Q3 2023

The S&P 500 Index closed at a year-to-date high of 4,588.96 on July 31, 2023, subsequently shedding -6.36% over the remainder of the quarter, with most of the drop occurring in September. The less ebullient investment environment did not help the performance of Sextant Growth Fund relative to the benchmark; the Investor Shares lagged, returning -5.57% against a -3.27% decline in the S&P 500. Year-to-date the Investor Shares outperformed the Index, returning 14.69%, while the S&P 500 provided a total return of 13.07%. More focused growth-oriented indices significantly outpaced the performance of both the Fund and the Index due to the strong appreciation of a handful of mega-cap Technology stocks, a topic covered in-depth in our last quarterly commentary.

Alphabet, Adobe, and Nvidia continued to provide positive returns, albeit at significantly lower levels than the previous two quarters. While nine of the second quarter's 10 Largest Contributors were Technology stocks (Lowe's being the sole outlier), several industries were represented in the third quarter, although returns and contributions were modest. The Sextant Growth Fund has held Costco since 2011, which continues to have growth opportunities in the US and abroad. Sales activity has been good, and we look forward to an eventual increase in membership fees and a special dividend since neither has occurred for several years. RPM appears to be executing on its margin expansion goals, although the slowing existing home market presents a headwind. We have discussed TJX numerous times and still consider it the premier discount retailer. Lululemon enjoyed continued success in its traditional line of business and did surprisingly well with its entry into men's apparel and its expansion into China. Trimble lagged for some time, but we believe its transition from hardware to services will pay off. Finally, we believe Zoetis stands as the best animal health company in the world and will continue to grow sales and expand margins.

Given the change in the rate environment discussed in the introduction, it's not surprising that long duration contributors from the first half of the year detracted from returns in the third quarter, led by Apple, Microsoft, and Oracle, with the former being the two largest positions in the Sextant Growth Fund. Enphase Energy and Albemarle also fall into the long duration category. We were probably premature in establishing positions. We were perplexed by Johnson Controls as management continued to execute and the company maintained a consistent record of double-digit earnings growth through the pandemic and subsequent years. Growth is expected to continue at that level. Edwards Lifesciences suffered from a decline in surgeries. It did begin to recover as the quarter ended, but the stock was highly valued. Edwards' heart stent remains the most innovative on the market and the patient population is expanding. Abbott Labs suffered a hangover from buoyant testing sales during the pandemic, and we are evaluating whether future growth prospects warrant inclusion in the Fund. Lowe's was a top performer in the second quarter and gave back some of its gains in the third. Finally, Corteva's growth trajectory slowed this year, but solid earnings per share (EPS) expansion in the mid-teens is expected in subsequent years, partially driven by falling royalty payments, which drop straight to the bottom line.

There were no entrances or exits for the Top 10 Holdings in the Sextant Growth Fund over the third quarter, although Microsoft became the largest holding, making Apple the second largest. We have difficulty remembering the last time Apple was not the largest stock in the portfolio. We are evaluating Abbott, as noted above, but otherwise are comfortable with these companies as our largest positions.

The Sextant International Fund Z Shares fell -6.02% in the third quarter of 2023, compared to a return of -4.05% for the MSCI EAFE Index over the same period. The Energy sector was the major outperformer, while Information Technology, Utilities, and Consumer Discretionary lagged with moderate to large losses. Year-to-date, the Z Shares' return of 6.36% trailed the Index return of 7.59%.

The top contributors during the quarter came from Health Care (Novo Nordisk) and Consumer Discretionary (MercadoLibre). Detractors came from Information Technology (NICE, Dassault Systemes, ASML), Energy (no exposure), and Communications (Telus). Health Care, Communications, and Consumer Discretionary were reduced and redeployed into areas such as Information Technology and Industrials.

Sticky inflation and stubbornly higher interest rates were the primary driving forces behind the downdraft in risk assets during the third quarter. Unfortunately for market optimists, 10-year Treasury yields broke through their prior key resistance level of 4.1% and have steadily marched higher ever since (at 4.7% as of writing). The move does not come as a surprise given how resilient the labor market has been, the consumer still spending, and the lack of external demand coming from historical Treasury buyers such as the Bank of Japan.

Equities were stuck between a rock and hard place. On one hand were high inflation and interest rates; on the other hand were signs of real economic deterioration including 13 straight months of Institute for Supply Management new orders below 50, sizeable increases in credit card delinquencies, and M2 growth in the US (which measures the money supply) declined about -4.0% to -3.0% over the last six months. This was already a recipe for stagflation, but if you sprinkle on a potential government shutdown, a consistently hawkish Federal Reserve, and a roll-off in student debt subsidies, market optimists might be served with a slice of humble pie.

