Roosevelt Investments is now CI Roosevelt Private Wealth

April 2023 | Equity Commentary

April 2023 | Equity Commentary

Published on May 12th, 2023

Stocks moved slightly higher in the month of April, with the S&P 500 index rising 1.6%. Eight of 11 S&P 500 sectors posted positive performance, with value stocks slightly outperforming growth stocks.1 Regional bank stress continued to hover in the headlines throughout the month, culminating with the closure of First Republic Bank on May 1—a failure that many market watchers had come to expect.2 Trading in regional bank stocks remained volatile, but the muted reaction from the broader markets suggests fear of contagion remains relatively low. The fixed income markets also showed little signs of investors fleeing for safety, with the 10-year Treasury bond yield moving only slightly lower in April, from 3.48% to 3.44%.3

The news of First Republic Bank’s failure also came with an announcement from JPMorgan and the FDIC. Under the agreement, JPMorgan would assume most of First Republic’s $92 billion in deposits and would buy most of the bank’s assets, with the FDIC agreeing to share losses on some of First Republic’s loans. JPMorgan CEO Jamie Dimon and Federal Reserve Chairman Jerome Powell both made statements suggesting that First Republic’s failure marked the end of this chapter of the regional bank stress,4 but it’s also true that crises in confidence tend to be very difficult to predict. Regional bank stocks remain under pressure, and we will still need to monitor the downstream effects on credit conditions and loan activity as the year progresses.

The Bureau of Economic Analysis (BEA) reported that the US economy grew by 1.1% in the first quarter, well below consensus forecasts of 1.9% and also the 2.6% growth rate posted in Q4 of last year. According to the BEA, the growth deceleration was primarily driven by a decline in inventories and business investment (as measured by nonresidential fixed investment). A bright spot in the GDP report was consumer spending, which benefited from a surge in retail sales posted early in the year. Imports and exports also increased.5

A majority of S&P 500 companies have now reported Q1 earnings, and the overarching takeaway is that corporations largely performed better-than-expected. As of May 5, with 85% of S&P 500 companies reporting results, 79% posted a positive earnings-per-share (EPS) surprise and 75% beat consensus expectations on revenues. According to Factset, Q1 2023 marked the best earnings performance relative to expectations since Q4 2021.6 Notably, large money center banks like JPMorgan, Citi, and Wells Fargo all reported strong earnings and expanding net interest margins,7 which was partly driven by an influx of new customers leaving regional banks. 

The Bureau of Labor Statistics reported that inflation (consumer price index, CPI) rose by 0.4% in April, following a 0.1% increase in March. Year-over-year, CPI registered at 4.9% in April, down from March’s 5% and February’s 6% year-over-year increase. April’s CPI reading marked the smallest increase since May 2021. Core prices, which strip out food and energy, were higher at 5.5% y-o-y, largely because of pressure in services prices—and specifically the shelter component, which makes up one-third of the index. The upshot here is that shelter prices measure what renters and homeowners are paying for new and existing leases, which means meaningful declines in rents will not show up immediately in the CPI number.8 An index of median rents in the US showed the first year-over-year decline since March 2020. Assuming the trend continues, the shelter component should contribute significantly less to the CPI number by this summer and fall.

The Federal Open Market Committee (FOMC) met on May 2-3 and announced another 25 basis point increase for the benchmark fed funds rate, bringing the target rate to the 5% to 5.25% range. In the official statement released after the meeting, the Fed importantly did not include the following sentence: “The Committee anticipates that some additional policy firming may be appropriate.” 9 We believe this omission is perhaps the clearest sign that the benchmark fed funds may have arrived at its terminal rate in this cycle. Assuming there is not a negative inflation surprise in the next few weeks, we would expect the Fed to “pause” at its June meeting and hold rates steady until inflation falls much closer to its 2% target.

While the economy has shown some signs of cooling in response to higher rates, the labor market has not. April’s job report showed a 253,000 gain in nonfarm payrolls, following a 165,000 increase in March. The unemployment rate fell to 3.4% in April from 3.5% in March, as 43,000 people left the work force and the number of unemployed Americans fell by 182,000. The three-month moving average of job growth in the US registered at 222,000, which shows hints of softening but not convincingly so.10

Looking ahead in May and early summer, the debt ceiling issue will likely figure prominently in the headlines. Market participants have largely come to expect a debate over raising the debt limit every few years or so, and many of the same warnings from Treasury officials and demands from political parties play out as they have in years past. It appears that the US will be able to meet obligations and debt payments for another month or two, which unfortunately for investors just extends the timeline that this story is likely to play out in the press. There have been some positive developments recently, with the House’s passage of the Limit, Save, Grow Act in late April11 and a meeting between House leadership and President Biden in early May. While neither development is likely to result in a deal on the debt limit, they at least serve as a starting point for negotiations.

Sources

1.S&P Dow Jones Indices, Market Attributes US Equities

2.FDIC_ Failed Bank Information for First Republic Bank, San Francisco, CA.pdf

3.Resource Center _ U.S. Department of the Treasury.pdf

4.JPMorgan Chase Takes Over First Republic After FDIC Seizes Bank – WSJ.pdf

5.Gross Domestic Product, First Quarter 2023 (Advance Estimate) _ U.S. Bureau of Economic Analysis (BEA).pdf

6.https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_050523.pdf

7.https://finance.yahoo.com/news/analyzing-q1-bank-earnings-good-221610442.html

8.https://www.wsj.com/articles/us-inflation-april-2023-consumer-price-index-48f0eac5?mod=economy_lead_pos1

9.https://www.federalreserve.gov/newsevents/pressreleases/monetary20230503a.htm

10.https://www.wsj.com/articles/april-jobs-report-unemployment-rate-economy-growth-2023-a500d302

11.https://www.nytimes.com/2023/04/26/us/politics/debt-limit-vote-republicans.html

As of April 30, 2023

 

Banking Crisis, 2023 Edition: New Risks, But Important Offsets | Quarterly Conference Call

Banking Crisis, 2023 Edition: New Risks, But Important Offsets

Recorded on May 4th, 2023

Robert Meyer, CFA, Senior Portfolio Manager, and Richard Konrad, CFA, CFP®, Senior Portfolio Manager, sat down to discuss the latest updates in the financial markets from this past quarter. In this webinar, they also discussed:

  • Capital Markets: Off to a Strong Start Even as Recession Clouds Gather
  • The Inflation Dragon: Will the Fed Finally Slay This Beast?
  • Debt Ceiling Showdown: America Runs Up Its Credit Card Limit–Again

First Quarter 2023 | Fixed Income Commentary

First Quarter 2023 | Fixed Income Commentary

Published on April 18th, 2023

The financial sector came under pressure in the first quarter following the failure of several U.S. banks.1 While the prices of many stocks and preferred equity issued by banks were negatively impacted as a result, at present, we do not believe the issuers of the securities held in our client portfolios exhibit the same risk factors which contributed to the recent bank failures. In our view, these factors included significant exposure to cryptocurrency deposits, concentration of deposits in too few firms or sectors, high percentage of uninsured deposits, and securities portfolios with material unrealized losses in excess of the bank’s tangible equity capital.

Background

In simplified terms, when a bank takes in deposits, it can either make loans with those funds or invest them in fixed income securities, typically government or agency bonds. When a depositor withdraws cash from a bank, the bank can either sell a portion of its fixed income holdings or borrow from various sources to fund the withdrawal request. We believe several recent bank failures were characterized by very rapid and significant requests for withdrawals (a “run” on the bank) combined with the inability to quickly access cash to fund those withdrawals, without realizing substantial losses on banks’ securities portfolios.  

Silvergate

Silvergate developed the first digital currency payments network by an FDIC insured publicly traded bank in 2019.2 Companies that utilized its payments network included the major crypto currency exchanges, and the exchange’s clients kept large deposits of digital currencies at the bank. Moreover, the top ten depositor firms by market share made up roughly 50% of total deposits.3 Silvergate appeared to have been troubled with declining deposit balances ever since the failure of FTX (a cryptocurrency exchange), which filed for bankruptcy in November 2022.4 In total, $8.1B of deposits (68% of total deposits) left the bank during the fourth quarter 2022,5 and on March 8, 2023 the bank announced that a voluntary winddown of operations was “the best path forward”.6

Silicon Valley Bank

SVB was a leading bank to the technology and venture capital community in Silicon Valley whose strong relationship with these companies contributed to its substantial deposit growth over the last several years, in our view.  In recent months, however, it appears the bank’s deposits declined at a rapid pace due to the high cash burn rate of their clients combined with a lesser amount of new venture funding for startups coming into the bank as new deposits.7 As a result, the bank had to sell a portion of its securities portfolio at depressed market values and “realize” losses of $1.8 billion.8 SVB had engaged Goldman Sachs to sell additional equity to help repair the balance sheet damage incurred from the realized losses, but quickly deteriorating market conditions eliminated that possibility.8  We believe the combination of this news, along with Silvergate’s downfall just days earlier, caused many depositors to have serious concerns about the financial stability of the bank, and many of them withdrew their funds at the same time, triggering a run on the bank.

In terms of overall credit quality, SVB was very well capitalized.8 The bank’s tier 1 capital ratio was in excess of 15% (well above the required minimum), the average loan-to-value (LTV) on the mortgage portfolio was low, and loans only made up 35% of total assets.8 Moreover, although SVB was a lender to the technology and venture capital industry, its overall exposure to the riskiest elements of this ecosystem was not high.8

In hindsight, we believe what investors overlooked at SVB was the concentration of its deposit base in one industry, venture-funded technology companies, whose secular trends exposed the bank to volatile and ultimately skittish depositor flows. While this alone may not have been enough to cause the bank to fail, when coupled with the high proportion of uninsured deposits, significant unrealized losses in the securities portfolio (large enough to wipe out the bank’s tangible equity capital), and the securities portfolio comprising a substantial portion of the bank’s total assets; taken together we believe these factors contributed to the bank’s overall failure.

