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The Quarterly Report

  • The Quarterly Report
  • First Quarter 2023
  • Iron Capital Advisors

How’s Business?

“Are we heading into a recession?”

This is the number-one question I have been getting from clients recently. I answer with a question: How is your business? The answers vary, even inside the same company.

One of our long-term clients is primarily in the transportation business. They have other businesses as well, including a few very good restaurants, but their main business is helping goods get into our harbors, off of ships, and up rivers. They have several locations around the country, and we get to go to all of them. I shouldn’t say this on the record because now they will be on to me, but casual conversations with this client have an impact on our view of the economy. They are on the front line. I almost laugh when they ask for my view – I sit in an office reading reports. These folks are moving a significant portion of everything you buy. They will know long before I do whether the economy is slowing down.

Just a few weeks ago I was visiting their Norfolk, VA, location. Someone there asked me about the economy, and I replied by asking about their business. “We are busy,” was the response. Last year was a record year and they are expecting it to be just a little higher this year. That is an encouraging sign, but is it universal?

A few weeks before that visit I was talking to the same company’s CFO. When I asked him how business was going, his response was a little different. He said that when viewing potential mergers or acquisitions, they now had to factor in the cost of capital. In other words, higher interest rates mean that it will cost them more if they decide to purchase another company. That may mean fewer business deals this year. That isn’t encouraging.

Meanwhile, one of my colleagues visited the same client’s New Orleans location. When he asked how their business was going, they said it was good, but some of their clients are seeing a slowdown because they used to bring grain from Russia, which now isn’t happening because of the war in Ukraine. That is interesting.

The same client, yet three different takes on the economy. I have also gone on record saying that I believe the power of the Fed over the real economy is hugely overrated. I still believe that, and I still believe that Wall Street and economists in general remain overly pessimistic. How do we make sense of these mixed messages?

Albert Einstein famously said, “If you can’t explain it simply, you don’t understand it well enough.” I believe he is correct, but it goes further. Most experts can’t explain things clearly because they are more concerned with being considered an expert than communicating clearly to the everyday person. In other words, their egos get in the way. They insist on peppering their speech with jargon, or worse yet, acronyms. As a result, in my opinion, they often lose sight of the most basic fundamental understanding of what is actually happening.

The experts cite past data showing that when the Fed raises interest rates, the economy goes into a recession. They get so focused on analyzing data that they forget to ask the most fundamental questions: Why? What is really happening?

Raising interest rates impacts just one thing: the cost of borrowing money. That is what interest rates are – they are the cost of borrowing money. When one purchases a house, she usually borrows the money in the form of a mortgage. That mortgage, like all loans, has an interest rate tied to it, and the interest must be paid. The higher the interest rate, the higher the monthly payment.

However, that same consumer, if she is being responsible, doesn’t borrow money to buy groceries, clothes, or any other day-to-day item. Most of the goods we buy do not require loans, so interest rates don’t have an impact. Likewise, a company will usually borrow money to buy another company, to build a factory, or for any other major business investment. That same company hopefully does not borrow money to hire a new employee, pay their office lease, or any other routine business expense.

Those day-to-day items, which are paid for out of pocket, make up the bulk of economic activity. Roughly 70 percent of our gross domestic product (GDP) is made up of consumer spending. For consumers to spend, all they need is an income source, preferably a job. Companies mostly hire without borrowing and most consumer spending is done without borrowing, so the majority of the economy is not actually impacted by the Fed raising interest rates.

However, there are items that typically require borrowing, and these items will be impacted by higher interest rates. For the consumer, those are primarily automobiles and houses. For companies, the biggest items that require borrowing in our current economy would be other companies – mergers and acquisitions. One of the primary drivers of an individual company’s growth is its ability to purchase competitors and/or suppliers. Occasionally they will even purchase a completely unrelated business.

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Mergers and acquisitions also fuel much of the financial universe. Investment bankers are the financial professionals who help negotiate and fund mergers and acquisitions. This is a large part of Wall Street’s business, and that is important to understand. Higher interest rates will make it more expensive to buy businesses, just like they make it more expensive to buy houses. That will result in fewer mergers and acquisitions.

How do fewer mergers and acquisitions impact the economy? Buying another company can be of significant benefit to the owners of both companies. The owners of the company being purchased get a big payday, and the owners of the purchaser now own a much larger company. What benefit is this to the economy as a whole? Very little, if any. Economic activity is measured by GDP, which is the gross domestic product – or in plain English, everything that is made and consumed in the country. The two companies produced a certain amount of goods. When they become one company, they still produce roughly the same amount of goods. There may be some efficiencies gained that boost production on the margin, but that also comes with the fact that two companies becoming one usually involves some people losing their jobs. This activity is great for owners and for Wall Street, but it doesn’t really help the economy.

Today we seem to be in the mirror image of what occurred in The Great Recession following the 2008 financial crisis. For nearly 8 years after that crisis, we kept hearing from Wall Street and economists that growth was right around the corner. Yet years after the crisis ended surveys suggested that most people still thought we were in a recession. Why? At that time the Fed aggressively reduced interest rates, eventually all the way to zero. Money was practically free to borrow.