Market Outlook

Looking ahead to the fourth quarter and beyond, there seem to be more reasons to be incrementally constructive rather than bearish. Negative catalysts were brutally well-synchronized in the third quarter, so a reversal of any of these trends would be positive. It is just a matter of time before the weakening forward economic indicators begin to impact the current and lagging indicators many market participants still seem to be focused on. For example, the latest core PCE (personal consumption expenditures, the Fed's preferred measure of inflation) ex-shelter reading for the third quarter, if annualized, was just 1.5%. This coincided with the University of Michigan consumer inflation expectation reading of 3.2% for September, down from a recent high of 5.4%.

Perhaps the bigger reason to be constructive — from a monetary policy standpoint, we have returned to "charted territory." When it comes to dealing with the economy, the Fed no longer has its hands tied like it did in 2022, given the decline in inflation and a much more stringent starting point in the monetary cycle. Even in the event of a relatively sharp and scary economic contraction led by a whole host of potential causes (collapse of consumer spending, business bankruptcies, commercial real estate defaults), this is a playbook that the Fed has had plenty of practice implementing since the Global Financial Crisis (GFC). Unless a highly systemic failure or otherwise unexpected downfall takes place, the probability of a manageable economic recession is rising every day.

Portfolio Positioning

Despite this upbeat longer-term outlook, we are not calling for an all-clear dive into equities. Although we are getting closer, the final slaying of the inflation beast is likely to be ugly from a near-term share price perspective. The Goldilocks scenario of an orderly trickle-down of macro softness leading to a reciprocal path to deflation would be nice, but certainly cannot be assumed as a base case. An equally likely scenario is that after something "breaks," the Fed would be forced to jump in to save the day with its quantitative easing playbook. Although there is light at the eventual end of the tunnel, this could be an ugly path that involves real casualties and economic roadkill along the way.

The strategy will be looking to take advantage of volatility as the above events play out. Specifically, businesses that are exposed to cyclical end markets such as Industrials, Technology, or Consumer Discretionary may initially face selling pressure. Among this cohort, certain companies will either have secular/structural demand drivers, or idiosyncratic growth engines embedded into their business trajectories, which will allow them to weather a potential economic downturn. These investment candidates are "detached growth" opportunities. The other consideration is that although hyperinflation may have been tamed, the costs of capital are likely to persist at higher levels than in the past. Because of these factors, it is likely that investment candidates with higher, detached growth profiles will stand out as the largest relative beneficiaries in the new, post-COVID economic regime.

The Sextant Global High Income Fund returned -0.50% for the third quarter of 2023, ending the period with $9.2 million in total net assets. The Fund's equity benchmark, the S&P Global 1200 Index, returned -3.66%, while its fixed income benchmark, the Bloomberg Global High Yield Corporate Index, returned 0.02%. The Fund's Morningstar Global Allocation peer group returned -2.70%.

Factors Influencing Performance

For the past 25 years, September has been the worst month for the US equity market. September 2023 was no exception. The proximate cause this year was uncertainty around a possible US government shutdown. Congress managed to pass a short-term spending bill and avert a shutdown. However, the medium-term political outlook remains precarious, with the combination of a divided government and a minority of far-right lawmakers holding a lot of leverage over their caucus.

Top contributors to Sextant Global High Income Fund performance included non-US telecom carriers such as Telenor and SK Telecom. On the flipside, US carrier Verizon was among the worst performers in the Fund for the quarter. The Fund's fixed income sleeve was also a detractor to performance as interest rates increased across the yield curve.

Looking Ahead

Political uncertainty and brinksmanship pose risks to the US and global economy for the remainder of the year. Fortunately, the Federal Reserve may be able to utilize its independence from the legislative drama and adjust its monetary policy to help offset negative fiscal developments. Squabbles over funding Ukraine as it defends itself against Russia, or how to address the migrant crisis at the southern border, show how the trend of de-globalization continues apace. On the margin, this trend is likely to result in higher import costs, higher wage growth, stickier inflation, and lower profit margins. Recent advances in artificial intelligence may help spur growth in productivity, but also threaten to disrupt many parts of society including education, the media, and knowledge work.

The Sextant Core Fund returned -3.10% in the third quarter of 2023 and returned 2.30% year-to-date. The Fund's benchmark, Dow Jones Moderate Portfolio Index, returned -3.52% for the quarter and 3.22% year-to-date. In January of 2023, the Fund trailed the benchmark by 287 basis points (bps), and the outperformance continued to weigh on the Fund's year-to-date returns. Despite the slow start to the year, the Fund continued to chip away at its deficit, generally performing better when the market turned from ebullience to consternation.

