Q1 2024

In the first quarter of 2024, the Investor Shares of the Sextant Growth Fund returned 9.17%, trailing the 10.56% return of the S&P 500 Index. By a wide margin, Technology was the largest contributor to Fund returns, with Nvidia playing the lead role. However, with Nvidia's meteoric rise, the Fund suffered due to having roughly half the exposure to Nvidia relative the S&P 500. Communication Services made the next largest contribution, but here the absence of Meta (Facebook) diminished returns. Health Care came next, which is also our third-largest sector exposure. Selection was positive in Consumer Discretionary and Materials.

Technology dominated the first quarter's returns. Nvidia's performance over the past year has been one for the ages, and we remain in the early innings of artificial intelligence (AI) development. Microsoft, Amazon, Oracle, Advanced Micro, Broadcom, and Google are all considered AI beneficiaries. Nonetheless, Google's performance trailed markets, which may be related to regulatory issues discussed in the introduction. Any resolution remains years in the future, but the case appears to have validity, which could erode future cash flows for the business. Since November 2023, Mastercard has rallied. Travel and consumer spending remain robust, benefiting their business. We believe Lowe's to be the most interesting home improvement DIY investment, given its opportunity to expand margins. Corteva performed poorly throughout 2023, but its January results announcement and guidance for the year were both ahead of expectations. Corteva's stock jumped, ameliorating concerns of extended difficulties.

Technology may have driven the bus in the first quarter, but not every stock was on board. Apple was left out of the AI discussion, as anyone who has used Siri likely understands. Following years of investment, Apple abandoned its self-driving car project. With iPhone upgrades becoming more incremental and the phones becoming more expensive, the replacement cycle extended, leading to slower sales growth. US-China tensions are a risk given Apple's reliance on China, not only as its most important manufacturing and assembly hub but also a market accounting for just under 20% of sales. Recently, the EU hit Apple with a $2 billion fine, and the US Department of Justice launched a monopoly investigation. While all of this sounds like a solid sell case, Apple continues to dominate the mobile phone profit pool, has a highly profitable services business, and earns excellent returns on capital. We see an opportunity for Apple to integrate AI into the iPhone and generate a huge upgrade cycle, despite its slow AI start compared to Samsung. Adobe, Lululemon, Zoetis, and Nike all reported results and provided guidance that failed to meet expectations. Except for Nike, we see these declines as an opportunity to increase holdings and retain confidence in the long-term outlook for the stocks.

Nvidia's dramatic first quarter rise pushed it into the Top 10 Holdings, along with Oracle, which also appreciated well ahead of the market. Monster Beverage and Motorola Solutions both exited the Top 10 during the quarter. Monster's performance was flat, and Motorola performed well but was still surpassed by Nvidia and Oracle.

In the first quarter of 2024, the Z Shares of the Sextant International Fund returned 7.17% compared to gains of 5.81% for the MSCI EAFE Index and 4.66% for the MSCI ACWI ex US Index. The Technology, Health Care, and Industrials sectors led gains, while Consumer Discretionary lagged with moderate losses. The top individual contributors during the quarter came from Technology (ASML, NICE, Taiwan Semiconductor), Health Care (Novo Nordisk), and Industrials (Eaton, Wolters Kluwer). Detractors came from Consumer Discretionary (Lululemon) and Technology (Dassault Systemes, STMicroelectronics).

Despite the lack of interest rate cuts investors expected in 2024, those cuts are not a prerequisite for equities to continue their upward trajectories; investors shifted their focus to ongoing earnings resilience and even a potential reacceleration in the broader economy. During the quarter, earnings per share expectations for the S&P 500 rose from $240 to $244, with the average magnitude of revisions upwards at 6.2%.⁶ The expansion of corporate profit margins was the underlying driver of this earnings momentum, particularly in Technology, Communication Services, and Consumer Discretionary. This follows broad cost-cutting and efficiency initiatives after the challenging environment for earnings from the fourth quarter of 2022 through mid-2023.

