A first quarter for the history books – Bonds and Big Tech become a haven for investors, but depositors lose faith in banks.

Last year was an historically wild and eventful time for the markets. The first quarter of 2023 is giving it a “run” for its money. The year began with optimism in January driving much of the quarter’s gains for stocks. The mood turned sour in February, and then the run on SVB (Silicon Valley Bank) kicked off a global banking panic that is still leaving everyone, Main Street and Wall Street, somewhat on edge. The dust seems to have settled for now, after large banking conglomerate Credit Suisse merged with UBS, US depositors were ensured their money was safe, and the banking system was flooded with liquidity.

The tech heavy Nasdaq Composite Index was the quarter’s big performance winner after experiencing losses for the last four quarters. The index rallied the most since the second quarter of 2020, finishing up 16.77% despite many headwinds*. The S&P 500 was positive for a second straight quarter clawing back 7%, around a third of the loss the large cap stock index experienced last year*. The Dow was a little more than flat, gaining 38 basis points (.38%)*. Gold gained over 8% to a near record high*. WTI (West Texas Intermediate oil benchmark) crude lost 5.7%, although oil futures have since regained those losses after OPEC (Organization of the Petroleum Exporting Countries) announced a surprise move to significantly reduce supply in early April*.

Big tech, big rally – can it last?

Most of the US Large Cap equity gains have been driven by just a handful of mega cap tech names. Chip maker Nvidia skyrocketed at a nosebleed pace, up over 90%*. Meta (Facebook, Instagram) also led the way, up 76.1%*. Apple was positive 26.9%, Amazon came in at plus 23%, Microsoft added over 20% and Alphabet (Google) was up 17.6%*. Stripping out those companies from the S&P 500, we are left with a little over 1 percent gain in stocks for the quarter*. It really shows a continued lack of breadth in the markets.

This is great news for tech investors who lost big last year, but investors should be wary. Margins and credit will only tighten as we move through the final innings of the business and monetary cycle. Looking at the US stocks earnings yield relative to the 10-year Treasury yield (the equity risk premium) - it has not been this low since October 2007 at just under 1.6 percentage points. The ratio is well below the long run average of 3.5%**. With the squeeze on earnings, ongoing inflation, and tightening credit conditions, fixed income relative to equities have clearly not looked this attractive since the 2008 financial crisis. As Benjamin Graham once said, “in the short run the market is a voting machine, but in the long run its a weighing machine.”

Bonds rally too – high yields and safety attract investors during banking chaos

Investment grade bonds across the yield curve appreciated in value during the quarter. Treasuries performed well with the yield on the two-year note falling around 35 basis points (.35%) to just over 4% and the yield on the ten-year note falling 40 basis points (.4%) to just under 3.50%*. The 10-year treasury had risen above 4% then collapsed after the banking debacle. The chasm in short-term and long-term rates are as wide as they’ve been this business cycle and have tested the record set in the early 80s many times this year*. The extreme inversion suggests the bond market is worryingly pricing in slowing growth and falling rates.

Longer term maturity yields have been entrenched stubbornly within the 3.5% to 4.5% range, reflecting the bond market’s belief in a slowdown, lower inflation, and a lower terminal rate - (the interest rate level that the Federal Reserve believes is consistent with a balanced economy in the long run). The data have been mixed and contradicting, making it hard for Wall Street strategists to formulate a forecast. The Federal Reserve’s job is even more difficult, having to maintain data dependence, independence from political influence, while working against the grain of persistent fiscal deficits.

With global growth stalled, are international stocks and bonds still attractive?

Internationally, MSCI EAFE and ACWI indexes were up over 8% and 7% respectively, despite the banking issues stretching to Europe*. Looking at global stocks now, valuations domestically are incredibly expensive relative to the rest of the world. The divergence between developed and the emerging market asset class prices have rarely been this wide. The suppression of interest rates for so long has created so many asset bubbles in the US and there really has not been a pop yet. Last year was a terrible year for growth and technology stocks, but the rebound has been buoyant and the mega cap tech names are relatively expensive again.

Despite underperformance in the emerging market returns, the fragility levels in these markets are quite low. At some point the global rate cycle will come to an end – we appear to be getting there with the Fed who was late to the game in raising rates. EM (emerging markets) countries have already been quite restrictive in their monetary policy, so rates should come crashing down if the developed world’s central banks begin to cut their policy rates. Real (inflation adjusted) rates are quite high. This makes emerging market bonds attractive as well as equities.

Counterintuitively, emerging market bank balance sheets are more conservative and EM country current accounts are in better shape than their developed market counterparts. Overseas, there are no significant asset bubbles or excess. Net interest margins are structurally much higher. Even more so than the largest developed market banks, EM banks are very well capitalized and there is higher tangible capital. If political structures maintain stability, there is strong long-term opportunity outside of the United States.

The cost of capital will only increase as credit tightens and inflation continues to permeate through the domestic economy. The US dollar is incredibly expensive and international markets with globally advantaged companies have been largely neglected for the last decade or so. This is a good reason to stay diversified internationally despite the frightening geopolitical risks and saber rattling among many nations.