Credit Suisse

We believe its Swiss National Bank-brokered combination with UBS helped limit contagion. Because Credit Suisse counterparties Greensill and Archegos failed in 2021,9 U.S. banks had time to reduce their counterparty exposure to the Swiss bank, in our view. The Fed stress tests also incorporate counterparty failures and suggest to us that this potential issue will not cross the Atlantic. The failure of Credit Suisse’s AT1 securities caught some investors by surprise, and a subsequent move to redeem AT1 securities by Deutsche Bank sparked a widening in the German bank’s CDS spreads and a selloff in its equity.10 Our strategy does not hold any European bank securities. 

Portfolio Review

In the wake of these recent bank failures, we have engaged in a detailed review of all the bank-issued securities we own in client accounts for similar risks: deposit concentration in too few sectors or firms, potential deposit flight from high levels of uninsured deposits, and potential unrealized losses embedded in securities portfolios that outweigh banks’ tangible equity capital. 

At present, we do not believe the banks to which we have exposure exhibit deposit concentration that could potentially be problematic; either via over-exposure to a single sector (like SVB) or via too few depositor firms (like Silvergate’s ten largest depositors). We believe the banks in which we have invested have a more diversified and stable deposit base.

We have also re-evaluated the portion of a bank’s deposits that are above the $250,000 FDIC guaranteed level. To us, this indicates the degree to which deposits could potentially be at risk of leaving the bank. Of the 25 largest U.S. Banks, SVB had the highest ratio of uninsured deposits to total deposits, at 88%. The bank with the second highest ratio of uninsured deposits to total deposits was First Republic, at 68%, which was a contributing factor towards our decision to sell the security. At present, we do not believe the other banks in which we are invested face a similar risk of losing deposits at a rapid pace. 11

Taking the analysis further, we assessed the potential impact on each bank’s tangible equity capital if all unrealized losses in “held to maturity” categories of securities portfolios, which record securities at book values as opposed to market values, had to be realized. An analysis of banks we own shows that all except for SVB and Schwab would have sufficient tangible equity capital (a tangible common equity to assets ratio > ~3%) remaining if all securities were sold, and all unrealized losses (after-tax) were realized. 11,12,13

For SVB and Schwab, tangible common equity ratios would fall to or slightly below zero in this situation.11,12,13 While this could have been a contributing factor to SVB’s failure, we don’t believe Schwab is at risk of facing similar pressures at this time. To be in a situation where the entire securities portfolio may need to be sold, deposits would also need to rapidly decline, and access to enough liquidity would also not be available, in our view. In Schwab’s case, uninsured deposits make up less than 20% over all deposits, which to us indicates that the bank is not at high risk of facing rapid deposit decline.12,13 We also believe Schwab has access to plenty of liquidity should the need arise. As Schwab’s CEO Walt Bettinger recently stated in the WSJ, “There would be a sufficient amount of liquidity… to cover if 100% of our bank’s deposits ran off,” “Without having to sell a single security.”14 Finally, unrealized losses in securities portfolios as of quarter-end 2022 have likely improved materially as Treasury yields have declined substantially since the crisis. 15

Subsequent to the bank failures in March, the Federal Reserve created a new liquidity facility (the Bank Term Funding Program or BTFP) which aims to help banks meet the needs of their depositors and help forestall any further bank liquidity problems.16 For the next 12 months, banks will be able to pledge their government bonds and agency mortgage-backed securities (regardless of the securities’ current market values) at the Federal Reserve and receive a loan back in return at the par-value amount of the securities.16 In other words, banks would not be forced to sell securities at depressed market values in times of stress, given the opportunity to borrow more than they are worth from the Fed. Banks also have access to additional liquidity sources such as the Federal Reserve’s discount window, as well as the Federal Home Loan Bank, where other types of collateral (besides treasuries and agency MBS) can be pledged.17

Outlook

While we do not foresee another bank failure impacting the portfolio at this time, we do believe bank profitability could face potential headwinds in the future. To retain customer deposits, banks may have to pay higher rates on deposits to prevent them from leaving and seeking higher returns. Banks may also reduce lending activity to hold more liquidity on hand just in case deposits were to decline. Moreover, should banks have to utilize additional sources of liquidity, they would have to pay interest on the borrowed funds to do so. Each of these factors could potentially reduce banks’ net interest margin, which is the difference between what banks earn on their assets vs. what they pay on their liabilities, and this could negatively affect their overall profitability.

Another area we are watching is the commercial real estate sector, specifically banks’ and life insurers’ loan exposure to office and retail properties. Higher interest rates and a shift to work-from-home trends that may permanently increase office vacancy levels could continue to pressure valuations of some commercial real estate. While this could have an impact on banks’ earnings or capital ratios in the future, for the US banks we own, we do not expect the impact to be material. In a stressed scenario that assumes a 21% default rate and 41% loss severity on office property loans and a 15% default rate and 42% loss severity on retail property loans, the annualized after-tax impact to banks’ capital ratios would be less than < 1%.18 For insurance companies, we believe the impact from deteriorating commercial real estate and CMBS fundamentals would also be manageable. Life Insurance companies’ commercial real estate loans are characterized by low LTV’s with long duration fixed rates and debt service coverage, on stabilized properties with very low overdue/default rates, and their CMBS exposure exists to highest rated CMBS tranches.18 In a draconian scenario that assumes office occupancy declines of 30% and default rates that reach 35%, investors in investment grade tranches of CMBS would generally be protected.18

We also continue to monitor the overall level of deposits in U.S. banks. Each week, the Federal Reserve releases reports which show the aggregate deposit levels for large and small/mid-sized banks have declined $411 billion since the first week of March.19 While this may seem like a large amount, it represents just ~2% of all U.S. banks’ deposits. Further, the largest banks may have been beneficiaries of the crisis because depositors believe they are too big to fail. The weekly Fed data shows a market share gain by the largest banks since the crisis even as total systemwide deposits have declined.19 In fact, Bloomberg reported that Bank of America collected $15 billion of deposits in the first week following the SVB and Signature failures.20 Additionally, the $30 billion rescue of First Republic by the private sector suggests the cohort of large depositor banks have more than sufficient liquidity.21 We hold many securities of this cohort whose credit may have improved in the last month.  Weekly regional Federal Reserve data also confirms that the abundance of short-term borrowings have been concentrated in the New York and San Francisco Federal Reserve Banks.22 To us, this indicates that the crisis has not spread far beyond those areas where Silvergate, Silicon Valley and Signature Banks are located.

In terms of the overall economy, we expect the Federal Reserve to rely on incoming data to determine appropriate monetary policy moving forward. On one hand, consumer spending is still growing at an annual rate in the high single digits23, the labor market is still strong22, corporate balance sheet fundamentals are solid24, supply chains are recovering and credit losses at banks are still very low, implying that the economy is still in good shape.25 On the other hand, we believe given the recent banking crisis, expectations for lending standards to tighten, and what appears to us to be a slew of recent weaker macroeconomic data that have missed expectations, the outlook for the economy and the Federal Reserve’s future actions may become more uncertain.

At present, we believe the portfolio is well positioned to withstand potential volatility from macro-economic uncertainties and any additional impacts from the crisis in the banking system. We will be scrutinizing first quarter earnings reports for uninsured deposit flows, the value of securities holdings, and any borrowings from emergency liquidity facilities. We will also be focused on the quality of CRE portfolios including delinquencies and credit reserves. We do not expect the banks we own to experience similar rapid deposit declines, and we believe the situation for any bank that needs quick access to liquidity has improved due to recent actions taken by the Federal Reserve in creating the BTFP. We continue to monitor the portfolio’s credit quality and interest rate sensitivity, as well as US banks’ deposit levels, exposure to commercial real estate and other metrics that could potentially impact any of our positions.

Sources

1 https://www.spglobal.com/marketintelligence/en/news-insights/blog/snapshot-the-ripple-effects-of-2023-bank-failures

2 https://ir.silvergate.com/news/news-details/2019/Silvergate-Announces-Closing-of-Initial-Public-Offering-of-Common-Stock/default.aspx

3 https://seekingalpha.com/article/4559549-silvergate-capital-depositors-at-the-gates

4 https://www.reuters.com/technology/silvergate-capitals-crypto-related-deposits-plunge-fourth-quarter-2023-01-05/

5 https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Intent-to-Wind-Down-Operations-and-Voluntarily-Liquidate-Silvergate-Bank/default.aspx

6 https://ir.silvergate.com/news/news-details/2023/Silvergate-Announces-Select-Preliminary-Fourth-Quarter-2022-Financial-Metrics-and-Provides-Business-Update/default.aspx

7 Q1-2023-Investor-Letter.FINAL-030823.pdf

8 Q1-2023-Mid-Quarter-Update-vFINAL3-030823 (1)

9 Credit Suisse, Burned By Archegos And Greensill Scandals, Shifts Focus To Wealth Management In Overhaul.pdf

10 Deutsche Bank shares slide after sudden spike in the cost of insuring against its default.pdf

11 Barclays: “State of the Industry Spring 2023” Slides

12 schwab_annual_report_2022.pdf

13 Calculations based on data from Schwab’s Consolidated Financial Statements as of 12/31/22

14   https://www.financialadvisoriq.com/c/3995094/511764/schwab_lose_bank_deposits_stay_open

15 Bloomberg USGG10YR Index.docx

16 Federal Reserve Board – Federal Reserve Board announces it will make available additional funding.pdf

17 https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/liquidity/pub-ch-liquidity-previous.pdf

18 JPM_Commercial_Real_Esta_2023-03-23_4367489.pdf

19 https://www.federalreserve.gov/releases/h8/current/h8.pdf (For the weeks ending March 08, 2023 – March 29, 2023)

20 https://nypost.com/2023/03/15/bank-of-america-gets-15b-in-new-deposits-after-svb-collapse/

21 https://www.cnn.com/2023/03/16/investing/first-republic-bank/index.html

 22 https://www.federalreserve.gov/releases/h41/current/default.htm

23 https://www.bls.gov/opub/ted/2022/consumer-prices-for-food-up-7-9-percent-for-year-ended-february-2022.htm

24 https://www.bls.gov/news.release/empsit.nr0.htm

25 Global Supply Chain Pressure Index_ March 2022 Update – Liberty Street Economics.pdf

As of March 31, 2023

 

