First Quarter Market Commentary – April 2023
2023 First Quarter Commentary
“You only learn who has been swimming naked when the tide goes out…”
-Warren Buffett, Berkshire Hathaway Chairman’s Letter, February 2008
While Warren Buffett was famously referring to the mortgage credit problems brewing at large financial institutions in 2008, his words echo today in a different context. Ultra-accommodative post-Covid monetary and fiscal policy swept in a tide of warm water for banks who wanted to grow deposits aggressively, and several niche players jumped in. During the spring of 2022, after the onset of the Federal Reserve Board’s recent series of rate hikes to counter inflation, the tide began to go back out. By the first quarter of 2023, we could begin to see which institutions were wearing bathing suits and which institutions’ high growth rates obscured the fact that they weren’t. The spectacularly fast collapses of Silicon Valley Bank and Signature Bank – and the contagion that nearly spread to the rest of the global banking system – are reflections of the unusual challenges now facing the economy and capital markets as a result of persistently high inflation, low unemployment, and low growth.
We’re just over 12 months into the rate hiking cycle, and the “long and variable lags” that economists talk about – the time between an increase in the Fed Funds rate and its impact on the economy -- are within striking distance. As Raphael Bostic, President and Chief Executive Officer of the Federal Reserve Bank of Atlanta, wrote in November 2022, “A large body of research tells us it can take 18 months to two years or more for tighter monetary policy to materially affect inflation.” However, “…one school of thought suggests that the lags may be shorter in part because of policy guidance that, in effect, allows financial markets to react to policy before we implement it.” (Bostic, 2022)
And hence, almost a year to the day after the first hike, the two largest bank failures since the Great Financial Crisis occurred. As the media has extensively reported, it wasn’t poor credit quality that took the banks down, but rather poorly managed interest rate risk: the banks invested deposits in long-duration US Treasury bonds and government-guaranteed mortgage-backed securities. While deposits are “sticky” in the sense that customers often keep their funds in the bank for long periods of time, they can be withdrawn at any time. In a crisis, therefore, the duration of deposits can shorten to zero very quickly as depositors panic and withdraw their money. That can – and in the cases of Silicon Valley Bank and Signature Bank did – leave a large mismatch between the sensitivities to rising (or falling) rates of the deposits and the bonds that are backing them. Exhibit 1 provides a glimpse of what happened:
1. March 2020 – June 2020 (“the tide is in”): the Fed reduced Fed Funds by 1.50% to a target range of 0.00% - 0.25% and added $4 trillion of assets to its balance sheet; in addition, the US Government introduced the first $2.4 trillion of what ultimately amounted to more than $5 trillion of Covid-related fiscal policy stimulus.
2. March 2020 – March 2022 (“the water’s warm”): extremely accommodative monetary and fiscal policy helped inflate asset prices, creating new lending and deposit growth opportunities for lenders; niche players pursued risky tech-related strategies that magnified their returns compared with those of larger, more stable banks. They brought in an unusually high percentage of uninsured deposits and stretched for income by purchasing high yielding, long-duration US Treasury bonds and negatively convex government-guaranteed mortgage-backed securities that would potentially lose value if interest rates rose.
3. March 2022 – March 2023 (“the tide is out”): the Fed raised Fed Funds by 4.75%, the most rapid one-year increase in more than 40 years. Over the same period, the 30-year and 10-year US Treasury yields increased by 1.74% and 1.54%, respectively, leading to massively negative returns in the assets Silicon Valley Bank and Signature Bank purchased to offset their deposit liabilities.
As rates went up, equity investors secularly reduced exposure to financial institutions, and the same dynamics that caused the niche banks’ stock prices to increase more quickly than those of the larger, more stable banks also caused their stock prices to decline more quickly. As the uninsured depositors watched Silicon Valley Bank’s and Signature Bank’s prices move lower and lower, they withdrew record amounts of deposits in an unprecedentedly short period, causing the banks to liquidate assets at high book losses and equity investors to further sell the companies’ stock, effectively initiating a rapid downward spiral leading to insolvency and conservatorship.
The economic fallout of the pandemic has likely created casualties that haven’t surfaced yet. Silicon Valley Bank and Signature Bank were probably not the only institutions swimming naked. More importantly, the economy and markets remain fragile. Jamie Dimon, Chairman and Chief Executive Officer of JP Morgan Chase & Co., wrote in his 2023 annual letter to shareholders “…the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come.” (Dimon, 2023)
Q1 Market Performance
Asset returns were robust during the quarter, but the ride was bumpy. The S&P 500 returned 7.5%, investment grade and high-yield corporate bonds returned about 3.5%, and US Treasury’s about 3.0%. January was a strong month followed by roughly offsetting performance in February and March (see Exhibit 2). The VIX Index, a measure of equity market volatility was itself volatile, ranging from a low of 17.9, which is slightly below average, to a high of 26.5, which is significantly above average.
Source: Bloomberg and AAFMA Wealth Management & Trust
US Treasury represented by Bloomberg US Corporate Total Return Index
TIPS represented by Bloomberg US Treasury Inflation Notes Total Return Index
Investment Grade Corporates (IG Corp) represented by Bloomberg US Corporate Total Return Index
High Yield Corporates (HY Corp) represented by Bloomberg US Corporate High Yield Total Return Index
Leveraged Loans (LSTA Lev Loans) represented by Morningstar LSTA US Leveraged Loan Total Return Index
First quarter industry sector returns generally mean-reverted, with the average sector recovering, or giving up, close to 75% of its 22Q4 performance. Notable exceptions were Semiconductors and Equity REITS. Semiconductors outperformed the S&P 500 by 5.1% and 28.8% in the fourth and first quarters, respectively, while Equity REITS underperformed in both quarters by 3.7% and 5.5%, respectively. The automobile sector, dominated by Tesla, largely reversed a 54% underperformance in 22Q4 with a 48% outperformance in 23 Q1.
