Markets showed their resilience in the first quarter despite being rocked by a variety of unanticipated events. Investors who ignored the bad news and kept their focus on long-term outcomes were rewarded. In fact, the first three months of 2023 offered textbook lessons on the upsides of turbulence and benefits of long-term thinking.
Investors were upbeat early in the year, hoping that subsiding inflation meant the Federal Reserve would begin to cut rates. But those hopes were dashed by a string of reports showing stubborn strength in the economy. Stock and bond prices slid as investors digested the economic news and the Fed tone grew stern. It was apparent that rates would not be cut, and in fact, might rise.
On the heels of this disappointment came the downfall of Silicon Valley Bank, the second largest bank failure in U.S. history. Soaring interest rates had slashed the value of the bank’s bond portfolio, and when investors rushed to retrieve their money, the bank collapsed. Poor risk management and inadequate diversification were other factors cited in the failure. Worries about similar risks at other banks spread, and soon toppled Signature Bank, another regional U.S. lender.
The Treasury Department, FDIC and Fed joined forces to quell rising financial panic. Interventions included the creation of emergency-lending facilities to protect customers, unlimited deposit insurance for failed banks, and a partial bailout by the biggest U.S. banks to shore up First Republic, another bank teetering at the edge of collapse.
By the end of March, the worst fears were over, but the damage had been done. With diminished deposits, banks began to tighten credit, which hurt business owners of all sizes. The evening news again warned about recession.
Keeping its eye on inflation, the Federal Reserve pressed head with a quarter point rate rise, lifting the Federal Funds rate to a new target range of 4.75% to 5%. There was a glimmer of hope as the Fed suggested it might soon ease up on its monetary tightening drive.
Waiting for the Other Shoe to Drop
While the immediate crisis of bank failures has fallen out of the news cycle, the First Republic mess is far from resolved. Behind the scenes may be many similar banks facing the same issue that brought down Silicon Valley Bank, that is, holding interest rate-sensitive assets in a high interest rate environment. It is likely that regulation and supervision will increase as policy makers scope the extent of exposure. Meanwhile, the risk of a broad credit freeze is real and present.
The problems are compounded by the industries in which banks are heavily invested. For instance, the commercial real estate (CRE) lending market, valued at $5.6 trillion, has secured at least 70% of its loans from small and medium-sized banks. “Small banks’ absolute dollar exposure to commercial real estate has grown at an accelerating rate over the past decade,” according to Morgan Stanley, as reported in the Financial Times (FT, 23-March). The FT and other financial news sources note that commercial real estate values were already under pressure before rates started to climb, due to the rise in Internet shopping and work-from-home trends that hurt retail and office space. But more pain is ahead, “Since $2.5 trillion of these loans are due to be refinanced in the next 5 years.”
While an end to interest rate increases would reduce the pressure on banks and the businesses that depend on them, many foresee the credit woes of commercial real estate market weighing heavily on banks—and the economy—for years to come.
The Banks in the Shadows
Every economic crisis creates new opportunities. After the Great Recession, greater oversight and tightened controls on commercial banks led to the creation of so-called “shadow banks,” financial intermediaries including insurers, hedge funds, pension funds and other asset managers. These intermediaries sidestep banking regulatory control because they do not accept deposits. And yet they are increasingly important players in the financial system, providing credit and equity, buying bonds and driving flows of global capital. And they wield enormous financial power, having risen from 40 to 50 percent of global financial assets since the financial crisis.
The Financial Times editorial board (13-April) quotes three factors, as identified by the IMF, that make these shadow banks a significant risk in a tight-money era. They include “the build-up of leverage in some institutions (albeit less so than banks), rising interconnectedness among non-banks and with banks, and the potential for asset and liability mismatches due to differences in liquidity and maturity.” The FT is among the industry pundits now calling for greater transparency, stress testing, and reporting on liquidity and leverage from shadow banks. Hundreds of millions of retirees and pensioners are reliant on the soundness of these unregulated institutions that are not backed by federal depository insurance.
The Rescue Economy
Has the U.S. government gone too far in its efforts to save flailing financial institutions? And if so, is there harm in that? A growing chorus of voices are answering “yes” and “yes” to these questions.
Ruchir Sharma, Chair of Rockefeller International, is one of several prominent financial pundits who calls state-sponsored financial rescues a threat to long-term prosperity (FT, 27-March). He writes that the “easy money” era of super low interest rates was shaped by “an increasingly automatic state reflex to rescue — to rescue the economy from disappointing growth even during recoveries, to rescue not only banks and other companies but also households, industries, financial markets and foreign governments in times of crisis. The latest bank runs show that the easy money era is not over. Inflation is back so central banks are tightening, but the rescue reflex is still gaining strength. The stronger it grows, the less dynamic capitalism becomes.”
Sharma argues that financial rescues cause “a massive misallocation of capital and a surge in the number of zombie firms, which contribute mightily to weakening business dynamism and productivity,” concluding that “Government intervention eases the pain of crises, but over time, lowers productivity, economic growth, and living standards.”
This was not the narrative during the Great Recession, when massive bank bailouts were considered essential to saving the world economy. But today we’re seeing a darker side of the rescue mentality, which is how showers of government money can undermine the financial strength of the U.S. dollar.
In Barron’s (14-April), Randall Forsyth quotes Peter Atwater, an adjunct professor at the College of William and Mary and the University of Delaware, disparaging the recent remarks of French President Emmanuel Macron. “Macron desperately needs the Chinese to love him,” Atwater says. Why? He needs their investment in the French economy.