March 2023 | Equity Commentary

March 2023 | Equity Commentary

Published on April 11th, 2023

March’s financial news cycle was dominated by the high-profile failures of Silicon Valley Bank and Signature Bank New York on March 10, spanning through to March 19 when UBS announced it was buying beleaguered Credit Suisse for $3.2 billion in a deal brokered by Swiss authorities.1 Apart from pronounced selling pressure across a handful of regional bank stocks, the equity markets were largely resilient to rising uncertainty over the health of the banking system. The S&P 500 and Nasdaq posted three consecutive weeks of gains beginning March 13, finishing the first quarter up +7.5% and +17.0%, respectively.2, Outperformance of growth and technology stocks may have been a wager that the banking crisis would hinder economic growth later in the year, thereby raising the chances of easier monetary policy sooner than previously expected. In the fixed income markets, US Treasury bonds across nearly all durations rallied for the month, with the 10-year bond yield declining from 3.92% to 3.47%.3 The 2-year Treasury pulled back in the months’ final days to finish above 4%, which further widened the yield curve inversion.4

Historically, bank failures tend to be driven by credit risk, but Silicon Valley Bank (SVB) and Signature Bank New York (SBNY) were unique cases where large bases of undiversified, uninsured deposit liabilities were mismatched with fixed rate securities that had fallen in value as interest rates rose – eroding the banks’ capital. SVB and SBNY ran into major problems in 2022 when the venture capital/startup world saw funding evaporate and the cryptocurrency industry suffered major setbacks. This led many early-stage companies (clients of SVB) and crypto firms (clients of SBNY) to draw down cash reserves to continue funding operations, which eventually spiraled into a run-on deposits once the banks’ balance sheet problems were exposed.5

Credit Suisse’s forced sale a week later made it seem like a global bank contagion could be underway, but the Swiss lender had already been troubled for months if not years. The bank arguably collapsed under the weight of unstable management, investment banking losses, and a string of bad bets—including its partnership with now-bankrupt Greensill Capital and a $5 billion loss from the collapse of Archegos Capital Management. Last October, rumors of the banks’ problems on social media led to a major outflow of wealthy clients. In 2022, deposits fell more than 40%, and assets plummeted by 30%.6

In response to the SVB and SBNY failures, the Federal Reserve, U.S. Treasury, and Federal Deposit Insurance Corp. issued a joint statement declaring SVB and SBNY “systemic risks,” which opened the door for making all SVB and SBNY depositors whole—including those with deposits over the FDIC-insured $250,000 limit. The Fed also created a special emergency facility called the Bank Term Funding Program, which allowed banks to use debt securities like long duration US Treasuries as collateral for cash loans for up to a year—giving banks access to liquidity without having to sell securities at a loss.7

By the end of the month, news of a possible banking crisis had largely faded. In our view, tier 1 capital ratios and loan-to-deposit ratios suggest the US banking is very well-capitalized, and we would note that nearly all large banks have the ability to meet withdrawal requests without selling illiquid assets or fixed income assets at losses.8 In fact, many large banks actually benefitted from deposit flows in the weeks following the failures, as clients pulled cash from several regional banks.9 We think the relative stability of the broad US stock market last month underscores the underlying strength of the banking system.

From an economic standpoint, banks outside of the largest 25 account for 40% of all loan activity, and small banks in particular are responsible for 67% of all commercial real estate lending.10 The economic impact—including the possibility of recession—could hinge on changes to loan activity in the coming months. In a statement, Federal Reserve Chairman Jerome Powell acknowledged this possibility: “Events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes. It is too soon to determine the extent of these effects, and therefore too soon to tell how monetary policy should respond.“11

Perhaps in recognition of potentially adverse economic impact—as well as the possibility that higher rates could create more losses on bank balance sheets—the central bank limited its rate increase to only 25 basis points at the March 22 meeting. The Fed also released projections for the benchmark fed funds rate to settle around 5.1% by the end of the year, implying one more quarter-point increase this year.12 Prior to the bank failures, we believe the Fed planned to forecast a higher year end rate at this meeting, and it was at least considering an acceleration in the pace of rate increases to 50 basis points.

Data suggests the US economy is moving in the direction the Fed wants, though probably not at the desired pace. Households increased spending by a seasonally adjusted 0.2% month-over-month in February, following a 2% month-over-month increase in January. Looking a bit more closely,13 the Commerce Department reported that spending at stores, online, and in restaurants dropped by 0.4% in February, signaling that consumers were pulling back even before the banking issues emerged.14 Job openings also fell in February, to 9.9 million from January’s 10.6 million. While this is down from the peak of 12 million job openings reached in March 2022, it still marks a sizable gap from the 5.9 million unemployed Americans seeking work.15

The Fed’s preferred core personal consumption-expenditures (PCE) price index rose 4.6% year-over-year in February, down from 4.7% in January. The producer price index also fell 0.1% in February from the prior month, a meaningful signal that price pressures are abating.16 Finally, the Fed also reported that M2 money supply declined by $130 billion in February and -2.4% year-over-year. This marks the fastest rate of decline in M2 since the 1930s, but it’s also true that it follows the historic surge of money supply in the wake of the pandemic. Even still, the sharp decline in M2 should eventually have an anchoring effect on inflation. That may help firm the case for the Fed to conclude its tightening campaign in fairly short order, which could be an important silver lining for investors following the spate of bank failures that brought new risks to the fore in recent weeks.17   

Sources

1.https://www.ubs.com/global/en/media/display-page-ndp/en-20230319-tree.html

2.Bloomberg: SPX Index and Nasdaq 1Q Performance

3.Bloomberg: USGG10YR Feb Mar Monthly Yield

4.https://home.treasury.gov/resource-center/data-chart-center/interest rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2023

5.https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/cwm/en/insights/eye-on-the-market/silicon-valley-bank-failure-jpmwm.pdf

6.https://www.wsj.com/articles/ubs-offers-1-billion-to-take-over-credit-suisse-bfac51fa?mod=djemRTE_h

7.https://www.wsj.com/articles/are-taxpayers-on-the-hook-for-svb-and-signature-bank-deposits-f9d22cf5?mod=hp_theme_svb-ribbon

8.https://www.fisherinvestments.com/en-us/insights/market-commentary/putting-the-regional-bank-scare-into-perspective

9.https://www.fisherinvestments.com/en-us/insights/market-commentary/the-early-deposit-and-loan-data-postsilicon-valley-bank-are-in

10.https://www.wsj.com/articles/banking-turmoil-tests-the-american-consumer-377d4c1b

11.https://www.wsj.com/articles/transcript-fed-chief-powells-postmeeting-press-conference-1b9b2bd1

12.https://www.wsj.com/articles/fed-raises-rates-but-nods-to-greater-uncertainty-after-banking-stress-6ae9316f

13.https://www.wsj.com/articles/consumer-spending-personal-income-inflation-february-2023-526279fe?mod=economy_lead_story

14.https://www.wsj.com/articles/us-economy-retail-sales-february-2023-6b98a40b?mod=djemRTE_h

15.https://www.wsj.com/articles/u-s-job-openings-dropped-in-february-d797e86b?mod=economy_lead_story

16.https://www.wsj.com/articles/us-economy-retail-sales-february-2023-6b98a40b?mod=djemRTE_h

17.https://www.reuters.com/markets/funds/us-money-supply-falling-fastest-rate-since-1930s-2023-03-29/

As of March 31, 2023

 

March Madness: Part Two – Bracket Busters

March Madness: Part Two – Bracket Busters

Published on March, 21st, 2023

After a tumultuous week that saw a California-based crypto-focused bank (Silvergate Bank) wind down its operations1 as well as the seizure by U.S. regulators of two other banks (Silicon Valley Bank2 and Signature Bank3), the following week many college basketball fans gathered to watch their teams play in the NCAA tournament.  At the same time that many fans saw their brackets implode as a result of surprise losses, investors in the banking sector experienced their own shock and disbelief as bank shares generally continued to decline.4  Concerns of both depositors and investors appear to remain elevated despite actions by the Treasury that it had hoped would stabilize the situation.5

At present, we believe bank investors may be asking the following questions:

  • Will there be more bank runs necessitating government intervention or seizure?
  • Could Credit Suisse – or another “too big to fail” institution – be among them?6
  • Will banks somehow be forced to realize heretofore unrealized losses on bank balance sheets that will materially impair their shareholders equity?7
  • Might many bank depositors grow so concerned that they shift their deposits to the largest banks?8
  • Will the Federal Reserve continue to hike interest rates despite recent turmoil in the banking sector?9
  • Do the recent bank seizures mean that smaller banks are going to see much more stringent regulations that will crimp their margins and ability to lend?10
  • Is this episode going to cause a pullback in lending by smaller banks, slowing the U.S. economy enough to cause a recession?11

At this point we cannot know if there will be additional bank failures.  We are monitoring a number of items to help us assess the situation.  Each week, the Fed shares information on its balance sheet, including bank borrowings at the Fed’s discount window, as well as usage of the new Bank Term Funding

Program the Fed created on March 12 to help provide funds to any banks needing them.12  Once things calm down, we would not expect to see much activity here.  We are also monitoring changes in the spread between the overnight lending rate set by central banks and the three-month interbank lending rate; this spread changes from minute to minute and over the past week it has been quite elevated.13  We believe its current level prices in a significant amount of fear and risk aversion; if this spread were to fall considerably, we would take it as a sign that concerns have eased. 

Moreover, in our view, bank stock prices can be a signal in themselves.  George Soros coined the term “reflexivity” to indicate the strange concept which is the opposite of what we believe to be true most of the time – that corporate fundamentals drive the price of a security.14  With reflexivity, a security’s price can drive fundamentals15 – in this case, a rapidly falling bank stock price might induce fear in depositors, adding to their concerns and convincing them that withdrawing their money and placing it in another bank is the right course of action.  This can become a vicious cycle, we believe, as more withdrawals may lead to a lower stock price, and so on.  Additional policy and/or funding announcements from the Federal Reserve may also act to change investor sentiment regarding the possibility of further bank problems. 

Our team has been delving into these issues ever since the FDIC seized control of Silicon Valley Bank.16  While the situation is still developing, it appears that over the weekend of March 18th the Swiss government is encouraging UBS to take over all or parts of Credit Suisse (CS)17, which in our view may forestall further problems that might otherwise develop if CS was left to sink on its own.  It seems unlikely to us that CS would be allowed to fail, given that it is a global systemically important bank18 and we believe the Swiss central bank has the means and the will to save it.  If this transaction is agreed to, one significant ‘problem child’ of the last two weeks would be removed from the list of investor concerns, in our view.

