Market Commentary Q1 2023

THE ONLY WAY OUT IS THROUGH

In our most recent Market Commentary, we described our outlook for 2023 as “a puddle of muddle.” We highlighted that earnings forecasts seemed optimistic, valuations weren’t particularly attractive and a recession appeared more likely than not. True, inflation was moderating, but was still in excess of the Fed Funds rate and thus hopes for a Fed Pivot struck us as premature. Consequently, we entered 2023 with “subdued expectations and a defensive posture.”

By January, that caution seemed unwarranted as the S&P 500 rose 6% and the Nasdaq had its best start to a year since 2001. 10-Year US treasury rates had been in steady decline since October and inflation data could be categorized as ‘less bad.’ To many, that sounds an awful lot like a soft landing. To be clear, we’ve never said it was impossible, just unlikely, and whether it was a bear market bounce or the end of tax-loss selling, January felt as if Jay Powell, Chair of the Federal Reserve, might actually pull it off.

In February, inflation came in hotter than expected and jobs data rose sharply, both of which argue for more restrictive policy. Ever data dependent, Powell gave a speech that the Fed was considering hiking by 50 basis points, twice the increase of the previous meeting. Suddenly, the soft-landing narrative began to look a tad suspect.

March brought its own set of issues. Many economists are fond of saying that the Fed hikes until something breaks. It’s difficult to identify a culprit ahead of the fact, but on March 8th, Silicon Valley Bank announced it had sold a sizable portion of its securities portfolio at a loss and was attempting to raise equity to improve liquidity. Interest rate mismanagement and persistent deposit outflows left a hole in their balance sheet. Depositors lost confidence, triggering a run that culminated in the largest bank failure since 2008. Over the next few days, several other regional banks required intervention and Credit Suisse found itself an involuntary participant in a fire sale.

Any bank failure is likely to invite comparison to 2008-2009, and while the causes were different (duration as opposed to credit) the reply is typically the same. Is this the beginning of a credit crisis? We don’t think so. Many banks are facing deposit outflows and unrealized losses, but few are of the magnitude of those that failed. A more pertinent question is how will it impact the economy? We suspect it will curtail loan growth, tighten underwriting standards and reduce credit availability for borrowers large and small.

Pundits are eagerly hunting for the next shoe to drop, whether that’s regional banking, commercial real estate or the leveraged loan market. While it’s tempting to guess tomorrow’s headlines, we prefer to spend our energy reviewing what we already own, diligently stress testing the balance sheets, liquidity profiles and interest rate sensitivity of our portfolios. Because access to credit may become more difficult, we prefer companies that control their own destiny and aren’t reliant upon debt markets for their success.

Markets appear to have been anxiously awaiting a reprieve from rising interest rates, and many suspect bank failures could stay the Fed’s hand. Expectations for future rate hikes have declined and major U.S. equity markets have been rising. While we do agree that we’re closer to the end of the hiking cycle than the beginning, we’re concerned that a pause in rate increases would coincide with a weaker economy and possibly end in a wash.

Complicating this math is that unemployment in January hit 3.4%, the lowest in five decades. While recessions are frequently accompanied by rising unemployment, a robust labor market suggests that the much-predicted recession could actually be quite mild. If that’s the case, we believe it could turn out not to be a soft landing, but softish.

So, despite a lot happening in the past three months, our description of 2023 remains the same. We have subdued expectations and a defensive posture. Things can and do change quickly and we are actively filling our on-deck list with new ideas. While volatility rarely feels good in the moment, it often presents opportunities. You’ve heard us say that a long time horizon can be an investor’s most significant advantage and we’re investing your capital accordingly. We thank you for your business and should you have any questions, please don’t hesitate to reach out to your Relationship Manager.

We thank you for your support and if you have any questions, please don’t hesitate to reach out to your relationship Manager.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Market Commentary Q2 2022

RECESSION; MORE LIKELY THAN NOT.

Nothing encapsulates the current economic crossroads so precisely as the word ‘dilemma.’ A dilemma is a choice between two equally unattractive alternatives. Since neither outcome is desirable, they often feel like no choice at all.