This dynamic is not surprising, and we reamain cautious that the Federal Reserve intends to keep rates high due to concerns that inflation could come roaring back. A so-called "pivot" to rate cuts would rely on rapid deflation, likely the result of a troubled economy. The Sextant Core Fund ended the quarter in a defensive posture, with 4.03% of the portfolio in cash and 17.59% of the portfolio in fixed-income securities with maturities of less than one year.

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 companies. The Fund generally holds equity positions in larger companies with strong balance sheets; the average market capitalization of positions held by the Fund was $200 billion with an average 18% total debt to market capitalization at quarter-end. The Fund's 54.38% equity allocation at quarter-end was comprised of 60 positions across 12 countries.

Performance in the third quarter was divergent, with a mix of cyclical and defensive companies among both the largest contributors and detractors. The Energy holdings of the Sextant Core Fund stood out, with three placing among the 10 Largest Contributors and providing 48 bps of the Fund's return during the quarter. In the third quarter and year-to-date, Novo Nordisk was the largest contributor to performance as the company's blockbuster drugs continued to exceed expectations. The Fund's largest detractors for the quarter varied from large-cap growth names like Apple to defensive utilities like NextEra, suggesting that while macro themes are still at play, investors are honing in on individual company performance.

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 45.62%, a sign of the Fund's defensive posture and the result of ongoing portfolio repositioning in the equity sleeve.

The third quarter of 2023 was marked by rising rates, particularly in the long end. During the quarter, yields on the three-month US Treasury increased by 12 bps, while the 10-year and 30-year Treasurys jumped by 78 bps and 88 bps, respectively. This so-called "bear steepening" indicates that investors expect interest rates to remain higher for longer, a message the Fed has consistently delivered. The relatively muted rise in short-term rates and the significant jump in long-term rates played out clearly in the Sextant Core Fund's holdings. During the quarter, one of the shortest-dated holdings, the Treasury bill maturing 5/31/2024, was one of the largest contributors. One of the largest detractors of the quarter was the longest-dated bond in the portfolio, the CSX bond set to mature 3/01/2068.

With one quarter left in 2023, the global economy appears to be heading toward a crossroads. Whether economies are battered by a recession or sneak through a soft landing has been on the horizon, like an approaching storm cloud on the open sea, for more than a year now. Still, the looming threat remains highly uncertain. The portfolio maintains a balanced approach with a diversified mix of assets and managers that prefer shelter from the storm to taking its brunt on the open seas.

The Sextant Short-Term Bond Fund returned 0.50% for the third quarter of 2023. The Bloomberg US Aggregate 1-3 Year Bond Index returned 0.74%. While the Fund underperformed the benchmark by 24 basis points (bps) for the three-month period, it outperformed on a 12-month basis, returning 2.94% relative to 2.80% for the Index.

The Sextant Bond Income Fund returned -4.07% for the third quarter of 2023, compared to -3.23% for the Bloomberg US Aggregate Index. On a 12-month basis the Fund returned 0.54% relative to 0.64% for the Index.

Over the third quarter, the bond market saw a renewed surge of volatility, with yields rising especially in the long end of the curve. The 10-year, 20-year, and 30-year Treasury bonds all saw yields rise more than 100 bps. Just after the third quarter ended, the yield of the 30-year Treasury hit a 16-year high as investors braced for a longer period of higher rates driven by strong economic data and large expected Treasury issuance.

The primary reason the Sextant Bond Income Fund trailed the benchmark over the quarter was its longer effective duration relative to the Index. The Fund had an effective duration of 7.35 years at quarter-end and the Bloomberg US Aggregate Index had an effective duration of 6.31 years. Following this pattern, the longest bond in the Fund, the 2048 Treasury, also had the lowest return. The bond with the highest total return, the 2047 State Street floating rate bond, had a long final maturity but a very short effective duration of 0.175 years, and it benefited from rising rates.

The primary reason that the Sextant Short-Term Bond Fund trailed the Bloomberg US Aggregate 1-3 Year Bond Index in the third quarter was the drag on performance from an overweight to cash. The Fund focused on buying short-term Treasury bills. Yields were over 5.0% for T-bills and T-notes, providing a compelling risk-return profile. As of quarter-end the Fund held 11.01% of its portfolio in Treasury bills and 15.78% in Treasury notes. The Fund ended the quarter with an effective duration of 1.27 years, lower than the 1.86 years for the Index. This duration profile contributed to the Fund's outperformance on a 12-month basis. For the third quarter, the best performer was the very short Mosaic bond maturing in November 2023. The worst performer was one of the longer positions, Procter & Gamble, maturing in 2027.

Going forward, we continue to be on the lookout for potential risks, especially related to credit and persistent inflation. As corporate debt matures and issuers feel the increasing strain of higher interest rates on their cost of capital, we will be vigilant for potential downgrades and credit spread widening. We anticipate taking advantage of some forthcoming opportunities, while maintaining a defensive position to weather a potential economic slowdown.