We believe U.S. banking analysts over the past ten days have been laser focused on several metrics to assess the likelihood of additional problems arising in the banking system.  In our view these may include the average deposit size at a bank and whether it is above the FDIC’s $250,000 insured amount, and relatedly, the percentage of a bank’s deposits which exceed that amount, the “uninsured” deposits.19  With this information, analysts may seek to assess a given bank’s risk of having larger depositors potentially move their funds elsewhere due to concerns about being over the insured level. 

We believe analysts are also scrutinizing bank balance sheets to determine if their bond portfolios have experienced losses, and if so, how large those losses might be relative to shareholder equity.20  Current accounting rules permit banks to hold bonds that have unrealized losses without negatively impacting equity, as long as those bonds are designated as “held to maturity.”21  By focusing on this measure, analysts may hope to determine the risk that if a bank is forced to sell bonds in order to meet depositor withdrawals, that it might have to realize these losses, and what the impact upon the bank’s equity might be.22  If equity is wiped out by realized losses from selling bonds, a bank may become insolvent. We believe this was the situation that management of Silicon Valley Bank found themselves in when depositors rushed to withdraw huge amounts of deposits from the bank in a very short period.23

It’s difficult to know in the aggregate how bank depositors have been reacting to recent events.  Banks are not required to report deposit levels daily, so over the course of the last week it is impossible to know – unless a particular bank decides to make a public disclosure24 – whether that bank is seeing depositors take funds out, move funds in, or leave them be.  It seems likely to us that the largest banks have been seeing inflows, given that they are considered too big to fail.  In our view, the recent announcement by a group of the largest U.S. banks to shift $30 billion of their deposits to First Republic would seem to indicate that those banks may have experienced significant deposit inflows, and therefore were comfortable participating in efforts to help a peer recover from what may have been material deposit outflows.25 

We are concerned that smaller banks may see higher costs of funding, increased regulation, and potentially changes in how ratings agencies assess their level of credit risk.26  Collectively these changes could cause headwinds for the U.S. economy, since smaller banks have been more significant engines for loan growth than larger banks.27  As credit becomes more difficult to access at smaller banks, borrowers may seek loans from larger banks.  However, lending is a relationship business, and larger banks generally will not have the same relationships with these borrowers that their smaller bank lending officers did.  We believe this is likely to result, in the aggregate, in a decline in the extension of credit.28 Offsetting this pressure to some degree, a lot of loans made in the U.S. economy come from non-bank institutions, such as insurance companies, private equity firms, and other alternative asset management firms.29  In addition, we believe mortgage lending is less likely to be impacted by this particular issue, given the government’s involvement in purchasing conforming mortgages and packaging them into mortgage backed securities.30

Could a decline in credit extended by smaller banks tip the economy into recession?  Many investors have been concerned about the possibility of a recession since the middle of 2022 when yield curves began to invert.31 We believe the recent bank failures increase the odds of recession. One offset is that the Fed is now more likely to be less aggressive with future interest rate hikes, and in fact the futures market is telling us at this time that investors now expect the Fed to cut rates as soon as June32.  Some of the prior rate hiking cycles saw the Fed hike into a serious problem or crisis, and as a result the Fed paused and sometimes reversed, and this succession of events did not result in a recession for many years into the future.33 

Martin Zweig, the respected investor and market forecaster, coined the phrase “Don’t Fight the Fed” in 197034, explaining his view that Federal Reserve policy can drive the market’s direction.  If we are indeed approaching a point where the Fed will be cutting interest rates to offset a recession or period of slower growth, then we may also be approaching a point where investors might feel more comfortable about investing in the stock market.

Source

1https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Intent-to-Wind-Down-Operations-and-Voluntarily-Liquidate-Silvergate-Bank/default.aspx

2https://www.fdic.gov/news/press-releases/2023/pr23016.html

3https://www.fdic.gov/news/press-releases/2023/pr23018.html

4Bloomberg. S&P 500 Banks declined 11.2% over the 5 days ended March 17, 2023. See Figure 1.

5https://home.treasury.gov/news/press-releases/jy1337

6https://www.snb.ch/en/mmr/reference/pre_20230315/source/pre_20230315.en.pdf

7https://www.fdic.gov/news/speeches/2023/spmar0623.html The total amount of unrealized losses on bank balance sheets was $620 billion as of December 31, 2022.

8https://www.bloomberg.com/news/articles/2023-03-15/bofa-gets-more-than-15-billion-in-deposits-after-svb-failure

9https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html As of March 17, Fed Funds futures markets are pricing in a 62% chance of an interest rate increase at the Fed’s next meeting on March 22, 2023. See Figure 2.

10https://www.nytimes.com/2023/03/15/business/economy/silicon-valley-bank-federal-reserve-regulation.html

11https://www.nytimes.com/2023/03/17/business/economy/economy-banks-recession.html

12https://www.federalreserve.gov/releases/h41/20230316/ Federal Reserve Statistical Release H.4.1 showed that, as of March 15, 2023, there were $12 billion of BFTP loans and $153 billion of discount window loans on its balance sheet. There were also $143 billion of other credit extensions to banks in FDIC receivership.

13Bloomberg. The Forward Rate Agreement-Overnight Index Swap spread was 0.47% on March 17, up from 0.03% on March 8. Its five-year average is 0.22%. See Figure 4.

14“The Alchemy of Finance” by George Soros. pp. 2-3. “The Concept of Reflexivity.” Wiley. 1987.

15“The Alchemy of Finance” by George Soros. pp. 2-3. “The Concept of Reflexivity.” Wiley. 1987.

16https://www.fdic.gov/news/press-releases/2023/pr23016.html

17https://www.wsj.com/articles/ubs-in-talks-to-take-over-credit-suisse-ed932b01

18https://www.fsb.org/2022/11/2022-list-of-global-systemically-important-banks-g-sibs/

19https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/svb-signature-racked-up-some-high-rates-of-uninsured-deposits-74747639

20https://www.ft.com/content/dff4e577-9282-450c-9ae4-58d6572123e5

21https://www.wsj.com/livecoverage/stock-market-news-today-01-05-2023/card/when-held-to-maturity-isn-t-and-why-that-matters-to-silvergate-M3iuQ83zpMGeZLYKQnRv

22https://www.ft.com/content/dff4e577-9282-450c-9ae4-58d6572123e5

23https://www.wsj.com/articles/bank-collapse-crisis-timeline-724f6458

24https://www.bloomberg.com/news/articles/2023-03-15/bofa-gets-more-than-15-billion-in-deposits-after-svb-failure

25https://ir.firstrepublic.com/static-files/18c04dea-0d44-43ed-b420-b066d56e1f54

26https://www.nytimes.com/2023/03/15/business/economy/silicon-valley-bank-federal-reserve-regulation.html

27https://www.goldmansachs.com/insights/pages/stress-among-small-banks-is-likely-to-slow-the-us-economy.html

28https://www.goldmansachs.com/insights/pages/stress-among-small-banks-is-likely-to-slow-the-us-economy.html

29https://www.federalreserve.gov/newsevents/speech/barr20221201a.htm Nonbank financial intermediaries, broadly defined, fund nearly 60% of the credit to the U.S. economy.

30https://www.fhfa.gov/about-fannie-mae-freddie-mac

31https://www.barrons.com/articles/yield-curve-inversion-bonds-a483aaed

32Bloomberg – see Figure 3 below

33Evercore ISI. Weekly Economic Report. March 12, 2023. See Figure 5.

34https://requisitecm.com/pdf/dont-fight-the-fed.pdf

Figure 1 

Source 4    

Figure 2

Source 9

Figure 3

Source 32

Figure 4

Source 13

Figure 5

Source 33

As of March 21, 2023

 

February 2023 | Equity Commentary

February 2023 | Equity Commentary

Published on March, 16th, 2023

The ‘economic good news is bad news’ trade was on in February, with the S&P 500 falling 2.5% for the month. The 10-year US Treasury bond yield rose from 3.5% to 3.9%, essentially reversing January’s move.1 During the month, we believe inflation readings appeared hotter than financial markets may have expected, and the economy showed few signs of weakening substantially.  This occurred in the backdrop of the Fed having slowed the pace of rate hikes from four consecutive 75bp hikes in June, July, September, and November, to 50bps in December and 25bps in early February.2 In testimony before the Senate Banking Committee on March 7, Chairman Jerome Powell said “if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes,” noting that recent data appeared to mark a reversal in the prior trend of cooling inflation. Interest rates futures markets continue to bid up expectations for the benchmark fed funds rate in 2023. At the last Fed meeting, market expectations were for peak fed funds of 4.9% in May, falling thereafter to a year-end level of 4.3%. By March 6, investors were forecasting a peak rate of 5.5% in September, declining only modestly by year end to 5.4%.3

Inflation data released in February did not offer much encouragement to the Federal Reserve, in our opinion. The Fed’s preferred measure of inflation – the Personal Consumption Expenditures (PCE) price index – increased by 5.4% year-over-year in January, which was slightly worse than December’s 5.3% print.4 The Consumer Price Index (CPI) and the Producer Price Index (PPI) continued to show improvements year-over-year, but the pace of deceleration slowed – a point we believe is not lost on market watchers and the Fed. 

The Labor Department reported a 6.4% year-over-year CPI increase in January, which marked only a very modest improvement from December’s 6.5% rate of increase. More worrisome to us was the month-over-month change in CPI, which at 0.5% from December to January was a significant move higher than the previous month’s 0.1% increase. Core prices, which exclude energy and food, were up 5.6% year-over-year, again only a slight improvement from December’s 5.7% year-over-year increase.5 Much like January’s CPI report, the January’s PPI improved year-over-year compared to December, but the 0.7% month-over-month from December to January was a sharp reversal from December’s -0.2% decline from November.6

We believe the divergence between goods and services continues to be the key sticking point in today’s inflation story. Core goods prices have stabilized while shelter costs (a key component of services) rose at their fastest annual pace since 1982.7This inflationary pressure is a byproduct of continued strength in the labor market, coupled with consumers increasingly shifting their spending from goods to services. Consumers spent more in restaurants, bars, and hospitality in January, helping drive a 3% increase in retail sales from December to January – the biggest monthly jump in almost two years.8

Energy’s contribution to inflationary pressures also remains high on our watchlist, particularly as the war in Ukraine continues. In response to Western oil sanctions, Russia announced it would cut oil production by 5% in March.9 In our view, this move should not impact global oil prices very much, but it does appear to signal Russia’s willingness to potentially disrupt global energy markets.