And yet the fact that Macron could undercut his relationship with the U.S. so publicly shows the power-play in motion as China and Russia seek to undermine the greenback’s global status. The idea that the dollar is dead or dying is premature, says Deutsche Bank macro strategist Alan Ruskin, who predicts that for decades to come, the dollar will remain the dominant reserve currency—mainly because there is no alternative. But that doesn’t mean it won’t lose value.
Macro Intelligence 2 Partners, quoted in the same article, believes “The greenback is vulnerable to an exodus of global capital, given the potential for a U.S. recession or a reversal in the substantial outperformance of U.S. assets, such as stocks.”
The U.S. has become dependent on money flowing to American investments. “But the massive fiscal borrowings following the 2008-09 financial crisis and the Covid-19 pandemic have raised concerns about the limits of Uncle Sam’s credit,” writes Forsyth. Things can change quickly, and as Macron now understands, people can turn on institutions if, say, their pensions are threatened and retirements delayed due to a government’s financial stress.
Generous handouts to financial institutions and the population at large (post-Covid) may appear to be a very bad decision should that come to pass here. Meanwhile, the United States may soon meet another crisis head-on if the debt ceiling isn’t raised.
How to Navigate Unknown Terrain
At the moment, one of the safest plays is relatively short-term U.S. government debt. Because of the inverted yield curve—in which yields are higher on short-term debt than long-term bonds—such debt pays a decent return with virtually no chance of a negative outcome.
Beyond that, in times of stress, many believe their portfolio should have some gold. Before rushing to gold, consider that for more than 200 years U.S. stocks have delivered total average real returns of more than 6% annually. And for the last five decades, a dollar invested in the broad U.S. market has outperformed gold by four-to-one, with twenty percent less annualized volatility.
Keeping out of trouble is a key focus, and Cardiff Park clients have the guardrails they need. As always, we encourage you to remain diversified, hedge your liabilities, match your asset allocation to your spending requirements, follow your investment plan, and focus on higher confidence, longer-term outcomes. Beyond that, it is important to have the right mindset. Accept uncertainty, remain disciplined, trust in the power of markets and broad asset prices to shake off market shocks, and don’t be tempted to play “catch-up” by timing the market.
For all the swirling fears, a crisis on the scale of 2008 remains unlikely. Bank capital is stronger now, and failures have largely been due to idiosyncratic exposures and poor management. Lending standards are better too. A tightening of credit is inevitable, but how severe it will be is unclear.
Do you have questions or concerns about your portfolio or asset allocation? Contact me. I am here to help.
Courtesy of DFA and Avantis
In financial markets, expectations switched from rising interest rates to falling interest rates. The Fed was seen ending its increases by May and reversing course in the year’s second half. Bond prices rallied, with yields falling. Stocks reacted positively to the prospect of future Fed easing and finished the quarter on a winning note.
Technology led the advance, with the Nasdaq Composite returning 6.78% in March and 17.05% for the quarter, its best showing since the second quarter of 2020. The broader large-cap market returned 3.67% for the month and 7.50% for the quarter, as measured by the S&P 500 index.
The U.S. equity market underperformed non-U.S. developed markets but outperformed emerging markets. Value underperformed growth. Small caps underperformed large caps. REIT indices underperformed equity market indices.
Developed markets outside of the U.S. posted positive returns for the quarter and outperformed both U.S. and emerging markets. Value underperformed growth. Small caps underperformed large caps.
Emerging markets posted positive returns for the quarter and underperformed both U.S. and non-U.S. developed markets. Value underperformed growth. Small caps underperformed large caps.
U.S. real estate investment trusts outperformed non-US REITs during the quarter.
The Bloomberg Commodity Total Return Index returned negative -5.36% for the first quarter of 2023.
Natural gas and nickel were the worst performers, returning negative -50.99% and negative -21.38% during the quarter, respectively. Sugar and copper were the best performers, returning positive 18.87% and positive .09% during the quarter, respectively.
Within the U.S. Treasury market during Q1 2023, interest rates generally increased in the ultrashort-term segment and decreased in the short to long-term segment.
On the short end of the yield curve, the 1-Month U.S. Treasury Bill yield increased 62 basis points (bps) to 4.74%, while the 1-Year US Treasury Bill yield decreased 9 bps to 4.64%. The yield on the 2-Year U.S. Treasury Note decreased 35 bps to 4.06%.
The yield on the 5-Year U.S. Treasury Note decreased 39 bps to 3.60%. The yield on the 10-Year U.S. Treasury Note decreased 40 bps to 3.48%. The yield on the 30-Year U.S. Treasury Bond decreased 30 bps to 3.67%.
In terms of total returns, short-term U.S. treasury bonds returned +1.87% while intermediate-term U.S. treasury bonds returned +2.27%. Short-term corporate bonds returned +1.68% and intermediate-term corporate bonds returned +2.50%.
The total returns for short- and intermediate-term municipal bonds were +1.37% and +2.35%, respectively. Within the municipal fixed income market, general obligation bonds returned +2.59% while revenue bonds returned +2.96%.
The Bloomberg U.S. Aggregate Bond Index advanced nearly 3% in the first quarter. Gains in January and March overwhelmed the index’s decline in February. All sectors delivered monthly and quarterly gains.
Annual inflation moderated in the quarter, with headline CPI dropping from 6.5% in December to 6% in February. Annual core CPI eased from 5.7% to 5.5%. TIPS performed in line with nominal Treasuries in March and outperformed for the quarter.
The Fed raised rates 25 bps in February and again in March. By quarter-end, easing inflation and banking sector uncertainty led to market expectations for no additional rate hikes and rate cuts later this year. However, the Fed indicated another rate hike may be necessary to quell inflation.
Investment-grade corporate bonds posted solid gains in March and for the quarter. High-yield corporates lagged investment-grade corporates in March and outperformed in the quarter.
Cardiff Park Advisors
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