Priced for Peace | AI Inflects | Hidden Credit Opportunities

Andrew Sarna and  Vanessa Hui unpack three themes shaping markets and portfolio construction: the recent market rally; a shift in sentiment around the Mag 7; and a bottoms-up approach to finding compelling opportunities.  

WHAT TO LISTEN FOR

:48 What’s behind one of the  strongest 10-day rallies in history?

6:37 What is driving the shift in AI sentiment and what does it mean for the Mag 7?

11:22 Where s are there still compelling opportunities in today's uncertain environment?

CONNECT WITH ANDREW SARNA

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CONNECT WITH VANESSA HUI

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This podcast is for informational purposes only and does not constitute investment advice. Views expressed are those of the speakers and should not be relied upon for investment decisions. 

Transcript

Andrew Sarna (00:04):

Welcome to Forthlane's Off the Charts podcast where every two weeks we cover three market headlines that matter. I'm Andrew Sarna, portfolio manager.

Vanessa Hui (00:12):

And I'm Vanessa Hui, senior client advisor.

Andrew Sarna (00:14):

And today we're going to cover the broader market oil and what has been an astonishing rebound since the conflict began. Second, what's actually going on beneath the surface with Mag7 and AI. And third, where we're spending time right now, where we're finding opportunities to deploy capital.

Vanessa Hui (00:33):

All right, Andrew, let's get started. In the last few weeks, we've seen a pretty unbelievable rebound in the broader market and then the rise and fall in oil prices since the conflict in the Middle East began. What's your perspective on all this?

Andrew Sarna (00:48):

The rebound we've seen over the past couple weeks has been nothing short of astounding. We're talking about one of the strongest 10-day rallies in history. I was looking at some numbers this morning. There was only one other time in history where we went from silver sold to silver bought conditions in 10 days. And importantly, it didn't happen when the war ended. It happened the moment talks of a ceasefire began. That was the bottom. Since then, markets have essentially gone straight up. On the surface that feels wrong, the conflict is still unresolved. Oil is still elevated. There's not ships transiting the straight of hormones. There's still very real tail risks at play, and yet the S&P 500 is now above where it started the conflict. So naturally, the reaction has sort of been, are markets getting ahead of themselves? And I mean, that's a real tough question to answer.

(01:46):

It is quite nuanced. Markets don't wait for things to be fully resolved before they start repricing. They move when things stop getting worse. So that moment when the market bottomed and markets started reversing, it is almost like the second derivative where things have stopped getting worse and they were marginally always improving. So we weren't bombing. Each side wasn't bombing themselves into infinity. It was a situation where at least they're talking about a ceasefire now and if they're talking about a ceasefire, they will probably get there at some point and the market began rallying on it. It's almost like it was the less bad rally. What's been more striking is what happened since. Even over the weekend, we had a real escalation rhetoric. You had the US threatening to strike Iranian infrastructure again. Iran responding in kind. It felt like things were devolving. And the running joke right now is that when the market's open, the straight is open and when the market isn't open, free rein.

(02:54):

So even this morning after what seemed to be a step in the wrong direction, the markets were down less than 1%. Oil was up a couple percent, but the market has almost stopped reacting to this sort of news. There's also been a second layer that I think is underappreciated, which is the role narrative. There's been lots of talk around the current administration manipulating markets and people potentially front running some of these decisions, but the administration has done a really good job managing the market. Every Sunday before future is open, we seem to get some version of a reassuring headline that piece is going to happen, progress talks, everything moving in the right direction. Even last Friday, you had headlines that seemed to be optimistic. The deal was imminent. And then as soon as markets closed, well, at least when markets closed on Saturday, it seemed like all those headlines were made up.

(03:55):

Because what it does is it creates this feedback loop where markets begin to believe that there's a floor to what is being managed. And that leads to this really interesting question. If markets matter this much to policymakers, maybe that's enough to mean that a drawdown is unacceptable. If Trump is actively trying to manage these markets, you'd think that in the event that the market was down 25%, well, they would probably do something about it. So maybe that is enough of a put for the market to say, "Hey, you know what? Regardless of what happens, the government is going to be here to save or bailout markets, and that gives equity investors enough comfort to chase." But here's the issue. We're now at a point where the market is effectively pricing in a resolution. SB, as I mentioned, was pretty much above pre-conflict levels. Oil is elevated, but not spiking.