Regarding the outlook for services inflation, the US labor market continues to look largely unresponsive to Fed rate hikes, in our opinion. Nonfarm unemployment jumped by 517,000 in January, which blew past consensus expectations for a roughly 200,000 increase10. Initial jobless claims – a proxy for layoffs – were also seen ticking slightly lower in the last week of February, which suggests to us, that employers continue to desperately cling to workers. First-time applications for unemployment benefits fell to 183,000, the lowest reported level since April 2022, and unemployment rate fell to 3.4%, a 53-year low.11 One bright spot for the inflation picture is that average hourly earnings rose 4.4% year-over-year in January, which marked the smallest increase since August 2021.12

Economic data in services and manufacturing remains mixed, in our view. In February, S&P Global’s index of services businesses rose to 52.1 pushing it back into expansion territory and marking the strongest reading in eight months. U.S. companies that participate in the surveys reported their first growth in output since last summer and indicated optimism about activity in the months ahead.13 

S&P Global’s February manufacturing index reading rose to 47.3 from 46. in January. While still contractionary, the improvement suggests that activity is contracting at a slower pace, and manufacturers indicated that softer demand has allowed them to work through the backlogs that remain a legacy of the pandemic ISM’s survey also showed contraction.14 Businesses said they were slowing output in anticipation of weak demand in the first half of 2023, but that expectations were in place for a growth pickup in the second half. A key data point, in our view, from the survey was that the index for input prices moved above 50 for the first time since September, a cautionary sign that price pressures could be creeping higher again.15

Sources

1Bloomberg. SPX 500 Index DES. USGG10YR GP Function

2United States Fed Funds Rate – 2023 Data – 1791-2022 Historical – 2024 Forecast

3Bloomberg: Implied Overnight Rate & Number of Hikes/Cuts 12/14/22 and 3/6/23

4Personal Income and Outlays, January 2023 _ U.S. Bureau of Economic Analysis (BEA).pdf

5https://www.bls.gov/cpi/

6Producer Price Index News Release summary – 2023 M01 Results.pdf

7https://www.nbcnews.com/business/economy/inflation-rate-january-2023-what-it-means-will-interest-rates-go-up-rcna70401

8U.S. retail sales roar back; manufacturing shows improvement _ Reuters.pdf

9Russia to cut oil output by 500,000 bpd in March _ Reuters.pdf

10https://www.cnbc.com/2023/02/03/jobs-report-january-2023-.html

11https://www.wsj.com/articles/january-jobs-report-unemployment-rate-economy-growth-2023-11675374490

12https://tradingeconomics.com/united-states/average-hourly-earnings-yoy#:~:text=2%2DYear%20Low-,Average%20hourly%20earnings%20for%20all%20employees%20on%20US%20private%20nonfarm,earnings%20since%20August%20of%202021

13Global economic growth accelerates to eight-month high in February _ S&P Global.pdf

14https://www.pmi.spglobal.com/Public/Home/PressRelease/f982d001dbbe4b4daec4f54d2260874e

15February 2023 Manufacturing ISM® Report On Business®.pdf

As of March 16, 2023

 

March Madness

March Madness

Published on March, 13th, 2023

A series of events last week culminated in the United States Treasury announcing over the weekend that it would take steps to stabilize the banking industry.  These actions included providing access to all depositor funds at two banks which were shut down by regulators, as well as a new funding vehicle to guarantee that all banks have access to liquid funds should the need arise in order to meet withdrawal requests by customers.  The pace at which these events have unfolded is concerning, but we believe these actions by the Treasury should stabilize the banking system and prevent further panic by bank customers.  However, there may be some additional issues which arise in the industry as the full implications of this episode become clearer in the coming days and weeks.

Last week, on March 8th, the holding company for Silvergate Bank announced that Silvergate would close down and liquidate its operations.  Silvergate was a California-based bank unknown to most Americans that went public in late 2019.1  The bank described itself as the leading provider of innovative financial infrastructure solutions and services to participants in the nascent and expanding digital currency industry.2  Silvergate also built and operated a 24 x 7 currency exchange where cryptocurrency traders could buy and sell digital currency instantaneously.3  As a result, a large proportion of the bank’s depositors were cryptocurrency traders.4

The downfall of Silvergate may have been catalyzed in part by the November 11 collapse and bankruptcy of the FTX cryptocurrency exchange, the details of which are still being analyzed and uncovered.  As a result of the FTX bankruptcy, cryptocurrency investors may have grown more cautious about the creditworthiness of the various entities operating in the crypto world.1 We believe that as Silvergate’s depositors began to withdraw more and more of their funds, this eventually began to put pressure on the bank’s balance sheet.  (This is referred to as a “run” on the bank.)

In a simple model of a bank’s balance sheet, the bank takes in deposits from customers and uses those deposits to make loans as well as to invest in safe fixed income securities, usually government bonds.   Typically, these bonds are divided into two categories, one of which is very short term and used for funding customer withdrawals, while the other can be thought of as longer term that might be held to maturity.5 

If more withdrawals are requested of the bank than can be funded by the short-term category, the bank must then start to sell bonds from the long-term category.  If those long-term bonds are priced at a loss because interest rates have increased, the bank must realize that loss by selling in order to provide funds back to the customers who are withdrawing their cash.  However, if these realized losses are large enough relative to the net worth of the bank, the bank may end up in trouble.5  On March 8th, this situation appears to have developed at Silvergate Bank.

The very next day (Thursday), Silicon Valley Bank, whose parent is bank holding company SVB Financial Group, also suffered a run by depositors, and its stock price fell by 60%.6  That bank’s shares never reopened for trading on Friday and it was seized by the FDIC.6 SVB was a somewhat unique bank in that its deposits were largely from start-up companies, many of which had not yet done an IPO.7  SVB was also far larger than Silvergate, with total assets at year end of $212 billion compared to Silvergate’s $11 billion.  According to company SEC filings, of SVB’s year-end deposits of $173 billion, just $74 billion were used to fund loans, while the remainder were largely invested in government bonds. 

Just as was the case with Silvergate, SVB’s depositors apparently began to worry about the health of the bank, and many rushed to withdraw their funds.  Ultimately SVB was in a situation where it began to realize losses on its bond portfolio which exceeded the bank’s equity,6 which seems to be why it was seized by the FDIC on Friday March 10.  Another bank said to have exposure to crytpocurrency, Signature Bank, was closed down on Sunday by New York state regulators.  Signature Bank had year-end total assets of $110 billion.

The unusual aspect as we see it to the seizures of SVB and Signature Bank is that both banks are apparently not facing problems with bad credit or delinquencies.  Rather, they seemingly faced issues of liquidity and access to capital to shore up their balance sheets in the short term.  We think that is what makes this episode so different, say, than the 2008 financial crisis where there were bad loans that ultimately destroyed the equity capital of many banks in the U.S.8  What we saw last week was not a credit problem. We believe that, in general, bank assets are creditworthy, and banks are well capitalized. Many rules promulgated since the 2008 financial crisis have required this, and the Fed conducts annual stress tests on the largest U.S. banks to ensure it.9 In our view, those tests were very tough in recent years, and all large U.S. banks passed them.

We believe that the bank seizures, as well as the winding down of Silvergate, can be at least in part tied to the Federal Reserve’s interest rate hikes which began in March 2022 as part of the Fed’s efforts to fight inflation, as well as the reversal of its quantitative easing program, called quantitative tightening.  In past rate hiking cycles, we have often seen that “something breaks” and the Fed has to stop. Examples that we think about include Long-Term Capital Management (1998) and Continental Illinois (1984).

On Sunday March 12, the United States Treasury announced that all depositors of SVB and Signature would be able to access all their funds on Monday. This includes all deposits, even those exceeding the FDIC insured limit of $250,000 per depositor. The Federal Reserve also announced a new Bank Term Funding Program that will lend against Treasury and agency securities at par for up to one year, providing another resource for banks to meet depositor requests for funds should the need arise, in addition to the discount window. For now, we believe these actions are likely to limit further contagion and fears about the health of the U.S. banking industry. That said, it is possible that other factors like rising deposit costs that result from this episode could continue to weigh on at least some banks going forward.

 

Source

1https://en.wikipedia.org/wiki/Silvergate_Bank

2https://www.silvergate.com/about-us

3https://www.reuters.com/technology/crypto-focused-bank-silvergate-plans-wind-down-operations-2023-03-08/

4https://www.forbes.com/sites/digital-assets/2023/03/02/crypto-bank-silvergate-sees-client-exodus-as-delayed-annual-report-puts-future-in-question/?sh=ceaf9175a197

5https://www.imf.org/external/pubs/ft/fandd/2012/03/basics.htm#:~:text=Although%20banks%20do%20many%20things,whom%20the%20bank%20lends%20money).