Inflationary AI

A common question among investors is: when will all the innovations propelled by generative artificial intelligence (AI) begin to cause real disinflation in the broader labor markets? Although it is possible that AI will catalyze gains in productivity and could lead to labor disruption and potentially even layoffs, the timing is still premature. AI will certainly have an impact on labor supply, but neither the technology driving these models nor the economy have reached the point where this happens in earnest. In fact, at the present, AI is probably more inflationary than deflationary. Capital expenditures have spiked in areas such as AI accelerator chips, data centers, semiconductor fabs, and power infrastructure.

After in-depth discussions with large enterprise software vendors such as ServiceNow and Salesforce, AI is enabling major productivity gains when deployed internally – i.e., they are eating their own products. This is likely why large software firms have recently reported operating margin expansions in the 100-200 basis point (bp) range, year over year. ServiceNow's customers have reported productivity gains in the 20-50% range using its AI products. Anecdotally, a senior software engineer at Meta noted how easy programming had become, with the company's AI coding platform essentially predicting large segments of code that he would have had to come up with.

However, there has not been a slowdown in hiring. In fact, in a survey of over 250 tech employers during the fourth quarter of 2023, 84% expected to maintain or increase employee headcount budgets in 2024.⁷ Why is this happening? A short explanation is that revenues are reaccelerating faster than the pace of hiring growth. As companies realize they can almost immediately make their core labor force more productive by 10-20%, perhaps more, downsizing those very employees would be a terrible business decision.⁸ This should continue to be the case until revenue trajectories decelerate, which does not appear likely to happen in the next few quarters.

Market Outlook

Market sentiment got a bit ahead of itself during the first quarter. Just as quickly as investors turned bearish in the third quarter of 2023, they swiftly adopted a "best of both worlds" view that inflation was going to continue its nice downward trajectory and the economy would stabilize and potentially even reaccelerate. Instead, it will be a matter of time, as was the case on the way down, when the recent economic strength trickles back up and begins to put real upward pressure on inflation, which is likely the beginning of what we are seeing now.

AI is unlikely to save the day on labor inflation any time soon. In these earlier stages of a decade-plus deployment cycle, AI is accelerating topline growth, profitability, and thus capital expenditures, which tilts more inflationary. The result is likely to be a "stickier for longer" inflation and interest rate outlook for the foreseeable future. As equity investors come to terms with this and recalibrate their cost outlook upwards, a quarter or two of indigestion and choppiness is a reasonable base-case scenario.

The consumer is the pressure point in the economy that bears close monitoring. The Federal Reserve Bank of New York's Household Debt and Credit Report showed that total household debt increased by 1.2% quarter over quarter as of December 31, 2023, to $17.5 trillion. The report also showed that credit card delinquencies reached 6.36%, up from 4.01% last year, above pre-pandemic levels. The cracks are becoming visible in long-time retail darlings such as Lululemon and Nike.

Portfolio Positioning

High costs of capital sustained for a longer than expected timeframe combined with an increasingly distressed consumer will be a drag on certain parts of the economy. On the flipside, corporate profits, especially those tied to secular themes such as AI and digital transformation, are healthy and will likely continue to accelerate from here. Overall, this paints a neutral-to-sluggish outlook for the cyclically exposed areas of the economy, especially in the event of inflation beginning to creep up in earnest. Amid this jumbled outlook, it is important for investors to properly assess how individual companies are exposed to these risks and opportunities.

The Sextant International Fund continues to prioritize "detached growth" opportunities: companies with business models that provide solutions that boost enterprise productivity will likely generate secular above-market growth, even in most recessionary macro scenarios. Within the broader detached growth opportunity set, areas of particular focus include digital economic transformation (ASML, Accenture, Taiwan Semiconductor, STMicroelectronics), artificial intelligence (NICE, SAP, Wolters Kluwer), and idiosyncratic compounders (Novo Nordisk, Ferguson).

The Sextant Global High Income Fund returned 1.85% in the first quarter of 2024, ending the period with $9.4 million in net assets. The Fund's equity benchmark, the S&P Global 1200 Index, returned 9.00%, while its fixed-income benchmark, the Bloomberg Global High Yield Corporate Index, returned 1.35%. The Fund's Morningstar Global Allocation peer group returned 4.38%.