Through the end of February, Banks were outperforming the S&P 500 by 4.3%, but, by quarter end, they underperformed by 19.8%, dragged down by the rapid demises of Silicon Valley Bank and Signature Bank.
The equity risk premium for the S&P 500, defined as the difference between the S&P 500 earnings yield and the 10-year US Treasury yield, is currently at among the lowest levels that it’s been since the Great Financial Crisis. There is some evidence to suggest that low equity risk premiums may forecast low equity returns. Quarterly changes in equity premiums are also highly correlated with quarterly changes in corporate bond spreads, both of which are negatively correlated with changes in breakeven inflation expectations. Together these relationships suggest that as market participants reduce their estimates of future inflation, equity and corporate bond spread returns could weaken.
Interest rates moved dramatically during the first quarter, reflecting uncertainty about the Fed’s rate-hiking path forward and its impact on the economy. In mid-March, for example, implied two-year rate volatility hit its highest levels since October 2008. On March 13th, in the throes of bank contagion fear, the two-year yield declined by 0.61%, the largest one-day drop since October 1982, when Paul Volcker was in the late stages of fighting the highest inflation the US has experienced since World War II.
Exhibit 3 expands on this point by showing daily changes in the two-year yield from January 1990 through March 2023. I like to think of the visualization of these changes as market “static”: the higher the static, the more challenging the markets. Notice the depressed levels beginning in August 2011, when Standard & Poor’s downgraded the US credit rating to AA+ from AAA, and beginning again in early 2020, at the onset of Covid. These two dates mark periods when the Fed aggressively bought assets to suppress volatility and fear. When the Fed began withdrawing accommodation in early 2022 by increasing rates and reducing the size of its balance sheet – essentially releasing previously suppressed volatility and fear -- the static spiked, culminating in the move on March 13th.
Source: Bloomberg and AAFMA Wealth Management & Trust
The Economic and Market Backdrop
Market participants and the media have focused recently on three key questions:
- How many more times will the Fed hike rates?
- Will the US enter a recession?
- How quickly will inflation come down to the Fed’s 2% target?
Obviously, these are difficult questions, but we can use current market pricing to provide some insight. For example, as of quarter-end, pricing in the Fed Funds futures market implied a 58% chance that the Fed would raise rates another 0.25% to a target range of 5.00% - 5.25% by its next meeting on May 3rd with no further increases. Prior to the banking crisis, the implied peak was 0.50% higher than that with a target range of 5.50% - 5.75%. We agree for now with the implied target range of 5.00% - 5.25% but also anticipate additional future hikes if inflation remains high.
We can use a model developed by the Federal Reserve to estimate the probability of recession. This model uses the difference between the yields of the 10-year note and three-month T-Bill (also called the “slope” of the yield curve). As of quarter-end, the model estimated a 60% probability of recession in the next 12 months. The probability rises to about 65% by summer, then begins to decline. To put these numbers in perspective, they are the highest estimates in 40 years. Interestingly, the high probability does not imply anything about the severity of a potential recession. Based on steps that we believe the Fed needs to take to reduce inflation, we expect the economy to enter a mild to moderate recession in 2023.
That suggests that we face the possibility of a high-inflation, low-growth environment. Paradoxically, pricing in the US Treasury and Treasury Inflation Protected Securities (“TIPS”) markets implies a very rapid decline in the Consumer Price Index (“CPI”). Based on the high correlation between CPI and Personal Consumption Expenditures (“PCE”), which is the Fed’s preferred measure of inflation, markets are implying that PCE will move from the current 4.6% to about 1.5% by September, then a gradual increase back to the Fed’s target of 2%. The average implied PCE through the end of the year is about 1.7%. The Fed itself is forecasting an average PCE of about 3.3% over the same period. We believe that this disconnect between market and Fed views defines the central risk to investors. If the Fed is right, Treasury yields will potentially sell-off dramatically. If the bond market is right, the economy will likely experience a moderate to severe recession.
During 23Q1, we swapped out of Knight Swift (KNX), a trucker, for CSX, a railroad operator. The Rail group had come under pressure due to the large derailment at Norfolk Southern (NSC), which, while tragic, does not impact the long-term earnings power of CSX. We believe that rails are a better business than trucking given the oligopolistic nature of the industry that gives rails pricing power, while truckers are a highly fragmented industry that lacks such power. This difference is particularly important in an economic slowdown.
We also swapped out of the PIMCO Preferred and Capital Securities Fund (“PFINX”), replacing it with iShares TIPS bond ETF (“TIP”). We were concerned with PFINX’s 89% exposure to financial institutions, whose earnings power is likely to come under pressure as funding costs increase and loan growth slows. TIPS combat inflation risk that erodes the yield on fixed-coupon Treasurys. In an inflationary environment, TIPS may provide higher levels of income and better total returns. The five-year break-even rate of 2.3% looks attractive versus current CPI of 6.0%.
Yours in trust,
Chief Investment Officer
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Bostic, R. (2022). On Long and Variable Lags in Monetary Policy. Retrieved from https://www.atlantafed.org/about/atlantafed/officers/executive_office/bostic-raphael/message-from-the-president/2022/11/15/long-and-variable-lags-in-monetary-policy
Buffett, W. (2008, February). Retrieved from berkshirehathaway.com: https://www.berkshirehathaway.com/letters/2007ltr.pdf
Dimon, J. (2023, April 4). JP Morgan Chase & Co. Retrieved from https://reports.jpmorganchase.com/investor-relations/2022/ar-ceo-letters.htm
© 2023 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal.