, ,

The Brave Report: Market Commentary for Q1 2023

Click here for the .pdf version of this report: The Brave Report-2023Q1

Over the past few months, I have paused the publication of the Brave Report in an attempt to fine-tune the proper frequency and format for the report moving forward.  I have spoken with clients and the consensus seems to be that the format works well but publishing on a quarterly basis (rather than monthly) along with one-off pieces when specific events arise is the preferred frequency.  If at any time between publications you have a question about a specific topic and how it impacts the markets, feel free to reach out directly.

Banking crisis, inflation and recession… These are the buzzwords for the past quarter.  Inflation and the fear of recession have been looming over the markets for well over a year now.  Rates have risen drastically to keep inflation in check and many fear that the only way to get it back to “normal” levels is to slow the economy into a recession.  Markets are now trying to handicap how deep and long-lasting any economic damage will be.  Throw on top of this the failure of a few banks and the fears of a repeat of 2008 come streaming back.  However, even with all of this negativity, the markets were able to rally throughout the 1st quarter. They had been sold off pretty heavily last year so they definitely had some room to jump but this resilience in the face of a lot of uncertainty should be looked at as a positive.  For the remainder of the year, I expect this push and pull to continue. Range-bound volatility will be the norm until we can get some more clarity on the strength or weakness of the economy.

Market Overview

Following what was the worst year in the markets since the financial crisis, the markets bounced back in the first quarter of 2023. The bounce, however, was not market-wide as there was a large dispersion between the three indices. During the quarter, the S&P 500 rallied 7% and the NASDAQ rose just shy of 17%. The Dow Industrial Average only advanced slightly, gaining around 0.3%.  This was a reversal of how things ended last year when the tech-heavy NASDAQ was the big underperformer. During the quarter we saw a rush into larger, profitable technology names as cost-cutting within the sector made headlines. These names emerged as the ones that are expected to be able to withstand the elevated rate environment and any subsequent economic downturn. They were also some of the names most beaten up over the previous 12 months.

On the fixed income side of the equation we are still seeing an inverted yield curve, with rates on the short end of the curve remaining elevated above their long-dated counterparts.  We did see rates come down a bit during the month of March as the Fed laid out its projections for future rate hikes and inflation continued to drop. However, if we look back a year, the rate on the 10-year is still 1.25% higher than a year ago.  The Fed, has signaled an end to their rate increases but there are still a lot of moving parts in the equation.  If inflation remains at elevated levels, we could see rates stay high for quite some time. On the opposite side, if economic data starts to signal an imminent recession, we could see rates soften.

SVB

The recent failure of Silicone Valley Bank, along with some other smaller institutions has brought memories of 2008 back to the forefront.  Before I dive into it, I want to make clear that what we have seen in the banking sector over the past month is very different than what we experienced in 2008.  The regulatory environment is much different, and our banking system is much better capitalized than it was back then.  With that said, there will be some long-lasting impacts from this recent turmoil.

First, what happened to SVB?  SVB was a unique player in the banking industry, catering primarily to venture capital firms and venture capital-backed companies and founders.  SVB was able to leverage these relationships to be a one-stop shop for the venture community.  These types of deposits were not very “sticky” as companies would routinely need access to their capital as they spent money to operate their companies.  They also had one of the largest non-FDIC insured deposit bases amongst any bank in the country, meaning that the potential for losses, if depositors couldn’t get their money out, would be substantial.

Along with other regional banks, they would offer higher than average rates on their banking deposits to help attract new capital.  In order to offer these higher rates, they had to increase the risk they took while investing these deposits, often investing deposits in longer-duration assets and  a mortgage-backed portfolio.  The problem with investing in these longer-duration assets is that as rates rose the portfolio lost money unless they could hold the positions to maturity.  As redemptions were called in, the bank was forced to sell some of these long-dated assets at a steep loss.  This raised concerns about the financial stability of the firm and when they attempted to raise capital through a stock sale, depositors panicked and started to withdraw assets at record rates.  The government had to step in and freeze redemptions to prevent a further run on the bank and within a few days the bank was no more.

From what we know so far this looks like a product of poor corporate management and not something that is systematically wrong with the banking sector. Thankfully for most depositors, the government was able to step in and insure all depositors, at no cost to taxpayers.  The good news is that this helped to prevent further contagion throughout the banking industry which would have been devastating for the industry moving forward. On the flip side, by the government stepping in they have removed a moral hazard from the banking sector.  If banks and depositors think that the government will just step in during a future crisis, then they are less likely to have proper risk controls in place to protect depositors.

There will be some other long-lasting impacts moving forward. As we saw during the days following the collapse, depositors flooded to the larger money center banks. This will lead to the big banks getting bigger and create a landscape where the smaller regional banks will struggle to attract new capital. Furthermore, the smaller regional banks could become more risk-averse in their investments and thus lose the benefit of offering depositors higher rates.  Profit at these smaller banks will take a hit and the large banks will reap the benefits.

