amount of margin debt outstanding, which is at all time highs. These heady levels have not gone unnoticed by corporate issuers. IPO offerings are at record levels, with companies rushing to sell shares into a market eager to buy.
When viewed in historical context, current equity levels stand out as outliers on both valuation and technical levels. So it’s clear earnings and market dynamics alone are not telling the complete story.
The second major driver of equity froth is the enormous amount of government stimulus that’s been pumped into the system. US fiscal policy remains exceptionally accommodative as legislators rightfully express continued concern about the impact the pandemic has had on both consumer and business finances. Our expectation is that federal support for unemployment benefits and other support for consumers and businesses will continue at elevated levels, as will aid to local governments. Though not their primary purpose, these actions have in effect buoyed the equity markets, by putting a floor under household income and by extension business revenues in several sectors.
Monetary policy is the third pillar that has supported stock valuations. The Federal Reserve has made large dollar amounts available to the banking system. M1, the basic measure of money supply was expanded to include money market accounts in May 2020. This led to a vertical rise in the graph below, which we can ignore. However, M1’s growth has accelerated as the Fed has bought treasuries and other debt instruments with dollars, expanding its balance sheet and injecting those dollars into the system. You can see this in the slope of the graph below, beginning in March 2020 and continuing till today.

The Fed balance sheet now stands at over $8 Trillion, twice what it was less than 18 months ago. That means the Fed has injected $4 Trillion dollars into the US monetary system, a multiple of that when we consider the velocity with which money changes hands. Many of those dollars have found their way to the stock market as noted above.

The Federal Reserve has also continued to keep long-term interest rates at historic lows. Though unemployment rates have come down sharply from a record high, the Fed remains focused on improving the employment picture. We believe the Fed has recognized this pandemic is restructuring the US labor force in more fundamental ways, which has led it to be more cautious around raising rates. The civilian labor force participation rate has been on a downward trend as the baby boom generation ages out of the workforce, with many older workers retiring earlier than planned.

As workplaces have reopened, several million American workers have thus far remained out of the workforce, neither returning to old jobs, nor looking for new work. This is a secular shift in the US labor market, and will affect long term productivity and growth rates. These changes, along with other shifts, will impact other facets of the economy, including productivity. That said, there are some indications that the Fed is considering increasing rates in 2022, which is a year sooner than it had previously communicated.
The Fed has a dual mandate, to support full employment and control inflation. Housing costs are the largest component of the consumer price indices and the single largest expense for households. Single family home prices have been bolstered by low interest rates and an increased interest in such properties from financial investors. This has moved housing costs upwards for households buying homes over the past year. We have seen anecdotal reports of rents rising sharply in many parts of the country, particularly smaller cities that have seen an influx of telecommuters from coastal metropolitan areas. These anecdotal observations are borne out in the data, the housing price index trend line has recovered and become steeper in the past few months. Food prices have also begun to trend upwards. The primary gauge of inflation in the US is the consumer price index, which measures costs for a basket of goods and services used by an average US household. The CPI recorded its highest reading in 30 years earlier this summer, suggesting prices in May and June 2021 rose at an annualized 5% rate. If similar data continue to come in, we should expect the Fed will begin to raise rates sooner than anticipated.