Allow us to explain. Would you rather:

1. Maintain a growing economy, albeit with unacceptably high inflation, declining purchasing power, persistent shortages and a drum-tight labor market?
2. Tame inflation, trigger a recession, reduce asset prices and increase unemployment?

When confronting these supposed alternatives, many would say ‘is there a third option?’ There is, the so-called soft-landing, but given the differential between where interest rates are and where interest rates need to be, we would ascribe this a low probability. Add a hawkish Fed, sour investor sentiment and the deterioration in real-time economic data and we believe a recession is highly likely. In fact, we may already be in one.

US Real GDP is estimated to have declined -1.6% in the first quarter and the Atlanta Fed currently estimates second quarter GDP at -1%. The definition of a recession is two consecutive quarters of negative growth.

The market is repricing risk assets both for higher interest rates and a recession which explains why the S&P 500 has declined 11 out of the past 13 weeks, on its way to one of the worst first halves in more than 50 years. Not to be outdone by its equity counterpart, the fixed income market is having its worst year since 1788. So much for diversification… In the past 12 months, only four sectors have positive returns. Energy is up strongly because of the sharp rise in oil and natural gas prices. Sectors traditionally perceived as defensive (and thus
more recession-resistant) like utilities, staples and health care have positive returns, while economically sensitive sectors like consumer discretionary wallow in a bear market. Economic hatches are currently being battened and business confidence is eroding fast.

As frequent readers can attest, owning risk assets during a recession isn’t just likely, it’s inevitable. The inexperienced and overconfident (frequently one and the same) may think they can pivot in and out of markets or tilt towards defensives at just the right time. While some may have successfully market-timed, those who think they can vastly outnumber those who have, reminding us that all investing involves risk.

We know that owning equities through recessions and sell-offs are part and parcel of being an investor. There have been 11 since 1948 and by our measure, equity returns since have been acceptable. It’s one of the eternal conundrums of investing; investors ‘should’ like low prices and the potential for higher returns that they imply, yet no one wishes for a bear market.

While it’s pure conjecture to opine how long or deep the next recession will be, there are signs it may be a manageable one. Our nation’s banks are currently well-capitalized suggesting ample wherewithal to absorb credit losses. Many consumers have strong balance sheets and there are few signs of excessive leverage in the system. The labor market remains sufficiently tight so that a modest deterioration may not be the worst outcome. Corporations have high margins which suggest the ability to absorb profit headwinds and debt appears manageable. If anything, we think systemic risk is more likely to emanate from emerging markets who have borrowed extensively in US dollars (which have dramatically appreciated, making them more difficult to repay).

We have no special insight into how long the current rate-hiking regime will last. We would describe the situation as ‘fluid.’ Nothing illustrates this as much as the Fed raising rates 75 basis-points in June, six weeks after saying a 75 basis-point hike was not being actively considered. We do know there’s an unavoidable lag to economic data and central banks often over-correct in their search for a neutral rate.

Regardless of what happens with interest rates or the economy, our process and discipline remain consistent. We seek to identify companies with competitive advantages, a reasonable expectation of growth and a decent probability of creating shareholder value over a business cycle. At the beginning of 2022, we said we didn’t expect the ‘everything rally’ to continue. While neither of the choices confronting central bankers seem palatable, we do believe that higher interest rates will eventually slow economic growth and subsequently inflation. Should a recession result, we believe the Fed would likely temper rate increases. Stock prices may continue to decline in the interim, so we continue to be measured in our approach, weighing the relative risk and return potential of each prospective investment.

Thank you for your continued support and as always, if you have any questions, please don’t hesitate to reach out to your Bridges Trust Relationship Manager or any representative here at the Firm.

We thank you for your support and if you have any questions, please don’t hesitate to reach out to your relationship Manager.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Bridges Investment Management Market Commentary May 2022

When T.S. Eliot penned “April is the cruelest month,” it’s unlikely he was thinking about the returns of common stocks. But after the Nasdaq index posted its worst monthly return since March of 2008, we’re willing to misappropriate the quote. Not wanting to be left out, the S&P 500 is having its worst start to a year since 1939.