This spurred a boom in housing and in mergers and acquisitions – big purchases that require borrowing. Housing will stimulate the economy, but as we discussed, mergers and acquisitions don’t really add to the economy as a whole. So, while business owners and financial professionals benefited from free borrowing, the bulk of the economy just didn’t grow. This led to an environment where economic growth kept disappointing the financial experts.

Today interest rates are rising, and the same financial experts who kept predicting growth that didn’t come a decade ago are predicting a recession that has yet to show up now. We can see why Fed policy impacts the owner class and financial professionals much more than it impacts the economy as a whole, but why can’t the economists see it? My theory is that it is human nature to see the world through one’s own view. In my experience, this happens regardless of one’s level of sophistication. We all tend to believe that people think the way we do, and that what we are experiencing is what everyone else is experiencing.

When interest rates are very low, things like mergers and acquisitions happen easily, benefitting business owners and financial firms who are the primary employers of economists outside universities. Their economic lives are good, so their view of the economy is positive. When interest rates are higher, things like mergers and acquisitions become harder, and that hurts business owners and financial firms. Their economic lives are in recession, so their view of the economy is negative.

Meanwhile, the vast majority of consumers are just going on with their lives. When there are a lot of mergers and acquisitions happening, rank-and-file employees are under stress. Things at work are changing and some are likely to lose their jobs. They may even curtail their spending. When interest rates are high, there is less change at work. The consumer hangs in there.

This explains a great deal about why, in the last 20 years or so of record-low interest rates, the gains in our economy have skewed to the owner class and financial professionals. There has been disappointing overall growth and an increase in inequality. It also explains our current situation, and the different stories from our client in the field and the chief financial officer.

But what about the slowdown driven by government sanctions on Russia? Economists love to analyze interest rates and tax rates because these are numbers and can be quantified. Government regulation, on the other hand, cannot be quantified easily, if at all. Sanctions against Russia are a great example: As long as our government says no to Russian grain, it will not come here. It doesn’t matter how much demand there is for grain, or what interest rates are. This is a structural barrier that cannot be overcome. Only the government can remove that barrier if they so choose.

I do want to be clear: Sanctioning Russia may very well be the right thing to do, but that is a political judgment and not an economic judgment. These sanctions, like all government regulations, create structural barriers to economic activity that cannot be overcome by attempting to stimulate the economy. This is important to understand, because over the last 23 years, there has been only one period of time when economic benefits were flowing to rank-and-file workers faster than to owners: that was in 2017-2020, when we saw the first decline in regulation since the 1990s.

When structural barriers are removed, then we can get real economic growth, which benefits everyone, instead of financial engineering, which only benefits the few. Today we are going in the opposite direction, which does not bode well for the longer term.

In the meantime, the economy is hanging in there better than most experts suggest. This is because rising interest rates are not actually stopping consumers from living their daily lives; they are, however, making it harder for mergers and acquisitions. They triggered a bear market last year.

This all means that those experts who are predicting doom and gloom are themselves experiencing a personal economic recession, coloring the lens through which they make their projections. What they are really saying is that they are being hurt by this environment and therefore they assume everyone else will be hurt as well. It is understandable, but it may not work out that way. We maintain our view that we will either escape a recession all together or have a very mild one. We are not basing that on our business, but on feedback we get from others.

So, how is your business?

Warm regards,

Chuck Osborne, CFA
Managing Director

Review of Economy

The 4th quarter 2022 GDP growth came in up 2.6 percent, which follows the 3.2 percent rise in the 3rd quarter. Most expect 1st quarter to be positive, but barely. This may prove overly pessimistic once again.

The official unemployment rate remains 3.5 percent through March. The labor market remains tight, and participation is
growing. This is occurring while inflation is coming down, so it will be interesting to see when this good news is treated as good news by the market.

Inflation is 6 percent based on the latest consumer price index report. While still high the level has been consistently dropping for several months. The producer price index, which tracks wholesale prices, is up 4.6 percent over the last 12 months. +

Review of Market

Tech stocks rallied. For the quarter the S&P 500 finished up 7.50 percent, and small company stocks represented by the Russell 2000 index were up 2.74 percent. Growth outperformed with the Russell 1000 Growth index up 14.37 percent while the Value index was up 1.01 percent. For small companies the growth index was up 6.07 percent, and the value index was down 0.66 percent.

Bonds also provided positive results. The Barclays U.S. Aggregate Bond index ended up 2.96 percent. High-yield bonds rose 3.72 percent. Bond yields remain attractive.

International stocks continued to do well. The EAFE index finished up 8.62 percent and the MSCI Emerging Markets index ended the quarter up 4.02 percent. +

Market Forecast

Pessimism remains, and results are still likely to be better than expected. This should continue to bode well for the market in 2023. Having said that we would not be surprised if markets correct after two positive quarters.

In the longer-term value stocks and small company stocks still look more attractive. International stocks look more attractive than domestic, and the currency situation seems to be normalizing. This bodes well.

Bonds still look worthwhile and are behaving like bonds should. Yields have come down to the lower end of their range so we may see yield rise in the short term. +