Category: Investment Letters

I was deep into drafting this letter when the futures market began selling off on Sunday night, forcing me to pause and rethink much of what I had written. The recent market volatility has been truly extraordinary. On the upside, it’s led to my phone buzzing nonstop with calls, emails and texts from concerned friends and clients, a level of engagement that I appreciate. 

On Monday, the Tokyo Stock Exchange Stock Price Index (“TOPIX”) experienced its worst day since 1987, serving as a stark reminder of the fragility of global markets. While we’ve weathered significant global storms such as COVID-19 and the global financial crisis, Monday’s plunge in the TOPIX was the most severe in nearly 40 years. Considering all that has transpired since 1987, it’s remarkable that Monday stands out as the worst day. Naturally, this turmoil spilled over into the U.S. markets, as global sell-offs often become contagious. 

 “Only when the tide goes out do you discover who’s been swimming naked.” — Warren Buffett

The U.S. market was already on shaky ground due to weak economic data, including disappointing labor and manufacturing reports, which stoked fears of a global economic slowdown. Many believe that the surprise rate hike by the Bank of Japan was the catalyst that ignited a broader market sell-off, shocking investors who had expected a continuation of low rates. This triggered a sharp decline in the equities of major Japanese trading firms, leading to turmoil across Asian markets and eventually cascading over globally. The interconnectedness of the global financial system means that events in one region can quickly affect markets worldwide. Specifically, many investors were short Japanese bonds to invest in higher-yielding assets elsewhere, and when a global shock occurs, those trades unwind violently. Of course, many apply copious amounts of leverage to this carry trade to increase returns. It’s a clear reminder that while markets tend to rise slowly, they often fall quickly—much like taking the stairs up and the elevator down. 

When the sell-off begins and volatility spikes, it’s a risk-off scenario across most risk assets. This is largely driven by leveraged positions and risk management practices. In leveraged portfolios, increased volatility translates to increased risk, prompting managers to reduce their exposure. This often leads to the selling of the best-performing stocks or other assets, exacerbating the decline. At one point, the VIX surged over 60% on Monday, marking the highest level since the COVID-19 shutdowns. What happens next? My phone starts to buzz… 

“If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.” — Milton Friedman

The unemployment rate is currently 4.3% and beginning to rise, but it remains well below the historical average of 5.7% over the past 70 years. The Federal Reserve, with its dual mandate to manage both inflation and unemployment, is now shifting its focus more towards the latter, as inflation appears to be under control at this juncture. 

It’s important to note, however, that the current low unemployment rate might be somewhat misleading. Recent studies have shown that a significant portion of post-COVID job growth has been driven by immigrants. In fact, one study suggests that 75% of employment growth since 2019 has been attributed to this demographic.(1) 

U.S. GDP has shown robust growth, with Q2 coming in at 2.8%, and the Atlanta Fed’s GDPNow currently estimating 2.9% as I write this. This is near the upper end of the healthy 2-3% growth range (see shaded area in the chart below). If this economy doesn’t feel like your typical growth environment, you’re not alone. Many have yet to fully adjust to the previous price increases, which still weigh heavily on consumer sentiment. Government spending has been a significant driver of recent GDP growth, fueled by the passage of the Inflation Reduction Act, the Infrastructure Bill, and the CHIPS Act. As these initiatives continue to roll out, we expect this trend to persist. Over the past six quarters, even if all other economic activity were stagnant, the economy would have still averaged nearly 0.7% GDP growth per quarter solely due to government spending. 

The market is currently pricing in five rate cuts by January 2025, with a 76% probability of a 50 basis point cut in September. Given rising unemployment and the difficult housing situation, I agree the likelihood of at least one rate cut in September is extremely strong. As I’ve highlighted in previous letters, the rate curve used to forecast these probabilities is highly volatile. We’ve witnessed market expectations fluctuate significantly—from anticipating seven cuts, down to just two, and now back to five—reflecting the uncertainty and sensitivity of market sentiment to evolving economic conditions. 

Looking ahead, we have two more CPI and jobs reports scheduled before the next Fed meeting. If these data points align with recent trends, we can expect the much-anticipated Fed cuts to begin in September. 

These rate cuts are particularly significant for smaller businesses. A compelling chart from Torsten Slok of Apollo illustrates the growing divergence between Large Cap (S&P 500) and Small Cap (S&P 600) companies following recent rate hikes. Smaller companies, which are more reliant on floating-rate debt due to limited access to capital, are particularly vulnerable to changes in interest rates. This sensitivity is clearly reflected in the data, highlighting the disproportionate impact that rate increases can have on smaller firms compared to their larger counterparts. 

“If you don’t know where you’re going, you might wind up someplace else.” — Yogi Berra 

So, where does this leave equity markets? They remain expensive. The S&P 500 is currently trading at 21.5 times forward earnings, nearly two standard deviations above historical norms. The bifurcation in small-cap performance, as highlighted by Torsten’s analysis, has led to significant underperformance of smaller-cap companies. Since January 2023, the S&P 600 has trailed the S&P 500 by almost 19%, underscoring the stark contrast in market dynamics between large and small-cap equities. While we expect that rate cuts could provide some relief to smaller companies, if we are indeed entering into a recession, the benefits of these cuts may be outweighed by the broader impact of a slowdown in economic activity. 

An interesting trend to watch is the performance of the AI hyperscalers—Amazon, Microsoft, Google, Meta, and Tesla—who are leading the charge in AI development and capital expenditures. Last quarter saw a noticeable shift among investors, who are increasingly focused on when they will see tangible returns on their AI investments and what those returns will be. David Cahn of Sequoia Capital published a thought-provoking article titled “AI’s $600 Billion Question,” which I highly recommend. The key takeaway is that the gap between expected AI revenue and actual returns, given the enormous spending, has raised concerns about the profitability of AI models going forward. This situation has profound implications not only for the hyperscalers but also for the overall performance of the S&P 500. While I’m far from being an AI skeptic, it’s important to note that if the return on invested capital decreases, it logically follows that multiples should adjust downward, ceteris paribus. 

Portfolio Updates 

We’ve made significant and exciting changes in both our Autumn Lane Diversified Strategies and Autumn Lane Alpha Opportunities portfolios. We’ve added some outstanding managers and have been reallocating from others. Due to lock-up provisions, it will take a few quarters to see the full impact of these changes. However, we are excited and confident that our expected risk-adjusted returns should improve materially. We look forward to continuing to enhance the portfolio and generate alpha. 

As always, if anyone has any questions or would like to discuss the markets further, please do not hesitate to reach out. 

Best Regards,
Jim Mooney
Partner and Chief Investment Officer
Autumn Lane

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

(1) Center for Immigration Studies, June 10, 2024.

The past quarter has flown by fast. Growing up, my stepmother often remarked that time accelerates as you age. At the time, I probably just ignored her warnings and went about my day, but now, I find that no truer words have ever been spoken. 

 “Las Vegas is the only place I know where money really talks — it says, Goodbye.” Frank Sinatra

I recently had the pleasure of attending an annual family office conference in Sarasota. It was a fantastic gathering where I met other CIOs to discuss investment ideas and market trends. Despite differing perspectives, I left with the same impression as when I arrived: there is a prevalent concern among investors regarding the valuation of public markets—and for good reason. 

Looking at the work and data of Nobel Laureate Robert Shiller, we find compelling insights from his CAPE (Cyclically Adjusted Price-to-Earnings) ratio, which has forecasted stock returns over the next decade since 1881. Assuming Shiller’s current math holds true, we might expect a real asset return of only 1.8% annually over the next ten years—a figure that is hardly compelling when compared to historical market returns. 

I keep hearing the argument about the record amount of capital in money markets, just waiting for the right moment to “buy the dip.” While it’s true that money market assets are near historic highs, their buying power, especially compared to all domestic public indexes, is below the average of the past twenty years (see next page). Not surprisingly, this ratio reached its peak during the Global Financial Crisis in 2008, indicating the highest level of ‘dry powder’ available at the time. 

“Inflation is like toothpaste. Once it’s out, you can hardly get it back in again.” Dr. Karl Otto Pohl 

Over the last past months, the Consumer Price Index (CPI) has started to rise again, presenting a bearish outlook for long-duration bonds and valuations overall. The primary driver behind this uptick has been the services sector, which traditionally shows less sensitivity to interest rate changes compared to goods. Alternatively, the services sector tends to be more influenced by wage levels and employment rates, both of which have remained robust—at least for the moment. 