6https://www.wsj.com/articles/silicon-valley-bank-svb-financial-what-is-happening-299e9b65

7https://s201.q4cdn.com/589201576/files/doc_financials/2022/q4/Q4_2022_IR_Presentation_vFINAL.pdf

8https://www.fdic.gov/bank/historical/crisis/overview.pdf

9https://www.federalreserve.gov/publications/comprehensive-capital-analysis-and-review-questions-and-anwers.htm

As of March 13, 2023

 

January 2023 | Equity Commentary

January 2023 | Equity Commentary

Published on February 15th, 2023

Market Overview

Stocks and bonds rallied to start the new year, as economic data and inflation continued to trend lower and paved the way for the Federal Reserve to scale down the size of fed funds rate increases. The US jobs market, however, continues to be an asterisk on expectations for further rate increases, as payrolls surprised to the upside in December. We believe too little slack in the labor market has been the proverbial thorn in Fed Chairman Jerome Powell’s side, which led him to reiterate after January’s meeting that inflation will not return to 2% until there is “better balance in the labor market.”1 Stocks declined following the jobs report, but still posted strong returns for the month with the S&P 500 rising 6.3% and the Nasdaq up +10.7%.2 The additional boost for tech stocks may have resulted from investors re-entering positions sold late last year for tax loss harvesting purposes. Bond prices also rose sharply in the month, with the yield on the 10-year US Treasury bond falling from 3.87% at the end of last year to 3.51% by the end of January.3

As we expected, the Federal Reserve raised its benchmark fed funds rate by 25 basis points at the January meeting, to a range of 4.5% – 4.75%.4 The week before the announcement, the Bureau of Economic Analysis reported that the Fed’s preferred inflation gauge – the personal-consumption expenditures (PCE) price index – increased by 5% year-over-year in December, a solid improvement from November’s 5.5% print and also the lightest inflation reading since September 2021. The Core PCE-price index, which measures inflation minus food and energy, rose 4.4%.5

In the Fed’s view, encouraging inflation trends are neutralized by strength in the labor market. In January, employers added 517,000 new jobs, essentially double what most economists had forecast. The four-week moving average of initial jobless claims—which is generally a useful leading indicator for economic weakness—fell to 189,000.6 For context, when the jobs market was considered strong in 2019, claims averaged about 220,000 each month. Job openings also rose to 11 million at the end of last year, which brought the ratio of unemployed workers to job openings back above 2:1.6

Chairman Powell holds the view that unemployment and inflation have an inverse relationship, which is the economic theory known as the Phillips Curve. While his ongoing hawkishness appears to be rooted in this theory, a bright spot for markets is that employment costs and private-sector wage growth have actually come down over the past few months, even as the labor market remains strong and the unemployment rate has fallen.7 For Q4, the Labor Department reported that employers spent 1% more on wages and benefits than they did in Q3, which was an improvement from the previous quarter’s 1.2% pace. On an annualized basis, wages and benefits grew by 4% in the fourth quarter, which is a marked improvement from the peak 5.8% pace set earlier in 2022. 4% wage growth is not compatible with the Fed’s 2% average inflation target, but it’s accurate to say that wage pressures overall have been getting better, not worse.8

The US economy grew by 2.9% (annualized) in the fourth quarter, according to an advanced estimate from the Bureau of Economic Analysis.9 While 2.9% is a relatively strong pace of growth, underlying drivers indicate the economy may be weaker than the headline number suggests. In manufacturing, the December PMI fell by 0.6% from November and remained in contractionary territory (48.4%). Industrial production also fell by 0.7% month-over-month in December, and manufacturing output declined by 1.3% with weakness reported across the sector.10

The US consumer also pulled back on spending in December. For the month, spending on services like rent, utilities, and dining out was flat, but when adjusted for inflation marked the weakest reading in 11 months. Goods spending as measured by retail sales also appears to be turning over, as consumers are confronting shorter runways with pandemic-era savings. According to data released by the Commerce Department, retail sales fell by -1.1% from November to December.11

Overseas, Europe’s economy appears to us to be performing better than most expected. We believe that one key reason for the resilience was the energy crisis that never came to fruition, thanks to a mild winter, energy-conservation efforts, and a shift in sourcing for natural gas. S&P Global’s composite purchasing managers index, which measures activity in services and manufacturing, showed Europe moving from contraction territory (49.3) in December to expansion (50.2) in January. Germany, Europe’s largest and most vital economy, showed strong signs of stabilizing, which prompted the German Economy Ministry to forecast 0.2% growth in 2023.12

China’s economy has seemingly benefited from the end of zero-Covid. In January, China’s nonmanufacturing PMI, which measures key services and manufacturing activity, crossed above 50 (signaling expansion) for the first time since last September – a drastic improvement from December’s 39.4 reading. Manufacturing activity rose above 50 for the first time since August, a marked improvement from December’s 47.0 reading. Consumers also showed strong signs of getting back out and spending, despite a surge of infections. Box-office revenues were the highest on record for a Lunar New Year holiday, and train travel surged back to 83% of 2019 levels.13

Tension between the US and China continues, with the latest episode of the spy balloon drawing ire from US officials. In our view, President Biden and President Xi appear to be intent on managing risk in the short-term, particularly as China focuses on an economic recovery in 2023. Incidents like this one strain bilateral relations, but should not escalate to the point of impacting markets or either country’s economic trajectory. As both countries harden their stance toward the other, trade continues to rise between the two: US imports from China increased by 6.3% year-over-year in 2022, while exports rose by 1.6% year-over-year. Despite tariffs and aired grievances, total trade between the two countries reached a record $690.6 billion in 2022.14

Source

1https://www.pbs.org/newshour/economy/powell-predicts-significant-inflation-drop-but-job-market-strength-means-more-rate-hikes

2Bloomberg: SPX Index, CCMP Index January Returns

3Bloomberg: USGG10YR Index Returns

4https://www.federalreserve.gov/newsevents/pressreleases/monetary20230201a.htm

5https://www.bea.gov/news/2023/personal-income-and-outlays-december-2022

6https://www.bea.gov/news/2023/personal-income-and-outlays-december-2022

7https://www.wsj.com/articles/beneath-the-surface-fed-sees-no-letup-in-inflation-pressure-11675293510

8https://www.wsj.com/articles/us-inflation-wages-employment-cost-index-q4-2022-11675120226?mod=article_inline

9https://www.bea.gov/data/gdp/gross-domestic-product

10https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/pmi/december/

11https://www.wsj.com/articles/us-economy-retail-sales-december-2022-11673990047

12https://www.nytimes.com/2023/01/31/business/europe-inflation-economy.html

13https://www.bloomberg.com/news/articles/2023-02-01/china-s-economic-recovery-still-patchy-despite-brighter-outlook

14https://www.wsj.com/articles/u-s-china-tensions-are-high-so-is-commerce-between-the-nations-11675920444

As of January 31st, 2023

2023 Outlook | Quarterly Conference Call

2023 Outlook: The Recession That Everyone Saw Coming

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December 2022 | Fixed Income Commentary

December 2022 | Fixed Income Commentary

Published on January 27th, 2023

Market Overview

After government bond yields increased substantially during the first nine months of the year1 , fixed income markets experienced a reprieve in the fourth quarter as two-year and ten-year US treasury yields increased by a modest 15 bps and 4 bps 2, respectively. The Current Income Portfolio’s fourth quarter total return was 1.2% gross, and 0.8% net, for an overall decline of -7.7% gross, and -8.2% net, during the 2022 year.

At the start of the quarter, inflation readings came in higher and more broad-based than financial markets expected indicating to us that the Federal Reserve would likely need to take an even more restrictive monetary policy stance to fight inflation.3  However, as the quarter progressed, financial markets apparently welcomed a reduction in the monthly pace of increases in the Consumer Price Index in October and November that signaled inflationary pressures could be easing.3 Taken together with recent softening in some macroeconomic data, this suggested to us that the pace of the FOMC’s interest rate hikes could slow in the months to come. In fact, by the end of the fourth quarter, Fed Funds Futures markets were already pricing in a Federal Reserve “pivot” (a shift in monetary policy action) that reflected expectations for the Fed Funds Rate to peak at 5% in July of 2023, followed by roughly 50 bps of interest rate cuts in the second half of the year.4

Although financial markets appear to have priced in expectations for monetary policy 4 cuts to begin in the second half of 2023, the Federal Reserve has reiterated its plan to maintain a restrictive policy stance5throughout the entirety of 2023. In the Federal Reserve’s Summary of Economic Projections (SEP) released in December 2022, not only did the committee revise expectations for inflation in 2023 upward from their September 2022 SEP release (f), but Fed Chair Powell also stated that “it will take substantially more evidence to give confidence that inflation is on a sustained downward path”.5 Additionally, according to the December FOMC meeting minutes, not one member of the Federal Reserve expects to cut policy rates in 2023.6 Over the course of the year, we think this will get resolved in one of two ways. Either the market will push out the time to first rate cut to 2024; or the Fed will begin forecasting a cut in 2023. The key determinant as we see it is likely to be whether wage growth, which is a driver of services inflation, is stickier than expected by the market. Goods inflation has already improved, and shelter inflation is beginning to moderate as well. Presently we believe the Fed has an incentive to insist that policy will remain restrictive, because any plans to be dovish in the future might spark an easing of financial conditions, possibly imperiling its war on inflation.

Source: Bloomberg

At the start of the fourth quarter, Fed Funds Futures markets projected the policy rate to peak at roughly 4.5% in mid-2023. By the end of the quarter, the market projection had shifted to a peak rate of 5% at midyear, followed by 50bps of rate cuts by year end. This policy rate path projection contrasts with the Fed’s recent release of rate projections (in the “dot plot”) as FOMC members expect rates to stay higher for longer.

We believe the U.S. economy is likely to enter a recession this year that is accompanied by a possible decline in corporate earnings. While this all sounds gloomy, in our view there are several factors that suggest a “hard landing” scenario, i.e. a deep economic recession (sometimes associated with a financial crisis) is unlikely. At present, it appears the labor market is quite strong7, middle-income households still hold some excess savings accumulated over the pandemic period8, and corporate balance sheets and profitability are currently in a strong position9. In addition, we believe the U.S. banking system is well capitalized, as demonstrated by the 2022 Dodd-Frank Act Stress Tests,10 while excesses in the capital markets, such as highly valued but unprofitable technology stocks, Special Purpose Acquisition Corporations, and cryptocurrencies have largely been wrung out of the system, in our opinion.

Additionally, while we believe the Federal Reserve is likely to pivot and begin to cut the Fed Funds Rate by the end of the year, we are uncertain as to whether inflation may prove stickier than what may be expected, especially in the services sector. Still, if inflation is subsiding by year end, and the central bank is both shrinking its balance sheet and holding the Federal Funds rate above 5%, this combination is akin to further tightening and suggests to us that real rates would effectively be rising as inflation is decelerating. If the economy were to enter a recession, the Federal Reserve would then be prompted to lower the Fed Funds Rate, in our view. Overall, we believe that we will most likely see a pickup in financial market volatility as well as the potential for wider credit spreads during the first half of 2023, before inflation eases and credit spreads rally in the second half of the year. 

