2022 December CAD

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0.68% MTD

-7.5% YTD

The Economy is Finally Slowing

What this means for stock and bond prices

The Caravel Capital Fund generated a positive return for the month of December of +0.68% to finish the year -7.50%. 

December’s return came from combining the Merger Arbitrage book and Pairs trading, while our Alpha trades were a drag on the portfolio. We have since exited or materially reduced the Alpha trades and have focused much more on adding shorter-term (3-6 years) investment-grade bonds. We will discuss that below.

We firmly believe 2023 will be a good year for high-quality corporate and government bonds, specifically ones issued in US dollars. We have been reducing our allocations to cash and equity-sensitive securities into mostly investment-grade rated bonds with maturities of 3-6 years. This is not something we just jump into - it takes some time as we analyze each issuer and try to avoid chasing prices. So far this year, bond prices have been steadily rising (yields falling), with a total return as of today of 2.9% on the Bloomberg USD index. We will continue to invest in merger arbitrage, convertible arbitrage, and event-driven catalysts where we can identify opportunities that provide attractive risk-adjusted returns. As interest rates have risen, the returns we require from these strategies have increased, narrowing the universe of investable deals. However, we are still digging through all the opportunities and currently have more than ten such positions.

Market Check-Up

Let’s revert to the title of this letter and break the fundamentals down. “The thesis that the economy is finally slowing is the foundation of our affinity for high-quality bond investments, which now represent over 40% of the capital in the fund. Recent economic data and corporate updates have further solidified our conviction. 

As the world emerged from the COVID-19 pandemic, governments, households, and businesses were flush with stimulus while supply chains were still impaired. Prices inflated faster than most central banks could tolerate, and they rapidly raised lending costs and dampened or unwound monetary stimulus in response. Both consumers and businesses have reacted in the exact manner desired by central banks (tightening their belts). As we highlighted in our last letter, the gauge used to calculate inflation incorporates historical data that is a year old. The latest data released in January indicates inflation could be running below 3% by year-end, which is where central bankers want it. The side effect of this is a much slower economy. So, what does this mean for bond prices, and what does it mean for stock prices for 2023?

The Case for Stocks

Stock prices have fallen from the highly elevated valuations in January 2022 (24.7x trailing earnings) to 18.6x. Make no mistake; no one should invest in a company based on what they did 12 months ago. Just like inflation, we need to examine what the current environment is telling us. 

For the S&P 500 index, earnings per share (EPS) estimates for 2023 have dropped from $250 to a much more modest $222 when this letter was written. So, buyers of the index today are paying over 18 times 2023 expected earnings. However, the developed world’s central banks are not finished raising interest rates. 

In fact, they have telegraphed this in press conference after press conference. North American Central Banks have raised the cost of borrowing money for their chartered banks from 1% to 4%. They continue to echo that they intend to increase them to 5%, or 25% more while holding the elevated rates there for a substantial time to confirm inflation is in check. We believe earnings expectations have further to fall, maybe 10% more, which means stocks are actually trading at over 20 times in a slow economy with interest rates going to 5%. Even if the Federal Reserve stops raising rates at 4.75% (current consensus) and leaves them there until December, the cake is baked, and earnings this year will likely come in around $200. At current levels, you are paying way too high a price for equities, and all of it is based on the optimistic expectation of what the central bankers will do. Everything can change in 30 days, but for now, let’s not fight the facts.

The Case for Bonds

If we believe the central banks’ actions implied in stock price expectations, then inflation will be tracking 2.5-3% by the fourth quarter. Based on this, a short-term investment grade bond yielding 5-6% is a steal! 

You have a real yield (interest earned less inflation) of 2-3%. THAT IS WHAT INSURANCE CEO’S AND PENSION PLAN SPONSORS DREAM OF EVERY NIGHT. And that is what we are investing in right now. 

We expect US treasury bond yields in the 3 to 6-year area of the curve, currently around 3.6-3.9%, to fall another 50-75 basis points this year and that investment grade corporate bond yields will follow suit. 

There will be bumps along this road, but we expect to generate double-digit returns on capital. Our risk is minimal - because we hold such short-term bonds, prices won’t fall much. For example, if a 5-year bond is currently yielding 5% and trading at $95, and in one year it is yielding 6% (a 100-basis point move), the total return on the bond will be about 1.4% over that period. We view such a move in yields as highly unlikely. We will speak more about this strategy throughout the year, but we will continue to add to the portfolio for now. We hold Canadian and American issuers.

Anecdotally, we wanted to share something we read last week. All bull markets reach the final stage and bottoming cycle once the “trendy names” or “water cooler stocks” finally fade from the news. Speculators still pay $20,000 US for one crypto coin and $1,500 for another, and they are still pushing up share prices of broke companies thinking they have won a war against wall street (whatever that means). Bear markets that are brought on by negative real rates take a prolonged time before they end. This one is about 60% there, we reckon. We believe the bear market ends with a 40% probability in the 3rd quarter and 40% in 4th quarter of 2023 and a 20% chance it takes longer (like the 1992 experience).

Caution is warranted.