Inflation and Rates

The big market-driving story over the past year has been elevated levels of inflation and the subsequent rise in rates to help combat this inflation.  The big question that investors have been asking is can the Fed thread the needle of taming inflation without causing a widespread recession?  It is a tough task because the impacts of rate increases tend to be lagging so we don’t fully know what impact these rate increases have had on the economy yet.  Pundits, large investors and economists have come out of the woodwork to state their case on what should be done and the dispersion of opinions has been all over the map. Some have said that markets will drop another 20% while others are calling for the start of a new bull market. This has made it very difficult to make investment decisions and even with the jump in some sectors since the start of the year, the markets are still fighting for directionality.

In times like this, when there is a lot of uncertainty, I like to simplify things, and understand what we do know and what we can control:

  • Inflation has been too high for a while but has been trending down over the past 6 months.
  • Prior to the pandemic, inflation was below long-term averages since the financial crisis so some of the jump in inflation could be some reversion to the mean.
  • Rates have been raised to levels we haven’t seen in over a decade, but the Fed has signaled that these rate increases will end soon.
  • The full impacts of elevated rates on inflation and the economy are still not known as there is a lag on this impact.
  • The yield curve is inverted offering investors a way to hide out in shorter-duration assets until the market shows some directionality.
  • The economy and employment market have shown signs of slowing but there are still just under 10 million job openings.
  • Earnings growth is expected to be right around flat if not a little negative but there are still some companies growing rapidly and little impacted by elevated rates.

 

So, what do we do with this information? I think it is important to first point out that I expect these uncertainties to persist for quite some time. There is too much dispersion of opinion within the investment community for real directionality to happen.  We will see continued volatility in both directions but large bounces in the markets will be sold and large drops will be bought creating a range-bound market, albeit with a relatively wide range.  This volatility will continue until we see some consistent data on the inflation and earnings front. I also expect this earnings season to help us understand who is winning in the current environment and in what sectors the signs of recession are starting to show themselves. Earnings guidance will be muted as is often the case during times of uncertainty, but a lot of this is already priced into many names.

For the long-term investor with few short-term capital needs, now is the time to make sure your allocation hasn’t shifted too far out of balance. There has been a dispersion between sectors, company size and style. This can lead to a portfolio being out of balance.

If you are investing in individual names, I would focus on those with consistent profitability and strong balance sheets.  Timing the market during these times of uncertainty can be difficult but adding to quality names when they are priced at a large discount to where they were a year ago can be a good way to add value to your portfolio.  However, I would recommend dollar-cost averaging into any new positions as I think this uncertainty will be around for quite some time, providing ongoing entry points.

I would also look to take advantage of the high rates on the short end of the yield curve.  The spread between the dividend yield on the S&P 500 and the 10-year treasury is larger than it has been in more than a decade, meaning the premium you are paying for dividend yield is not very attractive compared to bonds. Owning the treasuries or bonds directly is a much better option than owning a bond fund as this helps to eliminate price risk if you can hold the bonds to maturity, which is a lot easier with an inverted curve.

Strategy Commentary

I continue to maintain a neutral stance across portfolios.  I expect to see continued volatility for the rest of the year as the markets grapple with higher rates and the prospect of a recession.  Some of the economic slowdown is already priced into markets.  One of the driving factors for the rest of the year is going to be determining if anything more of the economic slowdown needs to be priced in. As discussed, I expect the market to be volatile within a wide range until we get some more certainty on how much the interest rate hikes will impact economic growth.  I am content maintaining a neutral stance until some of these questions get answered. I will look to add to some equity positions if we see a further pullback or we start to see signs that the recession fears are overblown.

Domestically, I am still advocating for a bar-belled approach with exposure to technology and communication services on one end and defensives on the other.  We saw technology pop in the first quarter and the defensives lag, but if we see the market turn more negative, the opposite will be true.  Within these sectors, especially on the technology side, I am still focusing on high-quality, profitable names rather than chasing the more volatile high beta names.  I do think stock picking will outperform for the rest of the year as some names are able to withstand the economic slowdown better than others. Finding these winners can help to drive outperformance in portfolios.

Internationally, the eurozone has performed well so far this year.  I have been neutral on the region so I definitely missed out on some of its outperformance.  I continue to maintain a neutral stance on most developed markets.  The threat of a spillover from the Ukraine conflict still adds additional tail risk to these markets and I am willing to sacrifice the potential outperformance to miss this risk.  The same can be said for emerging markets.  I have selectively added over the past year but these additions have been short-lived.  Uncertainties around China make it tough to invest with much conviction in the region.

On the fixed income side, I continue to reduce the duration of our positions and have been adding short-dated treasuries to most portfolios, especially in instances where we have excess cash. This is a great place to hide out until we have some more conviction in the equity markets. I have also been shifting some assets from bond ETFs to owning the actual securities. Owning the actual bonds or treasuries and holding to maturity eliminates some of the price risk and since we are buying mostly on the short end of the curve, we are not giving up too much liquidity.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *