We saw three potential factors that could drive equities higher in the second half of the year. Our bullish scenario rested on a combination of peaking inflation, a pausing U.S. Federal Reserve (“the Fed”), and an economy slowing but stabilizing. This last factor assumed that the Fed would become less aggressive in its monetary tightening and Chinese stimulus would kick in.
In fact, we saw strong indications of this scenario playing out through the summer as inflation data peaked and Chairman Powell suggested rates were at “neutral” during the press conference on July 27, 2022. The market was cheered, S&P 500 Index rallying 17.4% off the June 16 lows, helped by the unwinding of extreme bearish positioning.
Then came Jackson Hole. Powell’s speech atthe annual symposium dashed any hopes of an imminent pause or pivot, and so we lost one of the essential pillars of the larger recovery rally story. We are concerned that the Fed and other key central banks are going to make policy mistakes that create more economic damage than is necessary, risking a recession to ensure that inflation expectations remain truly anchored around 2%.
Unfortunately, recent inflationary pressures are being driven by many colliding issues that the Fed has little control over, which might mean greater tightening than necessary when simple patience might suffice. As a result of the Fed’s now-entrenched hawkishness, we believe the risks of new market lows are possible before our bullish scenario comes to fruition.
In short, we’re confident that inflation is peaking and will likely decline substantially from current levels. We are also confident in our belief that the economy is set to slow. Until the third necessary pillar of our headwinds-into-tailwinds thesis is in place (a data-dependent Fed willing to pause its tightening process), we remain concerned that equities may hit new bear market lows before staging a meaningful rally.
Small Cap Spotlight
We would like to highlight our position in Boyd Group Services (BYD)– We have increased conviction in BYD following Q2 results which displayed a first positive sign of margin inflection following a period of compression due to inflation pressures. BYD is one of the largest operators of collision repair shops in North America with 860 locations across North America. Given their scale, BYD has deep relationships with auto insurance companies, and is a preferred member of their Direct Repair Partner (DRP) programs which drives over 90% of BYD’s business1. Long term we like BYD’s business as their scale gives them operating leverage, and the industry is highly fragmented (top 3 industry players only have 18% total market share)1 which leaves a long runway of acquisition growth as BYD consolidates smaller players. During the pandemic, BYD’s margins were squeezed as increased labor costs, labor shortages, and supply chain issues impacted results in the short term. With Q2 results, BYD displayed first signs of improvement from this as rate increases from insurance partners were finally approved (and continue), and we have seen early signs of supply chain issues easing. We believe in time BYD can get back to historical margin levels, and valuation remains attractive.