(04:52):

So if you're deploying capital today, you're not getting paid if you're right that is when the ceasefire is announced. That's already in the pricing and you're only going to get hurt if you're wrong. And that's where the real risk comes in because we're starting to see early signs that the fiscal world is beginning to push back. There's a Japanese ceramic manufacturer that talked about reducing production last week. You saw a headline that KLM is cutting flights through the cost of jet fuel/kerosene. Even Air Canada announced last week that they're cutting flights from Toronto and Montreal to JFK over the summer. These are small things, but they're the tip of the spear. At some point, you're not going to be able to paper over real world disruptions. The Truth Social Tweet isn't going to prop up markets when you can't get your hands on physical oil and supply chains are grinding to a halt and we can't transport goods around the country.

(05:51):

These are real physical constraints that are going to start to bite. So where does that leave us? We got two paths. One, things deescalate a deal gets done in markets. Maybe we grind higher, but a lot of it is already priced in. Two, talks breakdown, escalation resumes, and you even get a much sharper downside reaction because markets seem complacent. There's asymmetry, which makes the decision a little tough right down from a top down perspective, knowing what the next move should be.

Vanessa Hui (06:24):

Moving on to our next topic. It feels like the negative sentiment around the Mag7 has shifted meaningfully with some notable positive momentum and prices. What's driving that?

Andrew Sarna (06:37):

I couldn't agree more, Vanessa. Under the surface, something has been happening. Sentiment around the Mag7 has been shifting. It wasn't all that long ago that the dominant narrative was skepticism. AI CapEx was too high. Returns were being questioned and CapEx or a data center overbuild seemed inevitable. There were even reports suggesting model performance was plateauing. But what we're starting to see is the data is shifting and along with it, the narrative. The GPU market has remained remarkably tight. Rental rates are still elevated. Usage is strong. Cloud is reporting increasing amounts of outages where people can't access the systems, which suggests something very different from the dotcom era. Back then, capacity was built ahead of demand. Fiber was delayed, but not used. This was what we call dark fiber. Here is the opposite where, yes, billions and billions of dollars is being deployed into building out this infrastructure, but the capacity is being used.

(07:44):

If anything, there are early size that demand is exceeding supply. And that's a big deal because the key question for the Mag seven has been for the past couple months or for the past year, are these companies going to earn a return on the billions of dollars that they're deploying? And if the demand is real, maybe you can make the argument that they are going to generate healthy returns. And if supply is tight, they're probably going to earn a very healthy margin on this investment. And what looked like it was going to be a headwind might actually be a tailwind. The interesting part is valuations had adjusted. It was only maybe weeks ago that I was writing about that Mag7 valuations had reverted to similar levels of the broader market. This reminds me of what we saw in 2022, where sentiment around the Mag seven turned very negative.

(08:40):

Multiples reset and retrace back to where the broader market was trading. And in the end, this ended up being a very interesting entry point into some of the highest quality, best run businesses in the world. This could be a similar feel. And another interesting observation is that we're starting to see some nimbyism around the data center build out across America. I think it was last week Maine put a moratorium on data center buildouts, which seems like not a good thing on the surface or a headwind for AI. But because of the game theory at play, the Mag7 might be okay not having to invest any more capital. They've already invested billions. And what was happening was because their competitors were investing billions that forced the individual companies to compete against the company that was deploying those billions of dollars, it was effectively an arms race.

(09:44):

And if we see public sentiment, whether that be state governments putting moratoriums on these things, they might be happy not to be able to slow down the pace of CapEx even if they are earning a great return. And even at a very practical level when you actually use these tools, it's clear something is happening. I recently built a website over a weekend just to play around with the AI capabilities. It's not silver bullet. Engineering isn't going to change overnight, but it's powerful. And for someone who hadn't built a website before, I was able to get it done, or I was pretty impressed with what the output ended up being, which feedbacks into demand. If people are becoming more productive, they're going to use it more. Once you get your hands dirty into actually using the offering, it's pretty clear that, you know what, this is pretty neat and it's not hard to imagine how a talented engineer could use these tools to amplify their abilities.

(10:47):

It's not a silver bullet. I don't think the software sector is going to get erased overnight, but it's useful. It's productive and it's powerful and people are using it and is showing in the data. And this might be the new emerging narrative that drives the Mag seven to the next leg higher.

Vanessa Hui (11:12):

Now for our last topic, with all the uncertainty in the world right now, where are you still seeing compelling opportunities for client portfolios?

