Clients of the Firm,

Today’s market selloff was driven largely by a higher than expected CPI report in which inflation came in at 3.1% y/y.  The number would have been higher except for the drop in energy prices from the prior year. Notably, shelter and transportation costs were up 6.0% and 9.5% respectively.   The CPI report can be found here:

https://www.bls.gov/news.release/cpi.nr0.htm

The market reaction was swift with equities selling off and bond yields rising to reflect later expectations for the timing of Fed rate cuts.  As you know from reading our prior notes, our core thesis has been rates will be higher for longer but not too high.  We expect that the 10-year Treasury will range from 4-5% over the course of the year.  We also expect that the Fed will keep short-term rates in the 4-4.25% range, even after it potentially cuts rates later this year. 

After the sharp rally we have seen for the past several months, a short-term market correction is to be expected and today’s CPI report was the most convenient catalyst.  Zooming out, we can see earnings continuing to come through for most companies we own.  One exception is that commercial real estate (CRE) continues to be weak.  We have begun to see some of the expected loan defaults in that domain. Consequently, banks have increased provisions for loan losses anticipating that we will see a weak credit cycle in CRE.  In addition, we have also seen multiple contractions in banks reflecting this lag risk to post pandemic lower occupancy.

Large tech companies continue to put up outstanding earnings and growth numbers.  Multiples in this sector reflect their earnings power, revenue growth and fortress balance sheets.  The long-tailed migration of legacy enterprise systems to cloud and now generative AI continues to drive innovation and efficiency within these companies and their end products.  The migration to cloud and AI allows companies to improve efficiency and customer insights and to automate jobs that were previously performed by people.  This allows companies to eliminate headcount and physical footprint while at the same time growing revenue and profits.

Duration exposure in bonds continues to show the most price volatility.  The market continues to try to front run Fed policy and whenever it gets offsides (either too bullish or too bearish) the market abruptly corrects.  This bond price movement has consistently happened during this Fed tightening cycle and we expect it to continue in advance of a neutral policy stance which may eventually be adopted by the Federal Reserve. Credit spreads continue to be tight despite the higher rates and aforementioned CRE risks.  In our view, junk debt is expensively priced relative to Treasuries and high-quality corporate debt.

J.R.R. Tolkien wrote, “All that is gold does not glitter, not all those who wander are lost; the old that is strong does not wither, deep roots are not reached by the frost”.

While the major snowstorm in Gloucester did not materialize today, the market provided its version of frosty old man winter.   Much like snowflakes, the market forces dance between the wind gusts sometimes blinding our vision of what we usually see clearly.  A long-term investor can wait out a sudden storm inside, admiring the view rooted in a fundamental-based approach to investing.  The chaos of the blizzard is rarely a good time to make aggressive moves, especially selling.  As the storm passes, we can look around, assess conditions on the ground and build our investment portfolio from the quality we find amongst the abundant snowflakes on the ground.  

 Sincerely,

Peter C. Wernau

President, CEO

Wernau Asset Management

http://www.wernauassetmanagement.com/

 Office: 617.871.0029

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