We view high quality corporate bond and preferred securities as particularly attractive in the current environment given our outlook for 2023.  Although investment grade corporate fundamentals may have just begun to show minor signs of deterioration, they appear to be in a stronger starting position than in past cycles heading into a potential recessionary environment.9 Profit margins, leverage, and interest coverage are all at some of the healthiest levels that they’ve attained in recent years.9 Moreover, given the significant portion of the preferred securities market that is issued by banks, insurance companies, and utilities, many preferred securities operate in a regulated environment which monitors their capital levels and capacity to pay dividends.10,11 We believe financial issuers can also benefit from higher interest rates through increases in net interest margin, providing another tailwind for many preferred securities in 2023.  Therefore, given our potential recessionary outlook, we consider our corporate bond and preferred securities selection able to withstand a moderate widening of credit spreads and pick up in financial market volatility due to their strong corporate fundamentals, solid balance sheets and regulated nature of their businesses. Our goal of reducing risk and enhancing income is unchanged, and we think high quality fixed income assets are uniquely positioned to deliver attractive risk-adjusted returns in 2023. 

Sources:

1Bloomberg: USGG10YR Index 12/31/21 – 9/30/22

2Bloomberg: USGG10YR Index 9/30/22 – 12/30/22

3https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm

4Bloomberg: MIPR, Market Implied Policy Rate screen

5 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf

6 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20221214.pdf

7 https://www.bls.gov/news.release/pdf/empsit.pdf

8 https://www.bea.gov/data/income-saving/personal-saving-rate

9Bloomberg: STRTN GO Fundamentals / EBITDA Margin, Total Leverage and Interest Coverage

10https://www.federalreserve.gov/publications/files/2022-dfast-results-20220623.pdf

11https://www.federalreserve.gov/supervisionreg/large-financial-institutions.ht

As of December 31st, 2022

December 2022 | Equity Commentary

December 2022 | Equity Commentary

Published on January 12th, 2023

Market Overview

Strong equity market gains posted from the October lows through November were pared back in December. It appears most of December’s drawdown came after the Federal Reserve’s decision to raise the benchmark fed funds rate by 50 basis points. We believe the issue for financial markets was not the rate hike itself—which was widely expected—but rather the central bank’s new projection for the terminal fed funds rate in 2023. In September, the Federal Reserve was forecasting a peak fed funds rate of 4.6% by the end of 2023, but the December meeting shifted the projection even higher to 5.1%. Investors may have been hoping that encouraging inflation prints for October and November would soften the Fed’s stance.1 The following day, retail sales came in weaker than expected, which may have accentuated Fed-related weakness. The S&P 500 retreated by -5.8% for the month, and US Treasuries ended a challenging year with even more upward pressure on yields across the curve. Stocks did well for the quarter, however, with the S&P 500 gaining +7.5% for the three months ending December 31, 2022.2

 The Labor Department’s headline consumer-price index (CPI) measure of inflation rose by 7.1% year-over-year in November, a marked improvement from the 7.7% rate posted in October and a significant decline from June’s 9.1% peak.3 The Federal Reserve’s preferred measure of inflation, the PCE Core price index, also improved, slowing to a 4.7% year-over-year rate in November from 5.0% in October.4 The Federal Reserve responded in December with a 50-basis point rate increase, a welcomed downshift following four consecutive 75 basis point increases. The fed-funds rate now stands at a range between 4.25% and 4.5%, a 15-year high.1

Encouraging inflation readings have yet to align the Federal Reserve with the market, in our opinion, however. Market participants appear to be anticipating a larger decline in inflation in 2023 – and thus a lower expected terminal fed funds rate – than current Federal Reserve projections. The expected inflation gap can be meaningful – according to Barclays, the bond markets are projecting the consumer price index will fall to 2.6% by the end of 2023,1 which would arguably put the Federal Reserve’s preferred PCE price index very close to the 2% target. Meanwhile, the Federal Reserve actually raised its 2023 core PCE inflation forecast from 3.1% to 3.5% at its most recent December meeting.1 Market consternation in late December appeared to be tied to this increasingly divergent outlook on inflation and interest rates.

As we have mentioned in previous months’ commentaries, the Federal Reserve has substantially shifted its focus to services inflation, excluding shelter (housing costs). Chairman Powell’s biggest concern, in our opinion, is the effect the tight labor market has on wages, which in many cases influences companies to raise prices to make up for higher costs. Ongoing tightness in the labor market could cause inflation to become entrenched, which is arguably the Federal Reserve’s biggest fear. In comments following the 50-basis point rate increase, Chairman Powell said, “the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers.” 1Wages and salaries grew 0.5% from October to November5, and prices for services rose over that period while prices for goods declined. We believe the Federal Reserve is not likely to waver from its hawkish stance as long as labor market strength persists, even if goods inflation declines sharply in 2023 as most expect.

The ‘good news’ here, in our opinion, is that aggressive monetary tightening to date has already slowed growth and overall inflation, and because rate hikes work on a lag, is likely to produce more economic weakness in the first half of 2023. Key leading economic indicators such as the Conference Board Leading Economic Indicator index and the OECD leading indicator appear to be at levels that have historically signaled a recession is in the offing. The inverted Treasury yield curve corroborates this view. Purchasing Managers’ Indexes are also declining towards contractionary territory,6 though are not there quite yet.

Housing is another key component of inflation, making up about 1/6th of the Fed’s preferred PCE price index.7 Existing home sales have fallen 32% over the past 10 months, and home prices have also come down from peak levels.7 In the rental markets, the supply of new apartments has hit a 40-year high, and more than 500,000 new apartment units are expected to hit the market by the end of 2023 – the highest total since 1986.7 Rents have fallen from their peaks in many major cities.7

In our view, the effect of slowing economic growth on employment has to date been modest, but not zero. Continuing unemployment claims bottomed near 1.3 million in May 2022, increasing to ~1.7 million by the end of the year, and job openings have come down from a March peak of 12 million to 10.5 million at the end of November.8 These are steps in the right direction, but further declines in job openings are likely needed in the new year for the Federal Reserve to shift its thinking.

Overseas, China made official the end to restrictive “zero Covid” policies, with the state now scrapping rules for mass testing, ending mandatory hospitalization for people who test positive, and reconfiguring how lockdowns are imposed, among other changes.9 We believe these changes are not likely to result in an immediate economic rebound, however, as the loosening of rules comes in the dead of winter when cases and hospitalizations are likely to rise the most. China appears to lack natural immunity from previous infection and also does not have access to highly effective vaccines, which means that even if shutdowns are no longer occurring, de-facto self-imposed lockdowns seem likely to increase as citizens hunker down to avoid infection. Our view is that after a weak first quarter related to the spike in infections, economic activity in China may rebound in the second quarter and more so in the second half, perhaps helped by fiscal stimulus from the Chinese government.  If so, this will likely exert a positive influence on commodity prices and growth in other economies as it occurs.

Sources

1 https://www.wsj.com/articles/jerome-powells-grim-inflation-outlook-is-at-odds-with-markets-11671072877?mod=djemRTE_h

2 Bloomberg Terminal: SPX Index Go TRA

3https://www.bls.gov/cpi/

4https://www.bea.gov/data/personal-consumption-expenditures-price-index

5 https://www.marketplace.org/2022/12/23/as-americans-spend-on-experiences-inflation-declines-for-goods-and-rises-for-services/

6https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/

7 https://www.wsj.com/articles/home-prices-fell-in-october-for-fourth-straight-month-11672150911?mod=economy_more_pos7

8https://www.bls.gov/news.release/jolts.nr0.htm

9https://www.wsj.com/articles/why-xi-jinping-reversed-his-zero-covid-policy-in-china-11672853171

As of December 31st, 2022

November 2022 | Equity Commentary

November 2022 | Equity Commentary

Published on December 13th, 2022

Market Overview

U.S. stocks and bonds performed well in November. The S&P 500 finished 5.6% higher for the month and the 10-year U.S. Treasury bond yield retreated by 44 basis points to end the month at 3.6%.1 Positive performance was driven early in the month by what appears to be encouraging inflation data. The Labor Department reported that the Consumer Price Index (CPI) rose 7.7% in October, a meaningful decline from June’s 9.1% report (which may mark the peak) and the 8.2% reading in September. Core CPI rose 6.3% year-over-year in October which also marked an improvement from September’s 6.6% reading2. On the day of the inflation data release, the S&P 500 jumped +5.6% and the tech-heavy Nasdaq posted a sharp +7.4% rally.3 There are many factors that ultimately drive stock prices, but recent price action suggests the current market continues to be very sensitive to how inflation data may influence Federal Reserve policy. Softer inflation readings suggest the Federal Reserve can slow its pace of monetary tightening, which is a likely tailwind for asset prices.

During November, speeches by Federal Reserve officials and eventually Federal Reserve Chairman Jerome Powell, in our view, appeared to indicate the Federal Reserve may be ready to reduce the magnitude of its rate hikes to 50 basis point increases. In a speech at the Brookings Institute, Powell said that “the time for moderating the pace of rate increases may come as soon as the December meeting,” but also that “wage growth remains well above levels that would be consistent with 2% inflation.” 4Powell also acknowledged that rate increases take time to work their way through the economy, an indication of the Fed’s sensitivity to potentially over-tightening in this cycle. Though the Federal Reserve may downshift in terms of the size of rate increases, we believe the central bank has also tried to stress that the terminal fed funds rate may wind up higher than investors are currently anticipating.

