U.S. stocks were lower in February as the market’s repricing of the Federal Reserve’s rate-hike expectations gave back some of January’s gains. It was a year ago this month that the Fed announced its first rate hike since 2018 as it sought to lower inflation. Recent data suggests that the Fed has quelled some of the inflation surge, but the Fed’s credibility remains in question after initially dismissing inflation’s non-transitory warning signs.
Macroeconomic data has driven most of the market’s volatility for the past six months, and February was no different. The Fed is trying to thread a needle to execute a soft landing that beats inflation and avoids a recession. As investors wait for positive momentum, we see this macro-driven volatility as an opportunity. Mr. Market’s panic and euphoria around inflation prints often create greater discounts to intrinsic value, which is exactly what we are looking for.
Growth stocks have substantially outperformed value stocks to start 2023, and we believe this creates an opportunity for us Value Investors. The “January Effect”, in which laggards from the previous year outperform in the first few weeks of the new year, was especially pronounced to start the year. This price movement has had little to do with fundamental value, but rather is based on more short-term trading dynamics. Rising interest rates will put a premium on the near term cash flows, which we prize in our stock selection process. Inversely, this has pressured and will continue to pressure growth stocks that have longer dated cash flow expectations.
The Convertible market followed equities lower in February after a strong start to the year. Companies that reported earnings this month generally reported strong quarters with cautious outlooks for the year as they remain very focused on expense reduction and profitability over growth. With many convertibles trading more like fixed income than equity equivalent, this focus should benefit convertible holders.
Convertible issuance picked up in the month of February, with attractive terms. We expect companies to use convertibles when raising capital this year to manage interest expense and extend maturities in a covenant lite structure. We believe many companies have delayed coming to the market and converts offer an attractive way for companies to add relatively low cost capital to their balance sheets. Continued issuance allows investors to stay current and by selectively layering new issues into their, they are able to maintain the asymmetrical risk profile we continue to believe in.
Despite a number of positive developments in the Merger Arb space, setbacks in several deals, plus the volatility in the markets and a return to “risk-off” trading, lead to wider spreads on a mark-to-market basis. In Standard General’s acquisition of Tegna, Inc., the FCC issued a surprise Hearing Designation Order (HDO) which could potentially extend the deal’s timeline beyond the merger agreement‘s termination date. More broadly, the recent elevated market volatility and uncertainty over the Federal Reserve’s trajectory resulted in wider spreads, thereby creating opportunities for us to earn greater absolute returns.
Although markets have gyrated and spreads have widened generally, there were reasons for optimism as a pair of deals that had become the subject of extended antitrust scrutiny won regulatory approval and closed in February. In addition, several notable deals closed including STORE Capital, which was acquired by a consortium led by GIC for $14 billion, KnowBe4 Inc., which was acquired by Vista Equity Partners for $4 billion, and CinCor Pharma Inc., which was acquired by AstraZeneca for $1 billion.
Despite interest rate and market volatility, companies continued to announce new acquisitions in February and March. So far in March SeaGen (SGEN-$200.30-NASDAQ) agreed to be acquired by Pfizer for $41 billion in cash, Univar Solutions (UNVR-$34.68NYSE) agreed to be acquired by Apollo Funds for $8 billion in cash, and Qualtrics (XM-$17.65-NASDAQ) agreed to be acquired by a consortium led by Silver Lake Management for $10 billion.
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