The Hilton Capital Management investment team held its highly anticipated second quarter investor call at the end of July to review the performance of its keystone strategy, Tactical Income, and offer several new data points and slides to contextualize the current economy. Hilton founder and co-investment officer Bill Garvey began the call with an overview of the markets, followed by an expanded economic presentation by Co-Investment Officer Alex Oxenham. CEO Craig O’Neill rounded out the call with an update on the portfolio, adjustments made over the quarter by the team and revised sector allocations.
Garvey began the call by once again acknowledging the human impact of the novel coronavirus (Covid-19) and the toll government shutdowns have taken on global markets and the world economy. Though characteristically measured in his comments and review, Garvey specifically pointed to some of the ongoing risks in an overvalued equity market and urged patience, which will “ultimately be rewarded.”
Since the collapse of all sectors, “investors have poured into low-quality, impaired balance sheet companies,” said Garvey. The rationale, reasoned Garvey, can be explained by the government-imposed safety net for all risk assets in the form of liquidity.
“The search for yield has resulted in spread tightening across the bond market with high yield moving in 260 basis points since the end of the first quarter,” he added. “With the government purchasing investment grade corporates, that sector has provided positive returns on the year with short-term bond ETFs ahead by over 3%.”
Garvey concluded his remarks by likening the current climate to an “episode of the Twilight Zone,” saying the recovery will be “an extended process with many fits and starts.”
Macroeconomic Analysis Overview
- Click here to visit our Resource Center and download the economic deck slides
- Click here to hear the audio recording that accompanies this deck.
What follows is an overview of the remarks given by Alex Oxenham along with a brief summary of individual data points.
Those accustomed to reviewing Hilton’s quarterly deck will notice a substantial adjustment of certain slides and data points considered by the investment team to account for the rapidly changing investment and economic landscape. Oxenham began his presentation by disclaiming some of the improved performance of certain factors, noting, “the data only had the ability to improve. Now we can begin to figure out the real severity and the time required to grow out of it.”
Most importantly, Oxenham urged attendees to pay close attention to the labor market as the best gauge of the economic recovery, though he acknowledged that even as we transition to a “normal recession,” we will likely maintain elevated levels of unemployment.
“We have transitioned the economic deck into more of a recovery analysis tool deeply rooted in understanding the inflection points around the US labor market to assist us in adding the appropriate amount of risk as we approach the next economic expansion,” he said.
The Federal Open Market Committee of the Federal Reserve met on June 10 and lowered its long-run real GDP projection for the United States from 1.9 to 1.85. The following data will look largely improved but it is distorted from the shutdown. While you can get a sense of the direction of the improvement, you cannot really get the magnitude. ISM Manufacturing versus Global Manufacturing highlights how the US has bounced more than global manufacturing economies, which is associated with our relatively less severe lockdowns and more stimulative central bank and fiscal response.
The full year 2020 GDP year-over-year will probably be in the neighborhood of down six to down four [percent]. The global financial crisis was down five [percent], so aggregate decline in output is very similar to what we experienced during the 2008 and 2009 Recession.
Conference Board of US Leading Indicators.
In the six previous recessions dating back to 1974, there have been signs of improvements toward the end of the downturns. Once we start to see sustained improvement in this dataset it will be very suggestive that the recession has ended. But the 12 month moving average implies the data will get a little worse before it gets better. Industrial production is very much in agreement with the GDP trends. We’re seeing similar declines to the global financial crisis and a more severe decline in manufacturing activity than the 1980, 1992 and 2001 recessions.
There continues to be very little inflation. Typically in pandemics you get disinflation and that’s exactly what has happened here—though there have been some notable increases in food and healthcare.
US Initial Jobless Claims.
US initial jobless claims are surprisingly still elevated. The worsening of this data supports the odds of fiscal policy extension from the US government in the form of unemployment benefits and perhaps additional stimulus checks. We should see improvement here but the real issue
is the potential of permanent job losses. It’s one of the factors that make us believe we’re in for more of a “W-shaped” recovery rather than a “V-shaped” recovery. Asset prices are different because of the Fed intervention but the labor market and view of permanent job losses gives us confidence that this view is correct.
Small Business Optimism Index.
There are a couple of key attributes here. It’s still significantly off its highs but there’s more optimism than we anticipated. The key will be to watch US hourly earnings and payroll growth.
Prior to the end of all the recessions you see an improvement in payroll growth. We haven’t started to see that yet but that will be a key indicator.
There is very little degradation in housing data, which is highly unusual, but the market is benefitting from two things. One, there’s a limited supply of new houses due to a national foreclosure moratorium, but that could end soon. Then you have the urban to suburban flight associated with concerns over living in densely populated cities. We should add there’s tremendous support through lower interest and mortgage rates, which have only recently started to come down. It’s possible they have even further to fall.
One of the new additions to our analysis is the introduction of alternative data, particularly as it relates to the consumer. The advantage of this is instantaneous foot traffic data in a variety of views. Essentially, this is real-time data given to alternative data providers through your phone and it’s incredibly granular.
First, you’ll notice an instantaneous decrease from shutdowns then a significant improvement when we reopened. Then you can see a downtick in recent data in all regions and locations, retailers and food categories, as the virus spreads in other parts of the country. As with most of the data, July will give us an idea of how severe this recession is going to be.