Our regular readers know that we write market commentaries quarterly, but more often in times of duress (like Spring of 2020, when we wrote five pieces opining on the pandemic). In our view, consistent communication helps clients understand our thinking, frame expectations and fosters alignment. While we just published a note in early April, recent events deserve comment.

Markets thrive off differences of opinion, yet seem relatively unanimous on the cause of the sell-off; namely interest rates. The US 10-Year Treasury began the year yielding 1.51% and is currently 2.96% (rates rise as prices fall). Higher rates aren’t a bad thing in and of themselves. They often coincide with a strong economy and low unemployment. But the value of a productive asset goes down when interest rates rise as alternatives for capital become more attractive. When interest rates were at their lowest, it pushed investors into risk assets, driving up their prices. We’re seeing that unwind now.

The length and duration of this repricing will depend on where interest rates ultimately find equilibrium and how quickly they impact economic activity. Last week the Fed raised their benchmark borrowing rate 0.50% and are expected to do so several times before year end. Higher interest rates have the primary objective of reducing demand, slowing the economy and taming inflation. Tightening cycles have tended to trigger recessions, which is why many investors are expecting one now.

So, falling stocks, higher rates, higher inflation and slowing economic growth, never mind Russia’s invasion of the Ukraine, high energy prices and the risk of a resurgent pandemic. These are all headwinds for risk assets, especially in comparison to the recent past, when growth seemed highly certain, capital was cheap and stocks could do no wrong.

Our long-time readers probably know what’s coming next. The outlook for equities in the next twelve months isn’t great. A recession seems likely. Why not just take some chips off the table and wait and see? The temptation to market-time is always highest when things are most uncertain. Crisis after crisis (and we’re not in crisis yet) has shown us that we’re not particularly good market timers. When constructing portfolios, we intentionally gravitate towards companies that we’d be comfortable owning during a recession, because odds are that eventually we will.

We wrote in October of 2019 that we were suspicious a recession was imminent. It turns out we were right, but not for the reasons we suspected. COVID did eventually cause a recession and yet the total return of the S&P 500 has been 41% from that date until now. While past performance provides no guarantee of future results, we believe the old adage is true, it’s not timing the market, it’s time in the market, and history has shown us that equities eventually compensate investors for bearing risk.

Many investors are clustering around energy stocks and other inflation-sensitive equities. We have no special insight on inflation, its duration or its magnitude. We do own equities that are inflation beneficiaries, just as we own equities that benefit from deflation. Our goal has never been to design a portfolio that is a one-way bet on a binary outcome (high inflation or low), but to strive to generate an acceptable return regardless of the direction of the economy.

Perhaps most painful is the sell-off in large cap tech stocks. While many enjoyed higher than market multiples (and were thus deemed ‘expensive’) we didn’t find their valuations particularly egregious relative to their fundamentals. While many benefitted from the pandemic and their fundamentals seem to be taking a breather, the trends of e-commerce, digital advertising and cloud computing are still very much early in their adoption curves. Regardless of the direction of the economy, we suspect we’ll be ordering more from Amazon, watching more YouTube and using more apps hosted by Microsoft’s Azure in 10 years than we do now.

While a dour outlook in the short-term, but a positive bent long-term is modest consolation, our job is to call them how we see them. We continue to test our assumptions, sharpen our pencils on valuation and allocate your capital to the best of our abilities.

We thank you for your support and if you have any questions, please don’t hesitate to reach out to your relationship Manager.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure

2022 Berkshire Annual Meeting Commentary

BETTER LATE THAN NEVER

Second-guessing Warren Buffett’s capital allocation decisions never struck us as a great use of time. We humans are an opinionated lot, prone to backseat driving and armchair quarterbacking, especially towards the successful. Human nature being what it is, naysayers often multiply when Berkshire underperforms. As recently as June 30th, 2020, Berkshire Hathaway B Shares had trailed the S&P 500 by 5.6% per year over ten years, (that’s 146% for those keeping score at home)1 and there were more than a few nays being said.

The complaints have been relatively consistent:

• Berkshire should deploy its excess cash
• Berkshire should buy more companies
• Berkshire should buy more stocks
• Berkshire should pay a dividend
• Berkshire should name a successor and Buffett cede day-to-day control.

These all basically boil down to capital allocation, something Buffett knows a thing or two about. While few (read any) of us have experience running a $390 billion equity portfolio, public opinion of Buffett’s capital allocation is often swayed by the stock’s performance. In the past twelve months, Berkshire Hathaway B shares have outperformed the S&P 500 by 15.8%. Consequently, claims that ‘Warren has lost his touch’ (an assessment we disagree with) have somewhat died down. While the elephant gun has been gathering cobwebs, there are two major developments in recent years that suggest Warren came to the right conclusion, albeit slower than we would have liked.

The first is the purchase of $51.8B of Berkshire Hathaway stock in 2020 and 2021. One could argue that Berkshire has held far more cash than it required for the running of its operations consistently since 2009. While the repurchases are welcome and (in our estimation) increased the per-share value of Berkshire, a fair question is why did he wait so long? His prior framework of only buying at a multiple of 110% of book value (later raised to 120%, then ‘below his estimate of fair value’) likely prohibited some very accretive purchases at much lower prices. While we understand his price discipline, the opportunity cost of sitting on so much excess capital seemed to dwarf the risks of overpaying.

The second development is the net purchase of $41.5 billion of equities in the first quarter of 2022. While most people think of Buffett primarily as an investor in public securities, he really hasn’t done much as of late. If you netted all of Berkshire’s equity purchases and sales from 2012 to 2021, it put a total of $7.7 billion into the stock market6. While this may seem large, it’s a rounding error compared to its means (cash totaled $160.3 billion at the end of 2021). The S&P 500 has returned 303% since January 1st, 2012. Had Berkshire not held excess cash for more than a decade, book value would be meaningfully higher.

Buffett has said that he finds very little in public markets that interests him (as recently as February 26th, 2022). And yet he reversed course and deployed more capital into public equities in the first quarter than the 10 years prior6. We’re really at a loss to explain what has changed. While only time will tell if these purchases were adept, it strikes us as a stark contrast to the second quarter of 2020, when Berkshire sold almost $13 billion in equities (at much lower prices). Buffett has long advised to buy low and sell high, but a chart of the S&P 500 versus Berkshires’ equity purchases would suggest he’s doing the opposite.

What’s more is that the securities he bought were stocks he’d sold at much lower prices. The annual meeting revealed that he’d bought $7.7 billion of Occidental Petroleum at $48.39 a share. He sold the same security in the second quarter of 2020 likely in the mid-teens. While we see the wisdom of changing your mind when the facts change, it doesn’t inspire confidence buying something up 200% from where you sold it less than two years prior.

All that’s a long way of saying we applaud putting the excess capital to work, but wish he’d gotten around to it sooner. Despite his shopping spree in the first quarter of 2022, Berkshire still has $95 billion in excess cash as of March 31, 2022 and finding something intelligent to do with it will continue to be our primary concern.

We suspect that Berkshire will continue to go through bouts of underperformance relative to the S&P 500, perhaps for a substantial period, but we believe the risk-adjusted returns have historically been quite acceptable although past performance provides no guarantee of future results. We see the wisdom of accepting a lower return provided it comes with less risk. In our estimation, Berkshire is no longer a get rich stock, but a stay rich stock and we’ve sized your portfolios appropriately.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Market Commentary Q1 2022

THE HITS KEEP COMING

Higher rates, persistent inflation, a hawkish Fed and geopolitical risk roiled the markets in the first quarter.

Three months ago, we published our outlook for 2022, titled ‘Less of a Sure Thing.’ Therein, we suggested that monetary policy could go from tailwind to headwind, inflation remain stubbornly high, interest rates rise, equity multiples contract and investors should be prepared for elevated volatility. We commented that the ‘everything rally’ seemed unlikely to continue and we advised approaching markets with equal parts vigilance and opportunism.

