Where Do We Stand?

Dear Fellow Shareholders:

As the infection pattern for COVID-19 grows clearer, the economic impact of social isolation becomes murkier. Authoritarian China appears to have controlled the virus by government mandated social isolation. More democratic governments have generally followed China’s path with less rigidity. As a result, the spread of the virus is coming under control. However, the economic impact of isolation and shutdowns remains unclear. Its magnitude depends on two factors: the severity of the crunch, and the government actions to counter the shock.

Prior to the virus, the global economy was growing slowly but steadily. This is good news. But stock markets were possibly extended, which is bad news. Our current situation contrasts with the circumstances prior to the global financial crisis (GFC). Back then, the economy was on the verge of overheating. In many nations, too much capital had been devoted to residential housing. Further, complex securities (such as collateralized debt obligations (CDOs) based on other CDOs) added a layer of risk atop the capital misallocation to housing. When the first bad home loans failed, Fed Chair Ben Bernanke pronounced that the crisis was contained to sub-prime home loans. So government response to the GFC was slow and potentially inappropriate (too much monetary stimulus, too little fiscal). Additionally, the European Central bank (ECB) provided only limited liquidity and raised rates too soon after the crisis. It wasn’t until Draghi replaced Trichet that the ECB undertook to do “whatever it takes.”

Fortunately, governments learned from the GFC and now have a better idea of what is required to halt an economic meltdown. During the GFC, the threat of a solvency crisis (loans which could not be repaid) led to a liquidity crisis (unwillingness to provide credit). During the COVID-19 crisis, the fear is that a liquidity crisis (broadly defined to include the lack of income for laid-off workers in the hard-hit service industries) will lead to a solvency crisis. To prevent this from happening, government response must be early and often, which is exactly what we are seeing.

Unfortunately, government reaction is never as effective as it could be. For example, sending $1200 to many Americans may be politically correct, but why not focus on those who have lost their jobs? Perhaps then we could “afford” to send $2400 checks to those most in need.

Historically, the economy falters due to a progression of somewhat predictable economic events. For example, New Century Financial, a residential home lender to sub-prime borrowers, filed for bankruptcy in April of 2007, nearly a year before Bear Stearns fell. In turn, Bear Stearns demise was six months prior to Lehman Brothers bankruptcy, which precipitated the GFC meltdown. Today, the economy has been derailed by a non-economic event. COVID-19 reminds us that not only are such non-economic events unpredictable, but they can impact the economy severely.

My prior comments suggested that turmoil was possible due to the elevated level of the stock market. I have compared the alarm you feel when the market sharply declines to the fear you feel when the plane you are flying in encounters turbulence–both very unsettling experiences. Years ago, I was about to land in Hartford when our plane suddenly dropped about 100 feet, and we were already close to the ground. I felt panic. When the plane leveled out and resumed its normal flight pattern, my fear was replaced by gratitude. The panicked market, too, will one day find a bottom from which it will rise. The question is: When? Two markers will show the way. The first is when we get better containment of COVID-19’s spread. In other words, when the global new-case curve begins to flatten. It is already happening in China with negligible new reported cases. Other countries shouldn’t lag too far behind. The second waypost is when the effect of the interplay between economic slowdown and government stimulus becomes clearer.

The best case scenario is that our economy, aided by effective government programs, returns to normal sooner rather than later. The worst case is a slow return to a level lower than normal, partially due to ineffective government programs. It is likely that neither of these scenarios plays out. Instead, our path forward will probably be somewhere between the two extremes: a moderate-paced return to a moderate reduction in economic activity.

The challenge with sending these comments is that they reflect where we stand at a single point in time. However, our current situation changes on a daily basis. I have tried to provide a general framework for my thinking as of the date these comments are sent. Inevitably, the passage of time will make much of my commentary irrelevant or even inappropriate. Our attitude at SCA is “this too will pass.” We are spending our time trying to grasp what the future will look like on the other side of this crisis. We are not making any dramatic moves, as trading in panicked markets is always unwise.

We are grateful that most of our investors are adopting the same attitude. You are willing to ride it out with us. Thank you. And thank you for your loyalty over the years. We appreciate you!

Sincerely,

Sam Stewart,

Partner

This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.

All investing involves risk. Investments in securities of foreign companies involve additional risks, including less liquidity, currency-rate fluctuations, political and economic instability, and differences in financial reporting standards and securities market regulation. Investing in small and micro-cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.

An investor should consider investment objectives, risks, charges, and expenses carefully before investing. To obtain a Prospectus, which contains this and other information, visit our website at www.sevencanyonsadvisors.com or call us at 1-801-349-2718. Read the prospectus carefully before investing.

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