We have also incorporated Google trends. This has been around for a while but it’s particularly relevant today because it helps predict the direction of government data. As such, we focused on the search terms “unemployment” and “PUA unemployment'' [Pandemic Unemployment Assistance]. As economies in areas with higher virus cases shutter yet again you notice the labor market beginning to worsen. These trends will precede actual government data by pretty large magnitudes, which gives us the ability to capitalize on instantaneous trends to make sure our portfolio is positioned appropriately ahead of the official data.
After a tremendous collapse in Crude Oil production, oil prices firmed up from 20 to 40 [dollars per barrel]. Many of the marginal producers have tremendous debt loads so they’ll need to pump as much as they can to service this debt. Overall, commodity prices saw a little bounce as the dollar continues to weaken. The biggest winner here will be Emerging Markets. Watch for a robust bounce back here as the dollar continues to weaken.
We’re experiencing the tale of two markets. The S&P 500 is a market cap weighted index, whereas the equal weight treats everyone the same. So the S&P is essentially flat on the year, but the equal weighted index is down 11%. This is easily explained by the fact that the top 50 names on the index have seen all of the inflows, whereas the bottom 450 have seen outflows.
Looking at the S&P 500 valuation we have unusually high valuation levels. The markets are trading at 15 times enterprise value to EBITDA levels, which may be unprecedented. We can’t recall a time where we’ve seen declining profitability with such elevated valuations. While we’re not sure exactly how to gauge this, there is a clear corollary with the government buying assets.
Internationally, the US continues to significantly outperform international equity returns. Junk bonds are down 4.52% year-to-date and we’re seeing unusually low spreads in investment grade and triple-Bs considering we’re in a fairly severe recession. Absent federal intervention we suspect we would have been well above cycle high credit spreads, so we’re thankful for that.
In generic treasuries we’ve seen very low yields across the board. They staged a rally associated with the re-opening but more recently interest rates have declined across all maturity buckets. It’s somewhat concerning because it suggests that we’ll have very difficult economic data over the next couple of quarters.
This is the story in many ways. The size of the Federal Reserve balance sheet increased by 70%, from $4 trillion to $7 trillion. More recently the size of the balance sheet appears to have shrunk, but we would point out that it hasn’t really. The Fed had Repo facilities open with foreign governments but because the markets are open and functioning now, they haven’t had to use them again. So at some point you’ll start to see the balance sheet increase again.
Oxenham concluded his remarks by setting expectations for the current bear market and recession. The investment team noted that based on recorded historical data, the average bear market and recession lasts approximately 15 months. They believe this recession will follow suit but that it will take time and space to fully clarify and assess the damage inflicted on the global economy from COVID-19 and forced government shutdowns. Thus, the committee is not prepared to take a fully “risk on” position.
Hilton Tactical Income Asset Allocation
Hilton CEO Craig O’Neill concluded the presentation with an overview of Tactical Income’s second quarter performance and asset allocation. The following are his remarks:
Craig O’Neill: Coming off the market bottom lows near the end of Q1 you may recall that we positioned the portfolio pretty defensively. Longtime Tactical Income investors know that one of the main objectives is to preserve capital. At the time of the collapse it was unknown what the full extent of the economic damage would be, how long the shutdown would last, and what the post pandemic landscape would look like. So we decided to reduce the volatility in the portfolio and take out some of the risks that we saw as black or white and add to asymmetric risks that would work out in multiple economic scenarios.
Broadly we came in the second quarter with 22.8% in cash, 23.5% in equity and 53.6% in fixed income assets. As the markets rallied off a Fed-fueled bottom we realized that we might have been a bit conservative in our allocation and we needed to play catch up. But under the pretense I mentioned earlier—constructing a portfolio geared towards lower volatility and preservation of capital-- we needed to do this in a responsible way.
As you can see we added risk to the portfolio throughout the quarter but we found ourselves in a hole relative to the overall market. At the end of the quarter we had to put a significant portion of that cash back into equities and into some fixed income to end the quarter at about 4.9 percent cash, 36.4% in equity and 58.73 in fixed income.
The overall equity portion of the portfolio was up 12.8 percent. The biggest additions we made were to consumer staples, healthcare, consumer discretionary, utilities and technology with pretty broad distribution overall and again going to the bigger names. The only sector we trimmed was financials, which we cut in half. Bigger and better was the theme. Lower levels of debt and better balance sheets. The strategy is to participate if there’s a continued march higher, while remaining less volatile if there’s a downturn and we get some of the rollover Alex mentioned.
Moving to the fixed income portion of the portfolio we have 58.7% in fixed income. Of that 24.6% is in corporate debt, 13.6% is in preferred stock and 11.4% percent is in agency mortgage backed securities. The balance is in US Treasuries. That was the biggest change we had in the fixed income side of the portfolio. Unfortunately the majority of the treasuries that we owned were in short-dated paper so when the correction occurred we didn’t get as much bang for the buck as we would have if we were in medium or longer term treasuries.
The Final Tactical Income Strategy Allocation - End of Q2
58.7% Fixed Income