Equity markets have been choppy so far in 2023, facing some familiar stressors and rocked by unanticipated events. The author Nassim Nicholas Taleb commented in his work: “The central idea in The Black Swan is that: rare events cannot be estimated from empirical observation since they are rare.” He has gone on to say: “Things always become obvious after the fact.” Last year saw Russia invade Ukraine, an ensuing energy crisis, rocketing inflation, rapid global central bank tightening, and poor performances in both equity and fixed income. It could be argued that something was bound to break. And it did, as this quarter witnessed the second and third-largest bank failures in modern U.S. history. While almost entirely unanticipated, in hindsight there were clear warning signs.
While broad U.S. stock market indices experienced declines during a challenging 2022, we witnessed a divergence in relative underlying performance, a phenomenon that has persisted during the first quarter of 2023. What has changed or rotated, however, are the specific investment styles and sectors that are currently outperforming or lagging. Subsequently, the S&P 500 ended the first quarter of 2023 at 4,109, delivering a return of 7.49% for the year to date. In contrast, the less technology-heavy Dow Jones Industrial Average (DJIA) ended March at 33,274 for a first-quarter return of 0.93%.
There are indications, such as the 2-Year Treasury yield at 4.1% falling significantly below the current Fed funds rate, that the market is expressing a belief that interest rate hikes may be nearing the end. Essentially, investors are willing to pay more for longer-dated bonds to lock in an attractive yield now. A future pause or reversal in Fed tightening favors growth stocks that rely more heavily on debt financing and whose current price assessments are more skewed toward future results. Information Technology has been a top performing sector over the past three months, while Financials, Real Estate, and Energy are among the laggards in negative territory. WTI crude is below $75 / barrel for the first time since 2021, reflecting a soft demand outlook for North America and Europe, not entirely offset by increased Chinese oil needs.
Consequently, in a sharp reversal of 2022 trends, growth strategies have roundly outperformed value ones so far this year. Additionally, major fixed income indices are in the green for the first quarter with longer-dates strategies outperforming shorter, as investors lock in yield in lieu of assuming rates will continue to rise.
Rewarding risk-free Treasury rates have placed additional pressure on banks, especially smaller and regional ones, in maintaining their depositor bases.
Central bankers are now facing the unenviable task of implementing policies that tackle high inflation while not exacerbating instability in certain sectors of the financial industry. The Federal Reserve’s attempt to thread the needle resulted in a quarter of a percentage point rise in interest rates announced on March 22nd. This brings the range of the Fed funds rate to between 4.75% and 5.00%, the highest level since 2007. Officials voted unanimously, and the decision marked the Fed’s ninth consecutive rate increase. This decision came less than a week after the European Central Bank (ECB) stuck to its plan to raise its rates by half a percentage point to 3%, the highest level since 2008.
The Fed tempered its language on future raises remarking that “some additional policy firming may be appropriate.” The consensus opinion of officials who participated in the meeting appears to be an increase of the Fed funds rate to at least 5.1% with no cuts this year. Federal Reserve Chair Jerome Powell made clear in his statements that “there are real costs” to bringing inflation down to a 2% annual rate, “but the costs of failing are much higher.” Mr. Powell acknowledged the possibility that the banking turmoil would further tighten credit and economic conditions, dampening or negating the need for future Fed hikes.
Policymakers have slightly revised their forecasts, now projecting slightly weaker growth of 0.4% and unemployment of 4.5% for 2023, together with core PCE inflation (Personal Consumption Expenditures excluding the more volatile food and energy numbers) revised modestly higher to 3.3% for this year. After inflation soared to a 40-year high last year, the latest annual figure for core PCE remains stubbornly elevated at 4.7% for January 2023, as does the headline Consumer Price Index (CPI) at 6.0%.
The course of interest rates is hugely consequential for public as well as private finances. As Republican congress members, holding a majority in the House of Representatives, face off against a Democratic President, Treasury Secretary Janet Yellen announced on January 19th that the country had hit its maximum debt of $31.4 trillion, and that “extraordinary measures” were being taken to conserve cash. Speaker of the House, Kevin McCarthy, has vowed to extract spending cuts in exchange for raising the debt ceiling, but opposing sides are currently in a negotiation stalemate.
There had been speculation that both the Fed and the ECB might have paused immediately following turmoil in certain areas of the banking sector. Some argue that such instability has been greatly exacerbated by aggressive rate hikes within a condensed time period. Earlier in March, U.S. regulators moved swiftly to shutter Silicon Valley Bank (SVB) in the wake of a bank run, as well as a second regional institution, Signature Bank. This marked the second and third largest bank failures in U.S. history, respectively, eclipsed only by Washington Mutual in 2008. In a joint statement, the U.S. Treasury, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board announced that all depositors, both insured and uninsured, of both failed banks, would be made whole for their deposits at no direct cost to taxpayers. Shareholders and other unsecured creditors would receive no special protection.