If inflation were to rise suddenly, we would expect the bond market to react quickly. Long term rates would rise, and bond prices would move sharply lower. Bond investors have been remarkably sanguine in this era of historically low yields, lulled into complacency by very low levels of inflation. We have not seen long term rates over 5% since 2006, and inflation has remained below 5% for at least as long. If inflation expectations were to rise, bondholders would quickly face the prospect of negative real returns. In such a scenario, borrowing costs for businesses and governments would rise sharply, negatively impacting earnings. Our view is that the stock market will anticipate these events and sell off if it becomes clear that inflation is materially higher than it has been in the past 2 decades. Given the heady heights the stock market has attained, the sell off would be remarkable.
In our view, the Fed has been too lax in allowing such a bubble in risk assets to develop. By keeping rates at extraordinary low levels for over 15 years, and engaging in outsized asset purchases, the Fed has again allowed a dangerous situation to develop in asset markets, which could have an impact on the real economy. That said, the blame cannot be placed on the Fed’s shoulders alone. The US is an outlier among industrialized nations in having a very weak set of social service programs. Even these are not uniformly implemented, with many states further undercutting an already weak safety net. Over decades, several administrations and Congress have allowed these programs to atrophy. Instead of funding social programs, they have leaned on the Federal Reserve to maintain very loose policy. To put us back on a sound, sustainable footing, we will need to see the balance between fiscal and monetary policy restored in the US.
Looking ahead, we continue to advocate for cautious allocations in investment portfolios, with lower risk allocations than investors would take on in ordinary circumstances. There are strong indications that we are towards the end of a bull market for both equities and bonds. We view speculative growth/momentum stocks to be most at risk on the equity side and long duration and high yield bonds most at risk on the fixed income side. We continue to prefer value stocks over growth (despite value being out of favor in the current market) and view precious metals, commodities and inflation protected bonds as good diversifiers and hedges against potential inflation risk.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear friends,
We hope this spring has brought you and your families a welcome respite from what was a hard, and isolating winter for many.
As we look forward to the course of this year, most observers are cautiously optimistic that the impact of the COVID-19 pandemic will steadily fade. As the pace of vaccinations has picked up in the US, so have expectations about an economic recovery. The impact of the additional stimulus bill passed by the new Congress has further driven optimism about the prospects for the US economy. Most equities analysts have chosen to write 2020 off as an outlier. Larger, public companies in many industries have managed to get through the past year largely unscathed, mainly due to the various fiscal and monetary measures put in place to aid them.
It appears as if the monetary stimulus in particular will remain in place for longer than some market observers view as necessary. Senior Federal Reserve officials have indicated the Fed has no plans to raise interest rates or amend its asset purchase program until 2024. This means bond investors can likely expect two+ years of stable, low short term rates. However, yields on intermediate and long term bonds have steadily crept up in 2021 driven by two factors: the recent sharp rise in commodity prices and the $1.9 trillion stimulus bill passed in March (with trillions potentially more on the way via an infrastructure bill). The rise in commodity prices signal higher inflation which some market participants think will cause the Fed to respond with an interest rate rise sooner than expected. The stimulus bill requires enormous amounts of treasury issuance to pay for it, and this influx of supply is causing longer term rates to rise. While this may end up being transitory and bond yields could settle back down, there is a chance that the Fed has not properly anticipated the possibility of a sharp rise in inflation and the glut of treasury supply may compound the issue for bond investors. Even with the recent rise on the mid/long end of the curve, bond yields remain low and we expect these lower yields and the possible risk of yields climbing higher from here to drive more bond investors into equities.
While equities may look attractive to bond investors smarting from rising yields, it has become an increasingly crowded trade. According to data compiled by Bank of America, more money has been invested in equity funds over the past five months than the previous 12 years combined. In dollar terms, that’s $569 billion flowing into global stock funds since November 2020 compared to $452 billion invested over the entirety of the 2009-2020 bull market. This kind of investment behavior is what markets tend to exhibit during manias as investors rush in to buy at any price. Though there are reasons to be optimistic about the potential for economic recovery, we believe the outlook for equities is far less certain. Equity investors today face prices that are at multi-decade highs, the prospect of higher corporate tax rates, an uncertain global vaccine rollout, and the possibility that a resurgence of the pandemic impacts critical sectors again.
The prevailing sentiment in the US is that the worst impact of the pandemic is behind us. That is not true for much of the rest of the world, however. COVID-19 cases continue to rise
in several countries and public health officials have responded by instituting closures to contain the spread. International travel remains uncommon and arduous in most parts of the world. The global economy continues to be susceptible to risks related to the pandemic. As stock markets globally are at or near all-time highs, equity risks are compounded by very high valuations. Historically low interest rates and the inflation outlook create similar conditions in bond markets.
With short and medium term market conditions so uncertain in both bond and stock markets, we advise investors to maintain defensive allocations. While risk assets may continue to rally on the back of continued easy monetary policies, valuations look stretched and risk/reward does not appear to be favorable. We still see some pockets of opportunity in value stocks, emerging markets and precious metals/commodities, but the pickings are increasingly slim. If sentiment shifts, we’d expect risk assets to pull back sharply, presenting better investment opportunities.
Best,
Louis and Subir
PS — We’ve moved! Our new office is located in the financial district: 222 Broadway, 19th Floor, New York, NY 10038. Attached is a notice about our address change, our annual privacy policy notice and our Q1 invoice.