Being ‘right’ has never felt less rewarding.

• The Federal Reserve raised rates in March and it expects persistent increases through 2023. Plans to reduce their balance sheet are forthcoming, which will further tighten credit.
• The most recent inflation reading was 7.9% year-over-year.
• The benchmark 10-year US Treasury rate has risen from 1.5% to 2.5%.
• Real rates (Treasury rates after inflation) are still negative but have increased 0.4%. As real interest rates rise, high-multiple growth stocks tend to do poorly.
• At one point, the NASDAQ Composite, which skews towards expensive tech, was down 19% year-to-date.

One quarter into the year, much has played out as we expected. But what we did not expect was Russia’s invasion of Ukraine in February. While the humanitarian costs are far more important, this has exacerbated an extremely tight commodity market. Oil rose from $78 to $128, nickel rose 90% in roughly a week and fertilizer prices skyrocketed. The ultimate duration of this conflict is anyone’s guess but combine this with additional Covid lockdowns in China and we no longer expect a reprieve from inflation in 2022.

The Fed has the unenviable task of taming inflation without causing a recession, a so-called ‘soft landing.’ They’ve done it before, most recently in 1994, but it’s an exceptional feat of central bankery. More often than not, increasing rates slows economic growth, dampens risk-taking, reduces asset prices and can often trigger a recession. The temple priests of macroeconomics like to study the shape of the yield curve, suggesting that a flat curve portends a recession is looming. And you guessed it, the yield curve is currently flattening.

While the persistence of inflation has been frustratingly long, and each factor has a rational and seemingly temporary cause, the more ‘the hits keep coming’ the more likely inflation is to become entrenched. Since last July, average hourly earnings have consistently grown at 4-5%. This, combined with over $2 trillion of excess savings from the pandemic has the potential to create a wage-price spiral, a self-reinforcing feedback loop of higher and higher inflation expectations. Consumers have noticed and sentiment is down sharply from pre- pandemic levels. It hasn’t resulted in demand destruction thus far, but it might, which would have negative implications for GDP growth.

Monetary policy is, by definition, a blunt instrument and increasing rates won’t ease supply chain disruptions or lower the price of oil. But the Fed’s patience is starting to look like a policy mistake. Many argue that they have let the economy run too hot for too long already, and they risk losing credibility with capital providers.

When it comes to higher rates and higher inflation, neither equities nor fixed income are immune. While equities may see their prices decline and their multiples contract, at least they could potentially earn their way out of it in the future. Bonds don’t enjoy the same optionality and the first quarter represented the worst performance for fixed income as an asset class since 1949. After a 40-year bull market in fixed income, it’s almost as if investors forgot they could lose money. Overwhelmingly, our clients remain short duration, which may help soften the blow from rising rates and allow them to reinvest at higher prevailing rates. But that’s the thing about inflation. Unless you own commodities outright, there aren’t many places to hide.

Like we said last quarter, we would advise moderating your expectations for strong returns in 2022. Markets price new information every day. Right now, it’s repricing higher rates, higher inflation and geopolitical risk. Some will argue that the price declines year-to-date already sufficiently discount sharply higher rates. Others that the conflict in Ukraine will find a peaceable solution (something we ardently hope for). We consider these possibilities, but also recognize that the world has a lot of excess liquidity and there aren’t many attractive homes for it, which despite short-term performance risk, leaves equities as one of the few games in town.

But that’s the beauty of our process. We buy exceptional businesses with strong growth prospects at reasonable valuations which shouldn’t require us to forecast inflation, interest rates or the outcome of military conflicts. While all investing involves risk, including the risk of loss, we adhere to our process because it seems a logical way to provide durable returns over multiple business cycles, whether rates are rising or falling and in times of peace and war. The returns may not be smooth and past performance provides no guarantee of future results, but thus far, they’ve been satisfactory.

Thank you for your continued support and should you have any questions, don’t hesitate to reach out to your Relationship Manager.

We thank you for your support and if you have any questions, please don’t hesitate to reach out to your relationship Manager.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure