Q2 2022 Investor Letter
Updates From the Desk (Originally sent out to investors on May 26th, 2022)
Despite a volatile first quarter of the year, NWTM as a firm came away largely unscathed. Like the overall sector, our crypto exposures experienced declines, but short equity positioning helped to buffer those losses at the firm level.
While risk assets caused many investors pain in Q1, it was interest rates that made the most extreme moves. See the below chart of the 2y US Treasury yield:
With 10y treasury rates breaking out of a many decade channel, we can most likely call the 20–30 year bond bull market dead (at least for now):
Several factors drove volatility in early 2022 as the US equity markets are begin feeling the pressure of a rising risk-free opportunity cost.
However, rising rates do not guarantee a painful future for all equities. With the consensus call of “inflation running consistently hot for the reasonable future”, capital allocators are forced to put money to work or risk losing substantial purchasing power. Also, with broad commodities nicely bid, real estate at all-time highs, and bond prices collapsing — equities don’t look horrible, even if the trend appears to be a continued grind lower. Further, after the market has priced in this magnitude of a move in rates, perhaps the next step is to begin pricing in the chance that the fed doesn’t hike to the extent currently priced or that perhaps we can prepare for something that many discuss but few have ever experienced — the mysterious and rare “soft landing”. One has to admit, that while quite painful, the selling has been orderly and nothing appears to be anywhere near broken (with the exception of course being the Luna/UST “algo” stablecoin which many viewed as flawed from the start). Nonetheless, as expected, higher rates have caused a clear decrease in risk tolerance from investors. With this concern in mind, there are a handful of vectors of potential within equities — some of these are highlighted and explained below:
· Safety (staples and/or utilities): These company types are least affected by the business cycle
· Quality (high quality profitable businesses): Companies which are price setters, and which classical economics would refer to as having inelastic demand.
· Growth: Typically high growth, primarily tech businesses
o This sector is embodied by the “grow fast and break things” Silicon Valley spirit, and as such we see a large divergence developing between those that can withstand inflation and a slowing business cycle — in comparison with those that cannot
· Value: Earnings accretive companies trading at attractive valuations while also strong free cash flows which are often used towards dividends or share buybacks
o While growth was the way to play equities for the past decade — value stocks have produced an obscene excess return to growth in 2022. While the move has been modest compared to the momentum in growth over the past decade — it remains to be seen whether the tide is turning for the long term or if this is just a short term reversion to the mean
The Safety, Quality, and Value vectors are straight forward, in terms of their resilience to a rising rate environment. However, the Growth vector requires a deeper dive.
By any measure, the last decade (ex 2020/2021 Pandemic) has been a time of extraordinary calm and steady market returns as ample central bank liquidity buoyed markets to defy gravity. Our base case is now that most equity multiples will revert towards historic norms over the next 1–2 years (they are nearly there…). If earnings can outperform then stock prices may in fact not take too much of a hit, but that is a big “if”. We are of the opinion that most high growth businesses (particularly those that have not made it to profitability yet) will see further multiple contraction as growth slows and earnings do not trend towards profitability. Others with true moats and market dominance could shine through this more challenging economic environment — we foresee a wide dispersion of results from here, but generally, more pain is likely ahead.
Observing consumers’ reaction in response to rising rates and inflation may help in the process of identifying companies with outperformance potential. Likewise, the ways in which consumers retreat from their typical spending habits may be a leading indicator for companies to avoid or potentially short. Other important metrics to track include the balance between spending on goods and services, the rate at which consumers tap into home equity, and overall consumer credit delinquency rates. Regardless, we are now in an environment where hedges should be utilized for any risky investment positioning and attaining uncorrelated exposures should be a priority.
Market Bubbles & The Natural Interest Rate
The first bubbles to pop have been unprofitable growth stocks and bonds — it is also worth noting that enthusiasm and speculation have decreased in the crypto space as well. The low-rate regime is decidedly over for now, but the real question is when (or if) it will return. We are confident that lower (if not negative) nominal rates will eventually return yet many scenarios allow for rates to remain elevated for a more medium term to longer term timeframe. Jerome Powell is an acolyte of Volcker and considers him a personal hero and the administration has made extremely clear that price stability and the taming of inflation is a top priority. The only questions that remain is if he will face a similar situation and how closely he will follow the Volcker blueprint. The bond market is in a phase of price discovery, and what we are in search for is r* — this is the natural interest rate which will prevail when the central bank removes itself from the market (it is worth noting that this is primarily an academic term, and it is likely that this may never happen in full).
With treasuries at currently stabilizing around 3% and inflation continuing to run hot, there is ample evidence that the empirical norm of 2% stated by Fed officials and policies is no longer sufficient. Federal and local government spending has remained strong considering broader social support, and these forces and their lasting effects have the potential to sustain inflation in the medium term, even while the Fed works to reduce it. Given that there is also material focus on wealth inequality — it feels like all signs point to a government and Fed with excessive ambitions to bring down asset prices. Further, since we have been in a low interest rate regime and supportive asset price environment for so long, there could be a shocking effect in markets as this complete 180 in monetary policy continues to take form. Giving the Fed an ancillary mandate to initiate social change seems like a stunning and dangerous experiment, however, this also appears to be the direction in which we are heading.
Studies have shown that the Fed’s monetary policy has historically explained at least two thirds of the movement in r*, and that the private sector’s expectations of this activity has been proven to enhance the effect intended by the Fed (by as much as 60%). If these norms hold true, it is quite possible we see the natural rate of interest edge up to 5%, with a result of 3 to 4% in the long run. Increased rates volatility, one of our key predictions for 2022, will likely hang around for most of the year, if not longer.
So, does this perspective provide any insight on which bubbles could pop next? One potential area is commercial real estate. This sector is closely tied to interest rate movements due to the purchase and development of real estate often being primarily funded with debt. Higher rates mean larger debt payments which will require a higher benchmark for profitability on any particular deal.
After the Great Recession, commercial real estate effectively experienced straight-line growth for the ensuing decade:
As you can see, this changing r* world has begun to slow this trend (see most recent plateau in the chart above). It is worth noting that cap rates on prime commercial property have fallen to historically low levels in this past decade and if the Fed maintains its commitment to raising rates, a best-case scenario for this space would be to maintain values. Yields on commercial property will need to rise to adequately compensate investors — these properties are not risk free. Further, there are significant other headwinds to suggest that change may be occurring in this sector.
Roughly 20% of the above index is weighted to office space, and another 15% is allocated to apartments. As the pandemic inevitably subsides, we will see if the migration to suburban life is more permanent then is currently projected, and whether traditional office demand will return in a world where remote work has largely proven to be a success. The latter point is particularly important: research suggests that total number of flexible workspace users will more than double from 2.4 million to 5 million by 2024 — we think this is an extremely conservative estimate.  An exodus of current office workers, from traditional office commercial real estate to more flexible environments in that amount would roughly equal the total labor force lost at the height of the pandemic. The turmoil of that transition would certainly damage traditional and existing commercial office space –that value could be a tailwind if captured by companies like WeWork and IWG.
As you can see in the charts above and below, flexible workspace has experienced consistent growth for over a decade — the pandemic further accelerated this trend.
Between rising rates and shifting consumer behaviors, commercial real estate may be a difficult space in the short term. The counterpoint here being the obvious data point that if you purchased prime property during every large drawdown ever and had the balance sheet to hold — you would have done quite well.
A stunning data point has been published by WeWork each quarter basically for the last year — WeWork is dramatically outpacing its commercial office real estate counterparts in major urban centers in regard to new leases signed. Let this stat sink in: despite WeWork only representing less than 1% of the market share of office space in the US and Europe — they are attracting nearly 10% of all new leases — a jaw dropping market outperformance of over 20x in many major markets!
One of our 2022 recommended pair trades is the following: short commercial office space, long flexible workspace.
While the dollar has surged amid market volatility — we could be hitting a short-term ceiling — as such, we also feel it is time to give Emerging Markets a good look. Relative valuations and interesting demographics infer that EM’s recent underperformance could be changing tune. While this may be counter-intuitive, capital must be put to work, and we feel some specific EM idiosyncratic risk taking appears quite attractive. Expect more from us on this soon.
Inside vs outside money
Recent events have begun to put further in motion a much longer-term trend which I would argue got a boost into the spotlight when crypto adoption began to heat up in 2012–13, again during 2015–17, and most recently in 2020.
Shifting preferences for currency is hardly a novel concept- civilizations have displayed somewhat cyclical behavior changing from one type of currency/asset in one era to another a few centuries later. Longer term trends suggest there is reason to believe we are in the midst a shift.
Below is a brief timeline of recent trends toward alternative sources of outside money since the turn of the century:
o Gold legs higher in early 2000s
o Banking system failures during GFC
o QE begins in 2009
o Bitcoin announced 2009
o Growth of cryptos in the ensuing decade
o QE1, QE2, QE3, and QE Infinity
o The Pandemic Bazooka
o Supply shocks and Commodity boom
We are nearing the end of a long-term debt cycle which started in the 1980s which is something of a catalyst and an additional cause of this trend is the continued deterioration of trust in governments to responsibly manage balance sheets and spending along with reckless central bank policy. This is no longer an Emerging Market or Emerging Economy issue and can now be seen across the world. Catalysts have been wide ranging — for example, most recently in Canada as bank accounts were shut down by the government for those who supported and donated to the “Trucker Convoy”. Many governments have used the Pandemic as an opportunity to clamp down on individual freedoms and regain power. QE infinity has caused many wealthy Americans to consider alternative forms of outside money as a hedge against the inflationary and diluted dollar system. This is not a new phenomenon as gold has been used for this purpose for a long time — it does however seem to be much more prevalent in recent years and is one of the reasons that Bitcoin has jumped from $0 to nearly a $600 Billion dollar asset as of current — which sparked the beginning of a trillion-dollar industry in crypto. While many incorrectly claim that Bitcoin doesn’t protect inflation — the fact is that Bitcoin front ran inflation. For instance, if you were to buy Bitcoin at the announcement or in the midst of any of the QE programs, or even at the announcement or in the months following the Pandemic Bazooka than your returns would have exceeded inflation by an extremely large multiple. While the fed is now tapering its easing programs and decreasing its balance sheet — it is severely unlikely that we will ever get back to the post Great Financial Crisis base.
Adding to the above, as the Russia/Ukraine situation was heightening, both the US and Europe sanctioned Russia’s foreign currency reserves. This adds a whole new level and scale to the distrust of sovereign currencies and will be a key component in causing global sovereigns and central banks to diversify their holdings. Many will look to ensure that at least a portion of foreign reserves are in a form that cannot easily be seized. This is a hot conversation topic and will be extremely interesting follow. Pulling a sentence from Arthur Hayes’ recent essay, “Unfortunately (but thankfully, if you are one of Satoshi’s disciples), the West’s decision to financially cancel the largest global energy and commodity producer is the biggest advertisement for the existential need of Bitcoin in a sovereign’s currency savings portfolio.” Of course, there are better cryptocurrencies to use as a secure and private store of value, but this will be saved for another conversation.
El Salvador was ahead of the curve here and has taken the step of adopting Bitcoin as legal tender, launching Bitcoin Bonds, and developing sovereign Bitcoin mining operations. While many are quick to criticize, this is an almost ideal way to store and secure reserves with respect to the trend towards alternative sources of outside money and other global government malfeasance. Recently, the President of El Salvador announced that he has invited central bank leaders and financial authorities from over 40 countries around the world to discuss the advantages of using Bitcoin as a reserve currency and/or legal tender. The central bank thesis for holding Bitcoin is in its early innings, see tweets below:
This trend and these recent events are REAL use cases supporting broad mainstream, retail, institutional and sovereign adoption of cryptocurrency.
While Ethereum has taken up much of the conversation recently as the protocol prepares for additional upgrades in an effort to scale and become more of a “store of value” focused crypto — we feel that both of the blue chip cryptos (Bitcoin and Ethereum) are important within a well balanced crypto portfolio. Our focus in this space continues to be to provide a wide range of exposures including, layer one protocols, value accretive positions, defi, liquidity pooling, NFTs, and other idiosyncratic positioning and/or more speculative early stage investments.
We now have 4 initiatives at the firm and are always looking for new business opportunities
• Scaling our flagship product Otium Absolute Return Fund, LP
• We manage an SPV which mimics the crypto portion of the fund (a pure play crypto product)
• We have begun investing in startups (primarily at the seed stage) and now boast a portfolio of close to 15 startup investments
• The firm recently launched a new venture focused on building awareness + community around NFTs, Fine Art, Fashion, and Events
Please feel free to reach out if you would like to hear more about any of these initiatives. We look forward to the opportunity to connect further.