Dear Trusted Partner,
Weak economic data helped decrease interest rates, which helped emphatically end the stock market’s three-month losing streak. Market participants took several anecdotes of concerning economic data to push interest rates lower across the yield curve. The approximate 65 basis point move down in the 10-year U.S. Treasury interest rate helped long-duration assets like technology stocks. The S&P 500 increased 8.92%. The Dow Jones Industrial Average and the tech-heavy Nasdaq appreciated 8.92% and 10.7%, respectively. Of note, precious metal gold had a good month, gaining 1.87% as Fed Futures moved heavily in favor of the end of the rate hike cycle and moved up the time frame of when the first rate cut would happen.
Overall, market participants are bulled up on risk assets right now. Various retail investor surveys from AAII and the CNN Greed/Fear Index all report that investors are very comfortable with the stock market. On the institutional side, Fed Fund Futures indicate a bias towards a “no landing” scenario. In a “no landing” scenario, the economy continues to grow as the Federal Reserve keeps rates “higher for longer” while inflation is coming down. We observe this conclusion by seeing Fed Fund Futures participants believe the Fed Funds Rate will bottom at 4% over the next five years. This confidence differs significantly from the FOMC member dot plots, where they believe the Fed Funds Rates will fall to 2.5% in the next 36 months.
The Federal Reserve interest rate hikes of the last 18 months have started to take a bite out of the economy. In a recent Federal Reserve Bank of New York survey, consumers reported needing help landing access to new credit. This difficulty confirms what we see in the banking sector, which is less interested in lending. We are witnessing the second-largest contraction in U.S. bank lending in the last 75 years as banks repair both sides of their balance sheet. Additionally, Ratings giant Moody’s recently stated that corporate default rates have increased to a point where, in their view, a new default cycle has begun. From a labor market perspective, approximately 20 million jobs are associated with high-yield (junk bond) and leveraged loan companies. The current pressure on the unemployment rate, up to 3.9% from 3.4% this summer, will continue to rise into the first half of 2024.
For the profitable companies that will weather the next default cycle, there will be concerns about how these companies will maintain their profit margins. Coming out of COVID, we saw a record amount of corporate bond and residential mortgage issuance. The notable trademark of these issuances is that these debt obligations were issued at historically low-interest rates. These lower interest expenses helped juice bottom-line earnings and cash flow. As we will witness from 2024 to 2026, we see a big wave of refinancings where interest expense will rise materially. Companies with low debt ratios will be protected from this rise in borrowing rates. Conversely, companies with high levels of indebtedness and relying on capital markets to fund their business will suffer (this ties into the previous paragraph). We are keeping this thought front and center on any prospective investment opportunity. Regarding residential mortgages, with more than 20% of mortgages owning an interest rate below 3%, the monetary policy transmission mechanism we have discussed often gets extended. There are higher odds that the Federal Reserve will have to keep interest rates higher to slow the economy and corral sticky inflation. As a result of maintaining these high rates, we expect that the pressures impairing companies and households will persist well into 2024.
Please see the following updates on existing positions held at the firm:
FirstSun Capital Bancorp (Ticker: FSUN)- The Denver-based regional bank announced good earnings with a stable net interest margin that settled at 4.23%. The variable rate loans that the bank has made over the last few years have helped to protect the bank’s margin. The bank’s over 20% non-interest revenue (relative to total revenue) helps separate the bank from a high reliance on interest rate spreads. Finally, the bank is still positioned for an eventual sale over the next few years.
Peoples Financial- (Ticker: PFBX)- The community bank saw strong appreciation as activist investor Joseph Stilwell continued to acquire shares leading up to the evitable proxy challenge in the late Spring—his most recent string of purchases ended on November 15th at $13.00 per share. PFBX management continued to become shareholder-friendly in the face of this challenge as the bank paid its first special dividend. On November 17th, the bank paid out a $0.23 per share special dividend, along with a regular dividend ($0.18 per share) that was increased by 50% quarter over quarter.
Cheniere Energy (Ticker: LNG)- The market welcomed Cheniere’s third-quarter earnings report and guidance in early November. The company had top and bottom lines beat and issued guidance confirming the solid free cash flow generation over the next few years. Cheniere’s leadership stated, “Looking ahead to 2024, construction on Corpus Christi Stage 3 continues to progress ahead of plan. I am optimistic that the first LNG production from Train 1 will occur by the end of 2024.” The structural shift of global demand towards American LNG will be a strong tailwind for Cheniere as the leader of LNG infrastructure.
Unit Corporation (Ticker: UNTC)- The company announced solid earnings and a small oil and gas asset sale in the Texas Panhandle region. As mentioned in recent monthly letters, the company is committed to maintaining a net cash balance sheet while paying an above-average annual dividend yield (~20%) that is fully covered by operations. Consistent with the last 12 months, we believe the company will pay a special dividend in the first quarter 2024. With respect to the earnings and asset sale, the most material announcement was the removal of the interim CEO title to Phil Frohlich, the largest shareholder of the UNTC. There was no formal announcement, but the earnings release showed Phil was just referred to as CEO. I followed up with the company to confirm I correctly interpreted the situation. The company did confirm our suspicions and removed the interim label during the quarter. This slight title change is crucial as now we feel even more comfortable in our investment thesis, which is that the company will continue to be focused on returning capital to shareholders instead of empire-building, which a new CEO could risk.
We are delighted with the strong relative performance over the last few years. We will remain diligent in managing the broader risks that are becoming pronounced in financial markets and the economy. Thank you for your continued trust throughout the holiday season!
Stash J. Graham
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