In my previous update, I mentioned that the market was anticipating six rate cuts by January 2025. However, as I write this letter, expectations have adjusted significantly downward to fewer than two cuts, with the precise figure being 1.66. If we take the Federal Reserve’s statements regarding their data-dependent approach at face value, it seems unlikely they will cut rates in the near future unless there is material change in the inflation data. 

“No government ever voluntarily reduces itself in size. Government programs, once launched, never disappear. Actually, a government bureau is the nearest thing to eternal life we’ll ever see on this earth!” Ronald Reagan

The Gipper was spot-on with his quote. One of the most alarming charts I’ve seen recently is from the Congressional Budget Office, projecting the US national debt to GDP ratio. I remember a time when at least one political party cared about deficits, but it seems the Tea Party movement has long faded. Meanwhile, proponents of Modern Monetary Theory argue that excess government spending or deficits don’t matter, often citing Japan as an example. Well, Japan is looking like it finally crossed the Rubicon. Since 2023, the yen has depreciated over 20% against the dollar, and the decline shows no signs of abating. In my experience, these economic shifts occur just as Hemingway famously described: gradually, then suddenly. Japan looks like they have moved on to the ‘suddenly’ phase, which I hope serves as a wake-up call for our Congress.

“That’s it, man. Game over, man! Game over! What are we gonna do now? What are we gonna do?” Private Hudson in Aliens

Given the current S&P 500 valuation coupled with concerns about persistently high interest rates, adopting a prudent stance is, in my opinion, important. In the near term, we are concerned about the valuations of longer-duration assets, such as bonds and corporate real estate. 

We have been strategically “weatherproofing” our ALDS and ALAO portfolios by increasing exposure to investments that will benefit from a higher for longer yield curve environment such as funds with exposure to floating rates. Furthermore, we are allocating resources to market-neutral funds with proven track records of profitability in various market conditions—whether rising, falling, or remaining flat. 

The present setup does not necessarily mean that equities cannot go higher; however, the path to achieving these gains becomes more challenging. To echo my earlier reference to Frank Sinatra, the cards are stacked against you. 

If anyone wishes to discuss markets at any time, please do not hesitate to reach out. I am always eager to assist. 

Best Regards,
Jim Mooney
Partner and Chief Investment Officer
Autumn Lane

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

I am thrilled to introduce myself as the newly appointed Partner and Chief Investment Officer at Autumn Lane, effective last Friday. It has been a pleasure meeting many of you, and I eagerly anticipate connecting with everyone else. Before delving into a few market insights, allow me to share a bit about my background.

With 18 of the last 20 years dedicated to principal investment roles at Millennium Management, Carlson Capital, and most recently, Everpoint Asset Management (Point 72), my focus spans global public equities, bond portfolios, and private equity investments.

My connection with David Andrew dates to our time at Lehman in the early 2000s. I became an early client of Autumn Lane in 2017, and our enduring friendship has only strengthened over the years. I am excited about the opportunity to collaborate with David and the exceptional team he has assembled at Autumn Lane.

In the second week of January, I had the privilege of attending a summit in Jackson Hole alongside impressive C-level executives from the Energy, Power, and Renewables sectors, as well as some of the largest global asset managers. It proved to be an enriching conference.

A key takeaway from other institutional investors was the macro impact on the market post-COVID era. I find myself closely following Fed meetings, a habit I didn’t have pre-COVID or even during the great financial crisis.

This week, the market’s attention is on the Richmond Fed Index (Tuesday), Purchasing Managers’ Index (PMIs) (Wednesday), Personal Consumption Expenditures and Durable Goods Orders, Initial Job Claims, New Home Sales (all Thursday), and Personal Consumption Deflator (Friday). While constructing portfolios throughout my career, I seldom focused on these high frequency data points, with the exception of PMI data as a leading indicator for commodity demand. The market eagerly awaits the next data point to gauge when the Fed might cut rates, with the current market pricing in six cuts by Q1 of 2025 (see below).

Why does this matter? The market seeks an anchor for the risk-free rate, in our case, the 10-year treasury bond. A lower 10-year rate historically correlates with a higher market valuation. As the risk-free rate contracts, justifying higher multiples becomes easier. However, the equity risk premium is currently the narrowest since 2002, emphasizing the need for accelerating earnings growth or higher market liquidity.

Empirically, equity performance (orange line) post the first rate cut has not been favorable. The market tends to peak into the first rate cut, forgetting that rate cuts (blue line) historically coincide with slowing economic growth and recession risk (grey bars).

In my perspective, the majority of the fixed income pundits are fixated on a post-Global Financial Crisis (GFC) world, deeming anything surpassing a 3% 10-year as excessive. However, let’s not lose sight of the broader picture – over the past 60 years, the 10-year has averaged approximately 5.9%. When we strip away core inflation as measured by the Consumer Price Index (CPI excluding food and energy), this yields a 2.1% real rate over the last six decades.

Perusing the chart below underscores that post the GFC, real yields reached multi-decade lows. Nevertheless, it doesn’t strike me as unreasonable for the market to anticipate a 2.1% real yield, excluding the financial effects of Quantitative Easing. So, where does this position us on a nominal basis? Assuming a 2.5% inflation going forward, a 2.1% real yield, and some term premium (let’s say 100 bps), a back-of-the-envelope calculation brings us to 5.6% for the 10-year UST. While adjustments to these inputs are prudent and necessary, it appears evident that anything below 4% seems overly ambitious, unless investors are positioning defensively for a significant downturn (aka the hard landing).

Where does this leave us? Concerned about both equity and debt markets. The 10-year and major US indexes do not seem to offer good value in our opinion. Nevertheless, companies with high-quality businesses, strong barriers to entry, and excellent returns on invested capital are poised to continue to outperform. Where could we be wrong? If data indicates a potential plunge into a severe recession, bonds are likely to witness a rally (price up, yields down), following a playbook observed for generations. The abundance of risk-free assets, stemming from government deficit spending, may not hold immediate significance. On the equities front, the influence of animal spirits could persist, propelling valuations even higher.

As we review and make recommendations for our existing portfolios at Autumn Lane, we are identifying compelling niches in the global markets that appear promising, and I look forward to sharing more details in my next update.

Best Regards,
Jim Mooney
Partner and Chief Investment Officer
Autumn Lane

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

Executive Summary

• There is a cost to the monetary and fiscal stimulus that has propped up asset prices;
• Market imbalances will result in government intervention through regulation and rising taxes;
• Investment opportunities exist, but a more active approach is recommended.

2021 – The Year Ahead (and Beyond)

In the spring of 1907, the panic on Wall Street first appeared as market volatility increased. Economies of the world were more closely tied to one another than ever before and fear of a global financial contagion was realized. The resulting panic erased nearly 50% of the U.S. stock market’s value and led to intervention by key financial figures, new legislation, and eventually monetary management via a central bank.

The years following the Panic of 1907 included America reluctantly at war and a novel influenza pandemic. Even though the economy was strong, a technological revolution exacerbated the existing income divide even as it improved the lifestyles of many. The war, economy, large-scale unemployment, riots and a desire to make America less interventionist influenced the Presidential campaign with a call for a “return to normalcy.” As 1921 began, America looked forward to a new year.

George Santayana wrote, “Those who do not remember the past are condemned to repeat it.” The similarities of the Panic of 1907 to the Financial Crisis of 2008 are striking. Both were caused by the failure of a bank that led to the evaporation of liquidity and debt unwinding. It was the strong financial leadership by John Pierpont Morgan in 1907 and Hank Paulson in 2008 that arrested the economic fall. Both experiences led to more monetary tools for economic intervention.

The Flu of 1918 and COVID-19 are, of course, coincidences. Both are the result of continuous mutations that eventually produce something awful. These two pandemics occurred nearly 100 years apart (like the cheating scandals that tainted our national pastime – the Chicago Black Sox and the Astros’ Banging Trash Can). While it is a stretch to compare WWI with today’s Middle East and Afghanistan, the resulting desire by many for America to turn its gaze homeward and away from the world is a familiar sentiment.

Today we find ourselves amid a technological revolution. One hundred years ago, the automobile, electricity and the assembly line were changing and, for the most part, improving the lives of everyone. These technological leaps hurt some industries and forced many workers to change occupations, but the efficiency and lifestyle improvements they brought were incredible. Today, we find ourselves in a similar state of technological evolution. Cloud computing, social networking, video conferencing and AI are disrupting the way many people and businesses conduct themselves. And while they are improving efficiency and creating new opportunities, they are also adding to social anxiety. This anxiousness is showing up everywhere, from the boardroom to our family dinner tables.

Sitting at our desks we cannot help but wonder if these similarities continue. Does the next decade look like the roaring 1920’s? Does President Biden imitate President Harding, who stated:

“America’s present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.”

More specifically though, does the economy of this decade develop the same time bomb as the economy of the 1920’s? What are the differences that hopefully result in something less depressing?

There are plenty of differences. The biggest is the standing of the United States on the world stage. Following WWI, our nation was just becoming a world power. Whereas today, the U.S. is a superpower, and our dollar has replaced gold as the world’s reserve currency.

A more nuanced difference is the possibility that today’s technological revolution permanently reduces the labor input required for economic activity. Whether it is the rapid adoption of videoconferencing as a substitute for business travel; contactless order and pay features replacing the need for checkout clerks; autonomous driving displacing taxi, truck and ride-sharing drivers; or Artificial Intelligence executing tasks from administrative to reading x-rays, the common thread is less future demand for human labor. This has severely affected the service sector. The big question now is where do these displaced employees land? It is easy to see how the saddleries of the 1900’s could evolve into the filling station of today and factory workers displaced by manufacturing improvements became the truck drivers delivering the mass-produced goods. Yet it is not as easy to see what will happen to the warehouse worker displaced by a robot, the kid at McDonald’s replaced by a mobile device, and the administrative assistant replaced by Siri.

These unemployed or underemployed exacerbate the social unrest that already exists. How much longer can technology companies improve profits by leveraging a low wage workforce? Think about it, Uber is worth $110 billion, and its main means of profit is making sure it doesn’t have employees but rather low-cost contract labor. How America and other world governments will respond to this is not known. However, the populist ideas catching fire across the world provides us with a hint. Governments will try to break up many of these new efficient companies or create policies and regulation that decrease efficiency (i.e. Uber drivers will be employees and subject to a new minimum wage).

Finally, the stimulus that governments have thrown at their economies has been primarily captured by the investor class, and the economic divide between the have and have-nots has continued to widen. What is the most probable government solution to this? Just look back to 1932, when the highest marginal income tax rate jumped from 25% to 63% (on its way to 94% in 1944). It is going to be hard to avoid the redistribution of income and wealth via the tax code.

Another difference and likely justification for increasing tax rates is the total U.S. debt-to-GDP ratio. In 1929, the U.S. Government’s debt to GDP stood at 16%. As of June 30, 2020, the U.S. debt-to-GDP ratio stood at 136%. Old debt is like an anchor when it comes to growth. You must spend money on interest and paying off the old debt before investing in the future. Thus, the US and most developed economies all have a heavy yoke to bear.

What is our prediction for the future? A relatively strong U.S. economy supported by its reserve currency should provide a better path than that of the 1920’s. However, combine increasing regulation and rising tax rates with the potential for inflation caused by a permanent expansion of the money supply, and valuations must come down. So, while we are looking forward to seeing our friends and families, we must unfortunately face the result of a decade of monetary and fiscal stimulus. There is no way around it. When a system becomes unbalanced, something must change to set things right again.

The forced rebalancing will cause a continued increase in the variability of asset prices. This increasing volatility will provide sharp investors with ample opportunity for excess returns. Thus, we believe that shifting a portion of passive market exposure (indexing) to more active, opportunistic investing (public or private) is justified. For those who have known us a long time, what we are saying is contrary to what we have said in the past. But the situation has changed, and a rising tide is about to start receding.

It is very difficult, if not impossible, to time the market. Thus, our belief of keeping risk capital invested remains unchanged; underinvestment is itself a risk. The key is to navigate the upcoming volatility with a more diverse portfolio of uncorrelated investments and stable assets that can withstand the upcoming political and inflationary risks. All of us at Autumn Lane will continue to look for these opportunities.

