Athos Capital Advisors – Monthly Newsletter – September 2022

Quote of the Month

“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”
― Warren Buffett

Market Update & Outlook

  • Interest rates have risen very quickly and likey have room to rise further
    • Inflation is persistent – not “transitory”
    • US 2 Year Treasury yields have risen to 4.3% and 10 Year Yields have risen to 4.0%
    • Mortgage rates are now above 7%
    • The implications for all financial assets are profound
  • The yield curve continues to be inverted  a classic indicator of economic slowdown and recession
  • Investors must position portfolios differently than they have for a long time as a result
    • The investment landscape is very different when inflation is persistently high and interest rates are rising quickly
    • Cash is no longer trash when you can get 3-4% on cash equivalents
  • Stocks and Bonds are down in tandem this year
    • Bonds have had their worst start to the year since 1981
    • The S&P 500 is down 24% and the Bloomberg US Agg is down 15%
    • The 60/40 portfolio is down 21%
  • Increase diversification to be prepared for a wider range of outcomes and include investments that do well in inflationary environments
    • Natural resources & energy investments are important parts of a portfolio
    • Be valuation disciplined  higher interest rates mean valuations compress, this has already played out violently in speculative growth stocks
  • Geopolitical tensions remain very elevated
  • Prepare for continued volatility across financial markets
    • Mid-term election years are historically very volatile and see big drawdowns (on average)
  • Increase allocations to alternatives and private real assets
    • Interval Funds (see attached our latest whitepaper) offer an attractive way to access these asset classes
    • 5-10% yielding assets, very low volatility, and low correlation to stock and bond markets
  • Look to be a buyer of equities on another leg lower below 3600 on the S&P 500

Interval Funds continue to outperform and provide a safe haven

Athos Capital’s Interval Funds have continued to perform very strongly in a challenging market.  We continue to think these are among the best assets to own right now and expect them to do well in a range of economic scenarios while providing income and low volatility returns. 

Interest Rate Suppression Has Ended

Interest rates – by far the dominant factor in the calculation and pricing of financial assets – have risen faster than we have ever seen.  The implications have been wide ranging.  Long duration asset classes (assets with cash flows far into the future) have seen declines of 20-80%. Cash will quickly yield 3-4% which radically changes the calculus for all assets.  The prior bull market was accompanied by Zero Interest Rate Policy (ZIRP) which had a huge impact on all long duration assets and that is quickly reversing.  The financial system is reacting to this massive shift – a process that takes time but is painful.

Conventional “Balanced Portfolios” Have Had Worst Year Ever

Stocks and bonds have declined in tandem, setting up for one of the worst years ever for the 60/40 stock-bond portfolio.

Bonds have had their worst year in nearly 50 years

Bonds, traditionally a safe haven asset class, have had a historically bad year.  Balanced portfolios have suffered as a result as investors have seen declines on both sides of the 60/40 portfolio.  Higher in-going yields likely provide a much better future return for bonds going forward.

Classic Recession Indicator

The yield curve (the spread between long and short term US government bonds) has been persistently inverted this year and the most in over 20 years.  Every recession in the post WWII United States has been preceded by an inverted yield curve, usually several months in advance.  Professor Campbell Harvey of Duke University first pointed this out back in a landmark 1986 paper.  Yield curve inversion are a necessary but not sufficient indicator of future recessions.

American workers continue to have inflation erode their wages

Real wage growth (nominal wage growth minus inflation) has been negative for the past two years as inflation outpacing increases in wages. This is a major headwind for the economy as the American consumer has less purchasing power.

Cash is no longer trash

In 2021, Ray Dalio famously said “cash is trash”.  It makes sense when inflation is 8.3% and yields on cash and short term bonds are zero but this has changed.  Cash now yields 3-4%.  Why buy a high dividend yield stock when you can get an equivalent yield on cash without any of the risk and volatility?  The market still needs to grapple with this new reality.  Interest rates were zero for the last decade of the bull market in risk assets and the market likely still needs to adjust.  This new reality is set to become more of a headwind for stocks in the coming months.  The search for yield has been altered considerably.  Cash is no longer trash.

Stocks and Bonds are down in tandem this year

Stocks and bonds have never gone down as much and as tightly correlated as they have in 2022.  This has been a massive challenge to the traditional “balanced portfolio” of stocks and bonds.  It has been critical to find diversification and income generation elsewhere.

Energy continues to be the best sector to have exposure to

The energy crisis, touching nearly every corner of the globe, is not being addressed correctly and has been years in the making due to failed energy policy across the Western world.  Energy stocks, the best performing sector in the market this year by far, remain the cheapest sector in the market and sport the most earnings growth.  After years of poor capital allocation and poor returns Energy companies are more disciplined and very focused on generating returns for shareholders – through earnings growth, increasing dividends, and share repurchases.

Strategic Petroleum Reserve draws have weighed on Crude Oil prices

The Biden Administration has drawn an unprecedented amount of oil from the Strategic Petroleum Reserve – one of the main reasons why oil prices have seen a steady decline.

Bond market continues to be very quiet, risk of stress

The bond market continues to see nearly unprecedented stress.  The US Treasury market has seen it’s worst drawdown ever and high yield issuance is historically low.  These markets under stress portends more volatility ahead for other financial assets.

CEO Confidence is near an all-time low

The leaders of American business have rarely been so pessimistic.

Bear Markets eventually end

This bear market, while very painful and likely to endure for some time, will eventually end.  It’s important to be positioned for a rebound when it does occur.

Strategy & Positioning Outlook

  • Avoid stocks and bonds until interest rates have peaked
    • Risk assets likely to rally when rates look to have peaked – historically this has been very consistent, harder to time in practice so scale into equities on weakness
    • Stock and bond correlations continue to be extremely high – find reliable diversification in our interval fund lineup
  • Be patient, make money in Energy, buy high quality stocks at lower levels after interest rates appear to peak
    • Look for fed funds to find a peak, 2 year treasury to level off
    • Fed rate cut in view
  • Interval funds continue to do well
    • Trim private real estate
    • Maintain CCLFX, CELFX, NICHX
  • Optimize cash
    • Ultra short stable value funds, 2.9% yield going to 4.0%