20 Nov Q3 2023
Interest rates were the key theme in economies and markets last quarter. The 10 Year US Treasury rate increased from 3.8% on June 30th to 4.6% on September 30th, and continued its upward momentum to 4.8% on October 6th, which is the highest level since 2007. The Federal Reserve lifted the Fed Funds rate by 0.25% in July to the highest rate since 2000, and indicated that they intend to keep the Fed Funds rate higher for longer. Federal reserve commentary and continued labor market momentum drove the US 10 year rate up by almost 100 basis points in the quarter.
The charts below help depict the magnitude of changes in interest rates. The first chart is a 40 year chart showing that the long-term downward trend was broken in 2020 and shifted back to levels not seen in over 15 years.
The next chart is a chart for the first 9 months of 2023. The US 10 year rate bounced between 3.4% and 4.0% for the first 6 months of the year before moving sharply upward during the third quarter.
After a historic rise in interest rates last year, the continued increase is starting to cause problems for highly indebted households and corporations.
The 30 year fixed mortgage rate has jumped to almost 8% from 3% just two years ago. High mortgage rates combined with high property values led to the National Association of Realtors calculating that the typical American family can’t afford to buy a median-priced home. Auto loan rates have also increased, driving up monthly payments for families:
Credit card rates may be the most punitive. According to the American Bankers Association, in the third quarter of 2022 56% of active credit card accounts carried a balance at some point. Average interest rates on credit card balances increased from an already high 14.5% last year to over 21% this year. The rapid rise in interest rates clearly has an impact on household finances.
In addition, federal student loan payments that had been frozen since March 2020 resume this month. The average payment is $200 – $300 per month, which equates to a 5% pay cut to the median household.
Shifting the discussion to corporations, the increase in interest rates also causes problems for highly indebted companies. Many corporations took advantage of the low rate environment a few years ago to borrow cheaply, however US companies are about to hit a “refinancing wall”. Morgan Stanley estimates that $2.6 trillion in corporate debt will come due between 2023 and 2025. Refinancing drives up interest costs for companies, thereby driving down profitability. As a result, companies are likely to cut back on capital expenditures and hiring. In fact, according to a recent survey of CFOs, 41% have already pulled back on capital spending and 42% have cut costs in other areas such as travel and advertising. Respondents to the CFO survey indicated that after several quarters of the labor market occupying their top concern, the primary concern is now interest rates.
One of Warren Buffett’s most famous quotes is, “Only when the tide goes out do you learn who has been swimming naked.” The significant increase in interest rates certainly has caused the tide to begin receding. According to The Wall Street Journal, large corporate bankruptcies tripled in the first half of this year compared to last year, headlined by Silicon Valley Bank, Bed Bath & Beyond, and the trucking company Yellow. A separate study by economist Torsten Slok at Apollo shows a significant uptick in bankruptcies, particularly hitting firms with high levels of debt and low earnings:
The uptick in corporate bankruptcies does not necessarily signal the beginning of a further surge in bankruptcies, rather it highlights what high interest rates, slow growth, and lingering inflation can do to weak balance sheets.
The key to navigating difficult times is to focus on quality. Companies with strong balance sheets, low debt, and high cash flows can be opportunistic while competitors with a weaker financial profile focus on survival. A focus on quality permeates all of our investment portfolios, and is critical during times like this. The current environment also offers opportunities in high-quality bonds that have not existed for over 15 years. This is a welcome change for bond investors after a long period of low yields in bonds.
Please see below for commentary and trading activity for our portfolios.
Core Equity
The top performing stock during the 3rd quarter was SLB, as a 28% increase in oil prices led to the energy sector being the top performing sector. Other top performing stocks included Ciena, Alphabet, and Eaton. Laggards during the quarter were AES, Zebra Technologies, and Xylem. Hershey is the one new company added to the portfolio during the quarter. We believe the pullback in stock price and valuation provides a solid entry point into a market leader. This investment also aligns with our market views discussed in this newsletter.
- New positions: Hershey
- Increase position size: Abbott Labs, Roche
- Exited positions: Pfizer
- Decrease position size: Nvidia, Advanced Micro Devices, Eaton
Covered Call
On average, five to six options expire each month in our Covered Call portfolio. If the option expires worthless, we typically sell another option on the same stock. If the stock price is above the option strike, and the underlying stock is called away, we typically replace the holding with a new covered call position. Trading activity during the quarter:
- New positions during the quarter: Qualcomm, Target, Oracle, Medtronic, Lowe’s, Abbott Labs
- Option rewrites: Kinder Morgan, Dow, Disney, CSX, Quest Diagnostics, Sysco, GM, Morgan Stanley, Texas Instruments, Citigroup, Corning
- Positions called away: Cisco Systems, Applied Materials, Comcast, Lowe’s, Danaher
Diversified Income
Top performing holdings in the Diversified Income portfolio were Abbvie, Prudential, Chevron, and Old Republic. Laggards during the quarter were Crown Castle, Healthcare Realty Trust, BCE, and Telus. Trading activity during the quarter
- New positions during the quarter: General Mills
- Increased position size: Pfizer
Tom Searson, CFA
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