Such an announcement prompted the question of whether a de facto blanket coverage of all U.S. banking deposits was now in place, irrespective of the FDIC’s ordinary insurance limit of $250,000 per depositor, per institution. The question was posed by Oklahoma Senator James Lankford in a verbal sparring session with Treasury Secretary Janet Yellen in front of a Senate committee, but the Secretary was circumspect in her responses. Ms. Yellen insisted that “our banking system is sound and that Americans can feel confident that their deposits will be there when they need them,” but fell short of assuring all depositors that they would be afforded the same expanded protection given to those in the recently collapsed banks. President Biden was more forthright, voicing a commitment to do “whatever is needed” to protect deposits.
At the end of 2022, Silicon Valley Bank was the 16th-largest bank in the United States, but in certain key respects was a stark outlier. According to S&P Global Market Intelligence data as of year-end 2022, SVB ranked first among banks with more than $50 billion in assets in having a staggering 93.8% of its total deposits uninsured, while Signature Bank ranked fourth in this metric. SVB’s depositors were concentrated among venture capital and startup firms, many facing cash crunches as tech funding cooled off. Higher demand for withdrawals collided with poor risk management at SVB as the bank was forced to liquidate fixed income assets that had fallen in value in the face of rapid rate increases. In a classic bank run, a contagious rush to exit led to $42 billion in withdrawals – nearly a quarter of the bank’s total deposits – the day before regulators took over.
The shuttering of Signature Bank appeared to be somewhat preemptive to stymie contagion risks and may have been connected to its dealings in the regulatory gray area of banking tied to crypto entities. Shockwaves in the banking industry were felt far, with U.S. sector turmoil cited as a contributing factor when Swiss authorities forced a shotgun wedding of two global banking giants. UBS Group will take over embattled 167-year-old Credit Suisse Group, with the impending deal backed by a massive Swiss guarantee. At home, the Federal Reserve Board has announced the creation of a new Bank Term Funding Program (BTFP), offering loans to eligible depository institutions to shore up cash availability in exchange for collateral such as U.S. Treasuries, which will be marked at par regardless of market value. We are in the immediate aftermath, but events do not appear to pose a systemic risk to the broad financial system.
While the world followed crises in the banking sector, President Xi of China traveled on a State visit to Moscow in March, where he met President Putin to discuss the nations’ expanding economic partnership. There has been a near-tripling of China’s imports from Russia over the last three years. Also on the table was a potential mediation effort by the Chinese to negotiate an end to the war in Ukraine. While the meetings were short on concrete results, it was viewed as an overt display of an accelerating rapprochement built on mutual strategic goals.
One such goal might be to usurp the dominance of the U.S. dollar in international trade, especially in global oil markets run on the petrodollar system. There have been persistent reports that the BRICS nations (Brazil, Russia, India, China, & South Africa) may be seeking a way to circumvent this system and possibly even establish a new reserve currency, but the path for that challenge to the dollar is unclear. While entities may negotiate individual energy trade deals, such as a Chinese national oil company recently completing its first yuan-settled LNG (Liquefied Natural Gas) trade with a French energy company, there is little appetite among OPEC (Organization of the Petroleum Exporting Countries) to enact large scale changes. Middle Eastern currencies are often pegged to the dollar, requiring a constant inflow of U.S. dollars to stabilize the system.
In more trying economic times, a level of upheaval and unrest is inevitable. President Macron in France is facing significant citizen backlash, strikes, as well as unrelenting protests which swelled to almost 1.3 million participants in early March. Mr. Macron used a special constitutional power to push through a reform without a vote that raises the retirement age for most workers from 62 to 64. Transport unions in Germany, demanding pay increases to compensate for rising energy and food costs, have also mounted a “mega-strike”, paralyzing the nation’s services, including airports.
Farmer protests in the Netherlands calling into question climate policies meant to limit the country’s nitrogen emissions led to municipal election victories for a farmer-friendly party, which is now the third-largest political force in the nation. In Israel, hundreds of thousands of protestors have recently taken to the streets over government plans to overhaul the judiciary. While motivations vary, populist revolts are a sign that factions feeling disenfranchised, economically or politically, seem increasingly prepared to exert public pressure on current leadership today.
At home, according to Raymond James, first quarter earnings estimates have fallen over 5% since the start of the year, and this decrease is larger than the five-year average of -2.7%. Banks are among the first to report, which will provide an early indication of the ramifications on deposit flows, loan loss provisions, and magnitudes of unrealized losses within the sector. Raymond James’ economist forecasts that a mild recession is looming based on three factors – a slowdown in consumer spending brought on by softening job growth, a draining of excess savings, and tighter lending standards limiting demand for credit. An especially vulnerable market is the commercial real estate sector, particularly inner-city office investment still reeling from the effects of Covid-19.
Here at Stolper Asset Management, we favor a bottom-up approach in evaluating investment opportunities, basing our assessments on individual merits and prospects. While subject to broader market sentiment and performance, we remain optimistic that our value-oriented discipline holds significant merit for those with a longer-term investment perspective. We hope you enjoy the beauty and renewal that spring brings and thank you, as always, for the confidence you show in us as your trusted financial advisor.
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