The strangest thing transpiring in the first nine months of 2023 is the level of short and long-term rates versus the long-term optimism of passive US stock market owners. As we write this, the 30-year Treasury is hitting 5% and US stock investors have not gone into a general panic. The bond market is feeling very uncomfortable, but bonds lose with inflation, right?
We don’t agree with the ‘stocks for the long run’ crowd’s idea of owning broad stocks just because there is inflation. Inflation affects all assets: stock, bonds, real estate, private equity, etc. Bonds are not the only subject in the loss of purchasing power. All wealth will be subject to this issue and the hurdle isn’t one asset class versus another. Earning real inflation-adjusted returns is the goal in the era ahead.
An event at play in the recent 90 days is a big move in the US dollar. Below is a chart showing the move in the third quarter of 2023. The British pound has lost 4%, the euro has lost 4% and the Canadian dollar has lost 3% against the US dollar during the third quarter. As the dollar rises, it is putting pressure on non-US economies because goods like oil are becoming more expensive for them. In effect, high dollar rates and high dollar value help American purchasing power and hurt the rest of the world.
The price of oil has made a move higher in 2023. The correlation between the dollar and oil is historically abnormal. Over long periods of time, these two assets have been negatively correlated. Below is a chart looking at 2000-2008 where you will find oil and the US dollar going in opposite directions.
Broadly, we are seeing the effect of interest rate risk in asset markets. We knew all along that this was a risk, but most people thought the Western world would never have to deal with it! They assumed that weak growth, weak labor prices and an abundance of products globally were the norm for a long time to come. In the post-pandemic world, the problem is strong growth, high labor prices and a shortage of products due to the fracture of global trade. Interest rate risk makes this worse as it drives up the cost of moving goods and ensuring their delivery.
In the strategy, we ultimately have sought to avoid interest rate risk as much as possible. As the title of this shareholder letter insinuates, we take the “or else” side of this. Whatever and wherever else we can take appropriate risks to avoid the change in the cost of capital is what we will seek to do. This does not mean that the strategy’s investors will not be taking currency risk, commodity risk, economic risk, etc.
In a low-interest-rate world, no one wanted to own European banks because the low return on equity (ROE) haunted the shareholders for over a decade. Now, interest rates going higher have positively benefited companies like Unicredit (UCG IM), Bawag Group (BG AV) and Bankinter (BKT SM). However, despite the inherent defensiveness they provide, stock investors haven’t priced these up to any kind of crazy level. To use Unicredit as an example, it still trades below book value despite producing over 10% ROE recently. If they can do that for 10 years, the investors in the strategy won’t care about interest rate risk.
Oil provides wonderful protection from the interest rate risk of today. As the dollar has risen and the Fed has tightened in 2023, oil has gone up. This rewards our ownership of Occidental Petroleum (OXY US & OXY /WS US), MEG Energy (MEG) and Cenovus (CVE CN). Ultimately, it perfectly shows that the interest rate risk of stocks is being swallowed by the commodity risk in these shares.
We continue to look at these types of risks in the energy space with our ownership of Whitehaven Coal (WHC AU) and Thungela Resources (TGA LN). These are both predominantly thermal coal businesses. Whitehaven is located in Australia and Thungela is located in South Africa. They are obviously taking commodity risk. Thungela’s location would make it also carry emerging market risk as well. Since coal is considered cancer in the Western world, you could add plausible duration risk, political risk and regulatory risk as has been seen in some European countries. These risks have made coal assets extremely cheap. They historically carry net cash on the balance sheet, trade below book value and produce over 20% return on equity. Their value will not be decided by just the gravity of interest rates with these attributes.
The last risk that we’d highlight is the economic risk. Retailers that we own like Next (NXT LN), WH Smith (SMWH LN), Pandora (PNDORA DC) and Canada Goose (GOOS CN) have this risk. Automakers like Volkswagen (VOW3 GY), Porsche Holdings (PAH3 GY), Porsche Cars (P911 GY) and BMW (BMW3 AG) carry this risk. Lastly, the oil tanker Frontline (FRO) carries this risk. Making, moving and selling products to end markets all carry the risk of a decline in economic activity, but it’s a two-edged sword. It also carries the hope of better economic outcomes. We are optimistic about the future and believe these businesses can outrun the interest rate risks tied to what they deal in with their end customers.
We assume investors get the picture of how dangerous the move in interest rates is, but they can take heart in the fact that we are more focused on unique risks than most passive or active investors are. Ultimately, the discounts that come with the risks we are taking should compensate us for the risks we’re taking in these businesses. Stock market failure is on the rise, particularly in the US. Our investors should set a goal to beat inflation over the next 10 years. If the risks we laid out cause these stocks to be cheap while interest rates stay high, we will be able to visit the same restaurants, shop at the same shops and vacation in the same places we do today with a smile. If it comes down to interest rate risk or else, the or else provides us discernible convictions.
Fear stock market failure,
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The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Smead Capital Management, Inc.(“SCM”) is an SEC registered investment adviser with its principal place of business in the State of Arizona. SCM and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which SCM maintains clients. SCM may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Registered investment adviser does not imply a certain level of skill or training.
This newsletter contains general information that is not suitable for everyone. Any information contained in this newsletter represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. SCM cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of this newsletter bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice. SCM, its officers, directors, employees and/or affiliates, may have positions in, and may, from time-to-time make purchases or sales of the securities discussed or mentioned in the publications.
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