Our perspective is that the labor market is a key reason the Federal Reserve continues to push the “long road ahead” narrative for monetary tightening. The U.S. economy added 261,000 jobs in October, and average hourly earnings rose 4.7% from October 2021. There were also 10.3 million job openings in the US as of the end of the month. A closer look at this labor market data offers some silver linings for the Federal Reserve, however. Though job openings remain too high, they did edge down from the previous month. Ditto for hourly earnings growth in October, which was still well outside of the Federal Reserve’s comfort zone but also marked an improvement from September’s 5.0% year-over-year growth rate.5

We believe the strong labor market has been helping US consumers navigate higher prices. Consumer spending rose 0.6% in September from August, and retail sales rose a seasonally adjusted 1.3% in October compared to September. These figures are not adjusted for inflation, so higher prices can result in higher levels of spending. But it is worth noting that consumers increased spending in non-essential categories, like outings at restaurants, home furnishings, and clothing.6 Anecdotally, the average Thanksgiving week airfare was up 46% year-over-year, but it did not stop Americans from making trips. Overall air travel still went up. 7

Wages are rising but have not kept up with inflation, and as a result Americans’ savings stockpile is starting to shrink – according to government data, somewhere between $1.2 and $1.8 trillion savings remain, which is a notable retreat from the $6+ trillion level reached in the months following the pandemic (when the first stimulus checks started to arrive). The runway for remaining savings may be as little as nine months, which could impact consumer spending particularly if inflation remains elevated. Worth noting is that the Federal Reserve Bank of New York said credit-card balances have risen by 15% year-over-year in Q3 2022, the fastest pace of increase in 20+ years. Consumers have been holding up remarkably well, but it remains to be seen how long the strength can keep up.8

Q3 2022 earnings season has wrapped up, and the latest estimates show earnings-per-share growth of 4.3% on 11.0% higher revenues. These results were largely seen as disappointing by financial markets particularly compared to previous periods, but they were not altogether surprising. Earnings estimates have been coming down all year, and Q4 estimates have already declined by 5.3% since September 30. 9Lower earnings estimates should not be viewed as a major negative, however. Falling expectations often mean a lower bar that corporations need to clear to deliver a positive surprise.

Overseas, China’s economic and socio-political woes joined the war in Ukraine as the biggest stories impacting the global economy. China’s years-long “zero Covid” strategy has reduced death and infection rates, but has also stifled economic growth and, most recently, contributed to citizen unrest and protests across major cities. On the economic front, November activity in China’s manufacturing sector measured by the purchasing managers’ index fell to 48 from 49.2 in October, marking two consecutive months of contraction. Another index that measures activity in the services and construction sector in China also fell month-over-month in November, to a notably weak 46.7.10

Part of the justification for communist rule in China is supposed to be steady economic growth and plentiful opportunity for employment, both of which have been severely compromised by the zero Covid strategy. China’s youth unemployment rate reached 17.9% in November,11 and a sputtering economy beset by strict lockdowns has diminished quality of life. The very rare show of defiance by protestors sent a strong message, however, with the state now scrapping rules for mass testing, ending mandatory hospitalization for people who test positive, and reconfiguring how lockdowns are imposed, among other changes. China is now belatedly shifting some of its focus to vaccinating a larger percentage of the population, particularly among the elderly, who currently have low vaccination rates. Only about 40% of those over 80 have received a two-shot vaccine plus a booster.12 China’s pivot comes as winter months approach, so there is good reason to be cautious about the short-term impact of infection spread, even as reopening is likely to support the economy over the medium term.

Source

1 – Bloomberg: SPX Index; CT10 Govt functions

2 https://www.bls.gov/cpi/

3https://www.cnn.com/business/live-news/stock-market-inflation-cpi-report/index.html

4https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm

5https://www.bls.gov/jlt/

6https://www.bea.gov/data/consumer-spending/main

7https://www.wsj.com/articles/thanksgiving-travel-roars-back-testing-airlines-after-turbulent-summer-11669089185

8https://www.wsj.com/articles/as-savings-slowly-shrink-consumer-spending-is-on-borrowed-time-11668956403?mod=djemRTE_h

9https://insight.factset.com/larger-cuts-than-average-to-eps-estimates-for-sp-500-companies-for-q4-to-date

10https://www.wsj.com/articles/covid-controls-hit-chinese-factories-adding-risks-to-global-growth-11669788260?mod=djemRTE_h

11 – http://www.stats.gov.cn/english/PressRelease/202211/t20221115_1890234.html

12https://www.nytimes.com/2022/12/08/world/asia/china-covid-rollback.html

As of November 30th, 2022

October 2022 | Equity Commentary

October 2022 | Equity Commentary

Published on November 8th, 2022

Market Overview

The stage was set for an equity rally in October, in our view, given that negative sentiment and oversold conditions had both moved to extremes. The S&P 500 index rebounded a stout 8.1% for the month, and the Dow Jones Industrial Average notably posted its best month (+13.95%) since 1976.1 Equity markets may also have experienced an early benefit from seasonal forces, in which stocks have historically performed relatively well in the November to January timeframe – especially when there is a US midterm election. In the 18 midterm elections that have taken place since 1950, stocks have risen in the 12 months following the election 100% of the time, with an average 12-month forward return of +18.6%.2 In the fixed income markets, the 10-year US Treasury bond finally ended a 12-week streak of negative price returns, with yields falling 0.20% to finish the month at 4.02%.3

As financial markets expected, the Federal Reserve raised the benchmark fed-funds rate by 0.75 percentage points at the November 2 FOMC meeting. Chairman Powell reiterated that the Federal Reserve would rather go too far in hiking rates than not go far enough, as the central bank would more readily accept an economic recession versus entrenched inflation.4 Powell added that if the Federal Reserve had released new federal funds rate projections, they would have likely been higher given ongoing strength in the labor markets and another elevated inflation print in September.

In Chairman Powell’s press conference following the Federal Reserve’s announcement, the message was clear to financial markets that while the size of fed-funds rate increases may shrink at future meetings, the terminal rate – which is the end target for the Federal Reserve’s interest rate – would likely need to move higher. In Powell’s words, “the question of when to moderate the pace of increases is now much less important than the question of how high to raise rates and how long to keep monetary policy restrictive.”5In other words, investors should not see a 50-basis point increase in December or smaller rate hikes in 2023 as a sign the Federal Reserve’s monetary tightening efforts are nearing an end. The Federal Reserve may go slower with rates, but they also may go longer and, ultimately, higher.

In our view, the macroeconomic picture influencing the Federal Reserve’s decision-making continues to be stubborn (US labor market) and sticky (inflation). The Labor Department reported that demand for workers continues to far outstrip the number of unemployed Americans seeking work. Total job openings unexpectedly climbed from 10.3 million in August to 10.7 million in September, which is slightly more than double the number of unemployed Americans seeking work (5.8 million). The September uptick may ultimately just be an anomaly, however, as the number of job openings has been in steady decline since its March 2022 peak of 11.9 million.6

On the plus side, we believe wages have been moving more favorably for the Federal Reserve, with average hourly earnings increasing by 4.7% year-over-year in October, a slightly slower pace than September’s 5%, and August’s 5.2%. The Atlanta Fed’s wage growth tracker, which measures the “nominal wage growth of individuals,” also fell in September from August – an early sign that wage pressures may have peaked.7 Additional data helpful to the Fed’s goals was the slight uptick in unemployment reported in early November, to 3.7% from the prior 3.5%.8 

US GDP grew at an annual rate of 2.6% in Q3, according to the Commerce Department. Better-than-expected GDP growth runs counter to the Federal Reserve’s goal of cooling the economy, but a closer look at GDP’s components shows that overall demand in the economy is indeed falling. Final sales to private domestic purchasers –which measures underlying demand in the economy – moved up by just 0.1% from Q2 to Q3, which while positive indicates a significant downshift in activity. Final sales to private domestic purchasers had moved 2.1% higher in Q1 and 0.5% higher in Q2. A major factor in GDP’s strong Q3 print was a 2.8% increase in net external trade, a reversal from earlier in the year when imports detracted from GDP as companies rushed to restock inventories. Consumer spending edged higher in the quarter.9

Services and Manufacturing activity in the US both slowed from September to October but remain in expansion mode. The October PMI for Manufacturing was 50.2 percent, which was 70 basis points lower than the September reading. New orders eased over the summer months and companies are largely preparing for lower demand in the future, according to the survey. The ISM report showed that supplier deliveries were moving faster, raw materials prices had declined, and supply chain bottlenecks were all but gone, all of which point in a favorable direction with respect to inflationary trends. On the services side, the PMI registered at 54.4 percent, which remains firmly in expansionary territory but slowed considerably from September’s 56.7 percent reading.10

Finally, the US housing market continues to show material signs of weakness as the average 30-year fixed mortgage rate now hovers around 7%. Pending home sales declined 10.2% in September from August, pulling sales back to levels seen at the outset of the pandemic. With the exception of May, pending home sales have fallen every month in 2022, a sign that rising interest rates are denting demand and also that pandemic-driven migration trends are fading. Home prices are also showing signs of plateauing, with the S&P CoreLogic Case-Shiller National Home Price Index falling 1.1% from July to August, the biggest monthly decline since December 2011. With shelter making up approximately one-third of the Consumer Price Index (CPI) measure of inflation, easing home price pressures register as a good sign for the data- dependent Federal Reserve.11 

Source

1https://www.cnbc.com/2022/10/30/stock-market-news-futures-open-to-close.html

2https://www.forbes.com/sites/michaelcannivet/2022/10/02/the-stock-market-has-risen-after-every-midterm-election-since-1950/?sh=4897b2bf7c48

3https://www.yahoo.com/now/treasury-market-rally-faces-reality-200000035.html

4https://www.wsj.com/articles/jerome-powell-to-markets-the-destination-matters-not-the-journey-11667427735

5https://www.federalreserve.gov/newsevents.htm

6https://www.wsj.com/articles/job-openings-hiring-economy-september-2022-11667249735?mod=djemRTE_h

7https://www.atlantafed.org/blogs/macroblog/2022/10/21/viewing-the-wage-growth-tracker-through-the-lense-of-wage-levels

8https://www.wsj.com/articles/october-jobs-report-unemployment-rate-economy-growth-2022-11667516355

9https://www.wsj.com/articles/us-gdp-economic-growth-third-quarter-2022-11666830253

10https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/

11https://www.wsj.com/articles/home-price-growth-slowed-in-august-11666702621

As of October 31st, 2022

Weighing the Impact of a Historic U.S. Presidential Election

Published on Oct. 1, 2020

Weighing the Impact of a Historic U.S. Presidential Election

The 2020 U.S. presidential election is fast approaching. No matter what your political orientation, this election cycle probably feels highly consequential and filled with uncertainties. And as if the election wasn’t enough, there is still a pandemic looming in the backdrop with an economy fighting to regain footing.

As the old saying goes, never a dull moment.

Read the Full Article Here
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