Andrew Sarna (11:22):

Yeah. As I mentioned, from a top down perspective, just given that markets have priced in the end of the war, even software, which we talked about a little bit in our last episode, saw a pretty incredible bounce. From a top down perspective, there's not a ton of glaring opportunities. I mean, we can even think back to pre-war energy was the cheapest sector, but that's rerated pretty quickly as oil prices spiked. So that forces us to look more bums up. And I know private credit has become a pretty dirty word. And I mean, there are so many negative headlines around it, but the problems in private credit are actually pretty specific and they're concentrated in the sponsor back lending space or, I mean, you can call that also the mega fund space, the Blackstones. I mean, Apollo is trying to combat these headlines, but I think they still have some exposure.

(12:19):

And then KKRs, Carlisle, et cetera. It's just too much capital, too much competition, everyone chasing the same sponsor back deals, which causes you to either charge lower interest rate or reduce the investor protections on that loan. And essentially, that's what you have to do because the capital has to get deployed in these evergreen structures. So the quality deteriorates. What we've been looking at is actually the opposite and taking a bottoms up approach to the space. And when I say bottoms up, what I mean is, I mean, I would almost characterize it as you're walking in a riverbread picking up rocks. You're not taking the 10,000 foot view of the investment space, as I would describe finding a top-down situation. It's looking under rocks, having conversations, and seeing from a one conversation with a manager playing a very specific niche, is this a compelling investment opportunity?

(13:28):

And we've been talking to this manager for a couple years, keeping in touch, and really where I think you have to look right now for the opportunities are these smaller, highly specialized managers operating in underserved parts of the market. Last week, I had probably my third call with a manager that's built a really compelling model. It's not a scale game. It's actually a sourcing game. They're able to win because of how many frictions there are to accessing their area of the market. They spent decades building relationships in a part of the market where capital isn't easily available and it's not easily deployed either. So when opportunities arise, they're not competitive auctions. They're the only lender at the table and it's either they take their money or they walk. And that's proprietary, that's edge, and that changes everything because if you can control sourcing and it's very hard for someone else to compete against you, that's a moat.

(14:30):

They're generating returns in the 15s, charging 15% interest rates with all the investor protections you could ask for, often over collateralized. When I speak to a credit manager, I want them to be paranoid about the downside. There's a joke amongst allocators that you want your credit managers to be paranoid, always thinking about what could go wrong. And then once they've sourced the deal, the work on the underwriting side is more blocking and tackling. Can they get the collateral? Can they get the investor protections? And UI's really paid off over a decade of track record where I think they've lost money on three out of over a hundred deals, which is exactly the way you should be thinking about credit. There was a great line from the CIO of Michael Dell's family office and he said, "The job and credit is simply don't lose money." And they think of their credit portfolio as the money they can't afford to lose.

(15:31):

I think that makes sense. I think what sometimes gets overlooked for your average family is the tax consequences because you know what, 10% coupon seems really great, but if you're paying income tax rates on that, it can get a little less interesting. This is all to say, I think this ties into an interesting, broader theme in markets right now that Apollo is pushing really hard for. And sometimes they talk their book, which they're clearly talking their book in this instance, but what they're saying makes sense. When you're looking at a credit or when you're looking at an equity, it doesn't really matter if it's public or private. Sure, there are nuances around the edges why one might make sense, but at the end of the day, an equity is an equity, whether it's public or private, a credit is a credit, whether it trades publicly or is a private credit loan.

(16:27):

What really matters is the underlying business you're exposed to. And so when we talk about, oh, private credit is a bubble, I think that's talking about broad strokes from a top down perspective. And I think, yeah, there's certain areas of the market that I'm worried about, but there's also areas if you're willing to roll up your sleeves and get your hands dirty that you can find where you know what, there's great investor protections and you can still earn a compelling return. So when we find managers, what we're looking for is understanding where the buys are buried. Have they got enough reps in to not make an easy mistake? And then really, are they pulling in a non-competitive pocket of the market where they can charge above market prices for what they're doing? And so what makes this really interesting is it's not scalable and they're not good marketers.

(17:20):

That's another thing that we really like is there's sales organizations and then there are investment organizations. The Golden Goose is really the amazing investor who doesn't care to market and just wants to invest their own capital. And if we can partner with people like that, that's really the recipe for success.

Vanessa Hui (17:40):

So to summarize our three headlines for today, number one, markets are responding to and rallying on narratives and potentially getting ahead of themselves. Two, AI demand looks more real than expected, driving positive momentum in the Meg seven. And three, in today's uncertain environment, some of the most compelling opportunities are increasingly bottoms up.

Andrew Sarna (18:07):

Thanks for joining us for another episode of Off the Charts. We'll be back in two weeks. Please follow the Forthlane Family of Podcasts, my newsletter, like and subscribe.