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

Executive Summary

• While we still believe as detailed in the Annual Letter dated March 9th that:
  • Real interest rates will stay low for the foreseeable future (think years);
  • COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
  • COVID-19 will be contained with a vaccine/treatment at some point; and
  • Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.
• We want you to consider the risk that the unprecedented monetary expansion will cause a devaluation of fiat currencies, including the US dollar.

Inflation Ahead…

In the months since the COVID-19 pandemic, there’s been a lot of concern about the consequences for our country, especially the 100,000-plus deaths and the economic catastrophe. Amidst unemployment claims topping 40 million, there hasn’t been a lot of attention paid to the threat of inflation which, perhaps, shouldn’t be that surprising. We tend to associate inflation with economies that are growing too fast or suffering a shock in prices like the oil embargo of the mid 1970s not with ones facing record unemployment. Indeed, the annual inflation rate was a mere 0.3 percent for the 12 months ending in April. U.S. consumer prices actually dropped 0.8 percent in April and, as we know all too well in Houston where I’m based, energy prices collapsed. Prices at the pump dropped some 20 percent in April.

But there is a reason for investors to be worried about future inflation and to consider what to do now in preparation. We wanted to share a few thoughts –not as specific investment guidance but as things to think about in the weeks and months ahead.

Why are we worried about the possibility of serious inflation? There are a few reasons. First, is the money that’s been helicopter dropped into the economy–trillions in direct payments to businesses, individuals as well as state and local governments. Congress has approved one $3 trillion package and there’s surely more to come. Then there’s the Federal Reserve not only cutting rates to near zero but engaging in quantitative easing that makes the 2008 financial bailout look like a payday lender. You don’t need to be a tight money zealot to believe that this deluge of money is the classic precondition for devaluing the currency and producing inflation.

You might be comforted by the fact that the economy was not racked by inflation following the Great Financial Crisis of 2008-9. But there’s little solace to be had from that example. Unlike the financial crisis, where the nation’s housing stock was overbuilt and there was lots of excess supply, this time there’s no such surplus. Furthermore, the banking system was in desperate need of support, and much of the money went to shore up banking reserves. Today, the banks are in much better position and do not need balance sheet support. Finally, the size of this government bailout dwarfs the Troubled Assets Relief Program (TARP) or other programs from the decade’s first century. TARP started as a $710 billion program which sounds almost quaint these days and it was cut down to under $500 billion. Eventually, someone is going to stop buying U.S. debt and when that happens, the dollar gets slammed and prices rise even more. Large government deficits lead to continued large debt issuance, which must keep expanding in order to hold government purchases the same. It’s a vicious circle.

Then there’s “cost-push inflation” — what happens when prices go up because it costs more to make things. Consider restaurants. They’re starting to reopen which is great, but most can only open at limited capacity. Already operating on a narrow margin, they not only can’t afford to cut their prices, they would likely have to raise them just to stay in business. The same goes for airlines which may have to cut back the number of seats in each plane not to mention gyms and salons when they start to open en masse. They’re not going to be in a position to cut prices. Hotel chains are going to have to spend more on cleaning to lure customers back. What’s more, there are other cost-push factors now that could well contribute to inflation. The Trump administration is ramping up rhetoric towards China and tariffs and other trade restrictions could well be in our future. This effort to “on shore” manufacturing and other businesses that produce at lower costs in places like Taiwan and move them to Toledo will add to price hikes.

Other prices will start to rise because of “demand-pull inflation,” which arises from the shortage of supply. Oil plunged drastically this spring and winter but that’s going to shoot back up as people come out of lockdown. Who’s going to want to utilize public transportation in the near future? There’s huge pent up demand to travel after being stuck in the house and people are going to do this in their own vehicles. That’s going to send oil demand up. Meanwhile, the crash in oil prices combined with the shrinking of oil investment dollars will reduce supply – leading to an increase in oil prices.

It’s entirely possible we could end up not only with inflation but stagflation, which first emerged in the 1970s when inflation combined with high unemployment. We could get rising prices from all that debt as well as residually high unemployment as jobs in sectors like retail or commercial real estate never bounce back to pre-pandemic levels. I’m not saying this as a prediction, only as something for you to think about.