Factors Influencing Performance

During the quarter, US stocks outperformed their international counterparts, furthering the decoupling of economic growth and market performance over the past decade, and largely powered by Technology sector leadership in the US. Interest rates in the US were relatively stable after rising through much of 2022 and 2023.

The top equity performer in the Sextant Global High Income Fund for the quarter was Southern Copper. The Materials company's return stood in sharp contrast to other Materials companies Norsk Hydro, South32, and BHP, which were the Fund's biggest detractors from performance.

Looking Ahead

After the strong equity performance in the first quarter, we have tempered our optimism for the remainder of the year. We are mindful that elevated inflation and interest rates may weigh on corporate profits. Meanwhile, policy uncertainty around the upcoming US presidential election is likely to limit further upside. Relatively high interest rates, with expectations for interest rate cuts, may help to provide some ballast to returns in the form of coupon payments and capital appreciation.

The Sextant Core Fund returned 5.03% in the first quarter of 2024. The Fund's benchmark, the Dow Jones Moderate Portfolio Index, returned 3.72% for the quarter. Since year-end 2023, the Fund increased its equity positioning by 237 basis points (bps) but remained defensive with a 2.23% cash position and an additional 17.67% held in Treasurys with maturities of less than one year.

Factors Affecting Past Performance
 
Equities

The Sextant Core Fund's mandate allocates a 60% weight in equity securities, with two-thirds being US-domiciled companies and one-third foreign-domiciled. The Fund generally holds equity positions in larger companies with strong balance sheets; at quarter-end, the average market capitalization of positions held by the Fund was $337 billion with an average of 17% total debt to market capitalization. The Fund's 58.75% equity allocation at quarter-end was comprised of 58 positions across 14 countries.

Performance in the first quarter was broad-based, with a mix of cyclical and defensive companies among both the largest contributors and the largest detractors. The Industrials, Health Care, Technology, and Materials sectors were all contributors to the Sextant Core Fund's performance, and five of the 10 Largest Contributors were companies in the Technology sector. That said, Eaton, an Industrial electric equipment supplier, was the largest contributor to Fund performance. The company has benefited from structural trends in data center buildouts and the energy transition. While its valuation has become full, we continue to like the prospects for the company's exposure to these long-term themes.

Similarly, the Sextant Core Fund's largest detractors were represented by a host of sectors including Consumer Discretionary, Industrials, Technology, Consumer Staples, Materials, and Health Care. The Fund's largest detractor was Lululemon, which reported strong performance in its most recent fiscal quarter but provided a more tepid growth outlook. The selloff comes after a strong 2023. While growth may decelerate in the near-term, the company's relatively low global penetration supports a promising long-term outlook.

Fixed Income

The Sextant Core Fund targets a 40% allocation to investment-grade fixed-income securities including government and convertible bonds, money-market instruments, and cash. The actual allocation to cash and fixed income at the end of the quarter was 41.25%.

While the federal funds rate was relatively stable in the first quarter after rising through much of 2022 and 2023, yields ground higher further out on the yield curve. The yield on the three-month Treasury declined 1 bp, while the 10-year and 30-year Treasury yields both rose 27 bps. This so-called "bear steepening" indicated that investors expect interest rates to remain higher for longer. This sentiment grew over the course of the first quarter; various data points showed continuing signs of a strong US economy. At the same time, the rise in yields at the long end of the curve led the Sextant Core Fund's longest dated bond, 03/01/2068 CSX, to be one of the largest detractors from Fund performance.

Looking Forward

While recent data suggests a resilient US economy, it also shows that inflation isn't going away without a fight. This leaves the Fed seeing risks as "balanced" between inflation remaining too high and the possibility for unemployment to take off. We see this outlook supporting the role "balanced" funds play in an investment portfolio. Should the economy continue running on all cylinders, equities provide exposure to growth. At the same time, if the economy falters, relatively high interest rates and the potential for Fed cuts may help provide a ballast to returns.

The Sextant Short-Term Bond Fund returned 0.65% in the first quarter of 2024 while the Bloomberg US Aggregate 1-3 Year Bond Index returned 0.45%. For the trailing 12-month period, the Fund returned 3.30% and the Index returned 3.56%. The primary reason that the Fund led the benchmark for the quarter was the Fund's relative shorter duration.