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Dear Friends,

In the new year, we had hoped to put behind us the volatile political situation that has afflicted our country for the past several years. Unfortunately, the events of the past week have dashed those hopes. A violent attack on Congress has shaken many of our institutions. A few years ago, it would have been unfathomable to imagine an outgoing US president would encourage his supporters to march on the capitol. And this unimaginable thing too, has happened. We are struck this week, by the variety of friends and colleagues overseas who have expressed their incredulity and concern that such a thing might happen in the US. And yet it has.

The long-term vibrancy or malaise of every economy is underpinned by its legal institutions and politics. US institutions have been shaken this week, in a manner that will likely have long term implications. The world’s assessment of the US’s political stability and uniform application of rule of law have been dramatically undercut by remarkable images of a mob running amok through the US capitol. The near-term impact will likely be contained by the almost uniform condemnation of the actions that led up to the sacking of the Capitol buildings. Underscoring the seriousness, almost every business lobby immediately condemned the actions of the mob, and the politicians who incited them. This includes the staid National Association of Manufacturers.

As with virtually all the dramatic political events of the past few years, the market seems to have shrugged the past week off. Major US indices remain at or near all time highs, seemingly oblivious to the impact of the on-going public health crisis and the significant impact it has had on much of the global economy. Many long term investors see the vast disconnect between the underlying economy and the markets and wonder: how long can this last?

In the fairy tale Sleeping Beauty, an entire realm is enchanted and frozen in place when the princess falls asleep. The cook was arguing with one of his assistants before the enchantment and is about to strike him. When the princess awakens, the very first sound is that of the cook slapping his assistant.

In similar ways, the US economy and large swaths of the global economy have been frozen in time, seemingly enchanted by the actions taken by governments and central banks around the world to alleviate the public health impacts. The Federal Reserve has conjured its own spells all year, conducting large asset purchases and hinting at a long period of zero or near-zero interest rates. Stock market investors have participated wholeheartedly in this enchantment, driving many stocks well into bubble territory.

Just as in Sleeping Beauty’s realm, we expect we will all wake up one day, a day like any other, with a slap in the face and this historic bull market for stocks will come to an end. Given the heady heights this market has reached, the long road down is likely to be unforgivingly treacherous. We recommend equity investors maintain caution as the new year gets underway. We cannot say when exactly this bull-market will end, but several indicators, the amount of new issuance, the extreme euphoric rise of the past few months, underlying economic conditions and nosebleed valuations are all signals that have presaged the biggest changes in momentum during past market bubbles. Though much of the market is extremely overvalued, as usually happens at the tail end of a bull market, there are some attractive opportunities in stocks at the value end of the spectrum. The renewable energy/cleantech sector, after having a break-out year in 2020, still has some compelling opportunities for long term investors. We also view the long-term prospects of many emerging markets positively, and the valuations in these markets are not nearly as extreme.

For bond investors, this year has capped several years of very low yields, and an interest rate policy that is bent on driving investors towards riskier assets. We believe investors should continue to maintain allocations to high-quality short and medium term bonds, despite the limited return they offer. Exposure to speculative or longer-dated bonds should be reviewed for appropriateness, since these issues can be volatile when interest rates or perceptions of risk change.

Though we are not yet past all the public health dangers, we fully expect that this difficult period for our country and the world will come to an end soon, and we will finally turn the page on the difficult year we have had. During these challenging times, we wish you and your families health and peace of mind.

Please let us know if you’d like to discuss any of the above in more detail.

Regards,

Subir Grewal, CFA Louis Berger

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.