Finally, we are worried that the Federal Reserve cannot and will not crush inflation like it did in the 1970s and 1980s when Chairman Paul Volcker dramatically raised interest rates. Volker deepened economic misery but dramatically halted rising prices and put the global economy on a good course for 40 years. That hard-earned credibility is atrophying, in part, because it’s widely assumed that the Fed can’t shrink its balance sheet. If the market loses faith in the Fed’s ability to crush inflation, then money expansion is here to stay.

What might be good investments if inflation is on the horizon? Equities should remain a central part of one’s long term strategy. I’ve never really recommended gold but there is a reason to look at it now because it’s a classic hedge against devaluing currency. Residential real estate is also worth examining, especially affordable housing, which a troubled economy will need.

We’ve been through an incredible period as a country in just a few months–a health crisis, an economic crisis, and civil unrest. After all of that, it’s worth thinking about and preparing for different challenges ahead.

Sincerely,

David E. Andrew
Partner
Autumn Lane Advisors, LLC

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

Executive Summary

• Real interest rates are low and will stay low for the foreseeable future (think years);
• COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
• COVID-19 will be contained with a vaccine at some point, likely 12-14 months from now;
• Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.

2020 – The Year Ahead

We started writing this letter in January, and back then we were planning on discussing a recent academic paper about long-term real interest rates. You will have to take our word for it; the paper was riveting (all 123 pages of it). While we will still incorporate our thoughts on this academic study, the spread of COVID-19 and its impact (both socially and economically) has taken over the stage.

Today is March 8th, and there is still a lot of uncertainty regarding COVID-19. We will do our best in this paper to highlight facts from conjecture. However, investment is always based on both facts and the expectations of the future. If we could always invest with 100% conviction of the right answer, every investment would be risk-free… That is not reality; there are always unknowns. COVID-19 was an “unknown unknown” up until December of 2019. Now it is a “known unknown”, and we must take it into account.

2020 BC (Before COVID-19)

Prior to COVID-19, the market was doing just fine. Riding a wave of optimism following a stellar 2019, market talk centered around the US election. If you haven’t forgotten, the US is electing a President at the end of the year… Additionally, interest rates had seemed to find support, with the 10-year UST rate bottoming at around 1.6%. Historically speaking, 1.6% is rather low. Only a few times in history had the 10-year UST reached such levels. One would logically assume that rates would revert to their historical mean (i.e. going back up). However, a recent academic paper by Paul Schmelzing actually argues against this. Instead, Schmelzing, in his paper titled “Eight Centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018” shows a trend decline of real rates between 0.6-1.8 basis points per year.
Having read this paper, we found ourselves wondering, what if the real risk-free interest rate did keep going down. How would this affect the construction of a diversified portfolio? The only reason to diversify is to obtain a different source of return, but what’s the point if that different return is zero? Finally, why would anyone buy bonds when their real return is effectively nothing or even negative?

2020 AC (After COVID-19)

The first report of a “pneumonia of unknown cause” in Wuhan, China was made to the WHO on December 31, 2019. On January 30th, 2020, the outbreak was declared a Public Health Emergency of International Concern. While the FED minutes from their January 28-29th meeting prominently discussed the emerging risk caused by the novel coronavirus, FED officials did not express a preference to provide additional policy accommodation and reaffirmed the FED’s intention to taper Treasury bill purchases. Now called COVID-19, the virus and its associated risk has finally started to impact the financial markets with the FED making an emergency 50 bps cut to the FED Funds Rate on March 3rd and the S&P 500 sliding 11.6% from 02/24 – 03/06.