The Sextant Bond Income Fund returned -1.08% for the first quarter of 2024, while the Bloomberg US Aggregate Index returned -0.78%. For the trailing 12-month period, the Fund returned 0.89% and the Index returned 1.70%. The primary reason that the Fund underperformed the Index was due to the Fund's relative longer duration.

Market Overview

The first quarter of 2024 built upon the previous quarter's momentum: financial assets demonstrated strong performance and valuations extended even further. Investor optimism that the US would avoid an economic recession and that the Federal Reserve would cut its benchmark interest rates sometime in the first half of 2024 continued into the first quarter as well. However, inflation was higher than expected in January and February, and investor consensus shifted to the possibility that the Fed would cut interest rates later in 2024. In January, the annualized consumer price index (CPI) was 3.9%, slightly above the expected 3.8%. In February, the annualized CPI reached 3.9%, above the expected 3.7%. The illustration "CPI Metric Compared to Federal Funds Rate" measures the US CPI Urban Consumers Less Food & Energy Index, the US CPI Urban Consumers Index, and the Federal Funds Target Rate - Upper Bound since January 2020 to the present.

This reversal in inflationary trends tempered — but did not dash — investor optimism; risk-assets experienced strong investment performance in the first quarter. Although inflationary pressures declined substantially, they did not decline enough to offer central banks the confidence to lower benchmark interest rates. This may motivate the Fed and other central banks to keep interest rates at their current high levels for an extended period.

Such a policy path would be viewed as prudent. A working paper published by the International Monetary Fund (IMF) in September 2023 found that in the more than 100 inflation shock episodes that have occurred since the 1970s, inflation was resolved in under five years for only 60%. Even in those "successful" cases, resolving inflation took over three years, on average.⁹

Using the three-year average, it is reasonable to expect inflation in the US to subside around the first or second quarter of 2025. The Federal Reserve began raising benchmark interest rates on March 21, 2022. In June of 2022, US inflation measured by CPI peaked at 9.1%. Using the five-year average would suggest that inflation may subside by the first or second quarter of 2027.

"Most unresolved [inflationary] episodes involved 'premature celebrations' where inflation declined initially, only to plateau at an elevated level or re-accelerate," said the IMF. "Countries that resolved inflation had tighter monetary policy that was marinated more consistently over time, lower nominal wage growth, and less currency depreciation, compared to unresolved cases." The IMF paper is an important cautionary warning for investors. We are taking recent policy actions by central banks in stride, while keeping in mind that taming inflation takes time.

Fund Performance

Corporate credit yields rose across the curve, with very large yield shifts — especially for "AA" and "A" rated corporate bonds – in the belly of the curve. "B" rated corporate bonds outside of eight years saw yields fall in the long end, displaying more stability than higher-rated securities.

Sextant Bond Income Fund

The Sextant Bond Income Fund trailed the first-quarter performance of the Bloomberg US Aggregate Index due to the Fund's longer duration. The Fund had a effective duration of 7.14 years while the Index had an effective duration of 6.14 years. Following this pattern, the shorter corporate bonds in the Fund had the highest total returns. The Fund's best performing security during the quarter was the 2047 State Street floating rate bond, which has a duration of 0.15 years and returned 6.51%. The lowest performing bond was also one of the longer bonds in the Fund, the 2045 Chubb bond, which returned -4.71 for the quarter.

Sextant Short Term Bond Fund

The Sextant Short-Term Bond Fund led the Bloomberg US Aggregate 1-3 Year Bond Index's first-quarter performance, as the Fund had a shorter effective duration relative to the Index. The Fund's effective duration was 1.53 years while the Index had an effective duration of 1.85 years. The corporate yield chart shows that "BBB" bonds with maturities of under one year performed better than other rating categories for the first quarter. Following that trend, the Fund's best performing bond in the first quarter was the 2025 Constellation Energy bond, rated "Baa1/BBB+/BBB+", returned 1.48%. Also following yield movement trends, "AAA" bonds inside of three years had relatively higher upward yield movements over the quarter. The worst performer was the May 2027 Treasury bond, which returned -0.19%. It was the only security in the Fund with a negative total return during the quarter.