Assessing the Macro Environment; When the Micro Truly Matters


David Sowerby, CFA, Managing Director, Portfolio Manager

When building client portfolios, our objective as portfolio managers is to blend each client’s personal needs with our overall view of the markets and the macroeconomic backdrop at any given point in time. In the current environment, there is considerable debate about a potential recession, though the health of the job market and low unemployment rate make an argument for recession avoidance. In addition, second quarter real GDP growth was +2.4%, comfortably above recession levels. In contrast, the last 18 months have marked one of the more stringent periods of monetary tightening and rising interest rates on record and higher interest rates, negative money supply growth and an inverted yield curve are traditionally harbingers of recession.

More importantly, recession or not, understand that it is not simply a binary event of all or nothing when it comes to the economy. Simply put, we are more likely to experience slower business conditions, which are inevitable in the business cycle. I have personally managed portfolios long enough to have experienced four economic recessions and seven bear markets. Each time, a good understanding of the companies in my portfolio and their financial strength has proven to serve me better than any macro forecast would.

I often discuss my unwavering focus on the “trinity,” namely a company’s balance sheet, statement of cash flows and income statement. Cash flow is an especially critical factor given that it has less manipulation compared to an income statement. In particular, I focus on free cash flow and free cash flow margin as a great decider between the companies I would own and those I would pass on. In addition, as interest rates have risen, the health of a company’s balance sheet is essential to maintain and grow their dividends and pursue share buybacks while servicing debt obligations. This steadfast focus has resulted in portfolio holdings that can achieve greater downside protection and preservation of capital.  

Regarding the much-discussed rise of artificial intelligence, there have been several high-profile technology stocks, such as Nvidia and C3AI, that are up more than 200% this year. We are believers in the productivity-enhancing potential of AI and are seeing its early benefits particularly in call center companies, greatly enhancing their output. This is not simply a replacement of jobs, but rather enhancing the output of existing employees. Several well-known companies, such as Microsoft, Apple and Broadcom, are both developers and eventual beneficiaries of AI. But the benefits can also extend to consumer beneficiaries such as Wyndham, Marriott Hotels and McDonalds, to name a few. More companies are profiling their AI initiatives on recent quarterly earnings calls. The chart below best shows the rise in AI interest via Google searches on the subject. We have a positive, but realistic, view of the benefits of AI, but will continue to pay great heed to the valuation of a company and not allow irrational exuberance to cloud our value discipline. 

U.S. Google Search Activity for the Terms “Artificial Intelligence” or AI 

Line chart of Google searches

Source: Google Trends as of 06/30/2023
A value of 100 is the peak popularity for a search term on Google’s Scale

In my experience, patient capital typically wins over full market cycles. It has now been 3 ½ years of investing since the onset of the pandemic. The early days were filled with high levels of uncertainty with the economy shutting down and a rapid 35% decline in the S&P 500. Forecasting the pandemic would have been highly unlikely and it served as proof that oftentimes the greatest risk is the one you do not know.  

An emphasis on bottom-up company fundamentals was essential pre-pandemic and has transcended multiple bear stock markets. Now, 3 ½ years later, markets are meaningfully higher than pre-pandemic levels. Even the worst bear markets have shown that the U.S. economy and companies prove resilient to the shareholder when given time. The table below reinforces this ability of U.S. businesses to achieve favorable results, even if one had bought shares just before a negative macro event and market decline. We worry about the macro, but more importantly invest bottom-up focusing on company fundamentals to see us through. 

  5-Yr Cumulative Returns Cumulative Return
Purchased 10/16/1987 9/7/2001 9/12/2008 2/19/20 as of 6/30/23
S&P 500 Index +72.8% +30.0% +50.3% +38.7%
ICE BofA U.S. 3-Month Treasury Bill Index +41.5% +12.0% +1.0% +4.3%

Source: Bloomberg

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