COVID-19 is an unexpected risk that has taken over the headlines, financial markets, and our day-to-day lives. While the mortality rate of the virus seems relatively low, the ability for the virus to be spread via asymptomatic carriers makes it hard to contain. Currently, there is still much we do not understand about the virus. Thus, we would like to think about the possible outcomes in the form of scenarios:

1. Best Case – media reports are overblown, and the virus is not nearly as bad as it seems. Morality rate is close to that of the seasonal flu, and warmer months slow its spread. In this case, China’s economy recovers without a respective rebound in the number of new infections. Financial markets return to normal by April or May. Global GDP growth is positive for 2020, and the S&P 500 gets back to 2,900 during the summer.
2. Base Case – while dangerous, the mortality rate comes in around 1% (about 10x as lethal as the seasonal flu), with most deaths occurring to those over 70 years of age. Therapeutic drugs (such as Remdesivir) are found to reduce the severity of infection, providing a means to treat critical cases. Available therapies reduce panic and allow economic activity to return by the summer, albeit at a lower level than normal. A vaccine is discovered and produced by March 2021, with global economy returning to full capacity shortly thereafter. Global GDP growth is flat for the year, S&P 500 earnings fall to about $120 with the price finding support around 2,400-2,600 range.
3. Bad Case – mortality rate is greater than 1%, and with no good means of treating the disease, the world must wait for a vaccine. In the meantime, “social distancing” becomes the prescribed method of reducing infection rates, and global economic activity grinds to a halt. S&P earnings give back a few years of growth shrinking to about $100 and multiples contract, causing the S&P 500 to fall to 1,600-2,000 range (about where we were 4-5 years ago).

These are just three simplified ways to think about what might happen. Obviously, the Bad Case (and hopefully most unlikely case) is a disaster. We do not think this will happen, but we at least need to recognize it as a risk. The Best Case would be a welcomed surprise. The Base Case is what we think will happen. It is based on the discussions, conference calls, and research we have participated and reviewed including contributions from:

• Luciana Borio – Vice President of In-Q-Tel and Former Director of Medial and Biodefense Preparedness Policy National Security Council (2017-19)
• Barry Bloom – Joan L. and Julius H. Jacobson Research Professor of Public Health Harvard T.H. Chan School of Public Health
• Eric Feigl-ding – Visiting Scientist of Epidemiology and Health Economics at Harvard T.H. Chan School of Public Health

While these people have impressive resumes and experience, all three at one point or another said “I don’t know” or some similar phrase. No one knows exactly how bad this virus is, and that is why the world is practicing/preaching the only known defense: social distancing/isolation. Unfortunately, the act of limiting our interaction with others dramatically slows the economy. This fact is showing up in the financial markets as investors rerate stocks (i.e. they are paying lower multiples for future earnings).

Lower growth leads to lower interest rates. This is because interest rates are basically the cost of money. If you have lower growth, there are fewer opportunities requiring capital. Thus, the competition to borrow money is less, and lenders must lower rates in order to encourage borrowing. The downward trend of yields is further exacerbated by investors fleeing to safety assets (i.e. increasing the supply of available capital for lending). This concept brings us back to original discussion before COVID-19. Going forward, a zero (or even negative) real risk-free rate makes sense, and the downward trend of the real risk-free rate also makes sense. If you think of the storing and protecting of your money as a service, then you should be willing to pay for it. A risk-free security does just this; it stores your money and gives it back to you. For years, people were actually paid to receive this service through a positive real interest rate. However, with improvements in liquidity and information, we believe “riskfree” has become less risky. For example, do you think the US Government today is less risky to lend money to than the Italian Government of 14th Century or the British Crown in the 15th and 16th Centuries? Back then, those governments were the “risk-free” borrowers. We would argue that the ability to monitor governments and the liquidity provided by the financial markets have effectively lowered the risk associated with such borrowers.

We bring this up to highlight an outcome we believe will occur after COVID-19 is under control. While we believe interest rates will rebound, we believe that the real risk-free rate will remain at or near zero. Thus, the interest rate that people commonly discuss, the UST 10 year, will reflect nothing more than the expected inflation rate during the term of the loan. And if inflation is low, expect nominal interest rates to remain low.

So, we are saving our money to invest in equities. As panic selling subsides, and cooler (healthier) heads prevail, equities will rerate back up. The monetary easing that many central banks will provide over the coming months will amplify this rerating. Additionally, the hit to S&P 500 earnings is transitory. It will go away, and the pent-up demand of millions of former “social distancing practitioners” will hit the stores, restaurants, theatres and airports near you. So, if there is a silver-lining to this note, it is that the equity markets will come back, and when they do it will happen quickly!

Sincerely,

David E. Andrew
Partner
Autumn Lane Advisors, LLC

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.