Ongoing reasons for caution in regional banking

January and February might as well have been years ago after the banking collapse in March. As the SVB and Signature Bank situation began to unwind (more on what happened in the previous update), the fears were reminiscent of the 2008 financial crisis. There are differences to what is happening now to what happened in the GFC (great financial crisis), but there is a common denominator any time a banking institution fails. Fractional banking is built on trust and credit. When there is a collapse in this trust and customers come for their deposits, banks will need a backstop to cover all depositors.

What is different now is the disturbing speed of collapse in mere hours and how quickly the contagion occurred. This called for a much more rapid response from regulators that was not seen (or as needed) in the past. The Fed, Treasury, and FDIC’s swift response, along with related mergers and acquisitions activity helped stabilize the banking sector late in the quarter, which in turn, helped to underpin the broader market. We also had banks lending and working with clients in a specific industry or sector instead of having a diversified deposit base.

Impact of digital and mobile banking

Current panics are now driven by instantaneous information exchanges. Digital and mobile banking along with social media can generate very intense panics and spark volatility unnecessarily. Another difference from 2008 is that while authorities do not seem to be prepared for these types of situations, the damage has been relatively limited so far. The risk remains if trust is eroded in even the smallest banks and the dominoes begin to fall. If depositors flee an institution, especially those with more uninsured deposits, the deposit franchise evaporates, and the unrealized losses on even “held to maturity” securities on bank balance sheets become realized. Bankruptcy then becomes unavoidable, and the government must make swift and often unpopular choices to prevent contagion.

How does this compare to other bank crises?

As one can see, not all bank crises are created equal. The good news is that there is less fragility in the US banking system than in 2008. Loan to value ratios are much lower now. Banks were more highly levered with much less capital. SVB failed to manage risk and the asset side of the balance sheet. They had a duration crisis where their assets and liabilities were severely mismanaged. This is not a good thing for a large bank in one of the few countries where the banks are not required to mark their “held to maturity” assets to market, meaning current market pricing. Regulators should have a close watch on this as interest rate stay elevated.

Several banks with similar profiles to SVB such as First Republic Bank, which lost nearly 90% of its market value during March, must be closely watched in the coming months. They suspended their preferred shares dividend and have lost many top financial advisors since SVB’s collapse, an ominous sign for an institution that caters to high net worth clients with a very large amount of uninsured deposits.

Bank risk spreading to commercial real estate markets?

Jamie Dimon, CEO of JP Morgan Chase, recently warned that while we might be getting to the end of the current banking crisis, there are recessionary clouds on the horizon. He highlighted the difference between now and the ‘08 crisis noting there were “hundreds of institutions around the world with far too much leverage. We don’t have that.” Regarding small and regional banks, commercial real estate is something to keep an eye on as capitalization rates continue to rise, the cost of debt moves higher and higher, and property valuations fall. Many regional banks and their balance sheets are dominated by commercial real estate loans. Too many defaults and failures can easily create another SVB like run on any of these banks.

Real estate in general, especially office space, will be tied to the real economy and economic growth along with new trends in working from home. Nearly a quarter of office property loans are turning over and need to be refinanced in the next year at higher rates. Industrial, multifamily (apartment), and retail properties in attractive locations are in good shape. High quality area loans should perform fine, but lower quality properties where vacancy rates are substantial are at the greatest risk. There are more of these areas post covid.

There is a material difference between the transactional valuations and appraisals in commercial real estate because of a lack of transactions. Historically, real estate’s true volatility is much higher than what appraisal-based indexes show. In residential real estate, mortgage demand is at a 28 year low. Prices have stayed elevated and higher interest rates have squeezed out many potential buyers.

What about PEVC?

Private equity and venture capital could have vulnerability as well with credit conditions tightening and demand for liquidity from clients. There has been a significant increase in private credit investment as banks have stepped away. With higher base rates and less value, there is always higher risk of default. Cash is being hoarded everywhere with higher rates. Firms that are looking for credit and are cash poor will struggle the most in these conditions.

Businesses are still adding or retaining workers, but more people are joining the work force as layoffs increase and job openings decline

After a blow-out jobs report in January, the labor market is cooling down in an orderly way. March jobs numbers showed the lowest monthly gain since December 2020. Payrolls data came in line with economists’ expectations at 236k jobs added versus an estimate of 230k jobs***. The unemployment rate fell to 3.5% from 3.6% as more people joined the labor force, a welcoming sign as shortages have persisted throughout the COVID pandemic***. The labor force participation rate ticked up for a fourth consecutive month. The JOLTS (Job Openings and Labor Turnover Survey) report and job postings are showing declines*.

Businesses are hanging on to workers until there is more clarity on where the economy is headed. March hourly earnings rose .3% month over month in line with expectations***. It shows that wages are not quite keeping in line with inflation, which while not good for the consumer in the near term, it is good news for the Fed’s fight on rising prices.

The jobs numbers are a lagging indicator of what is going on in the real economy. The Fed will now have to rely on the next few inflation reports and economic data to determine if they hike rates in May. Disinflationary signals are many, yet service demand remains elevated and is moving the economy along. Leisure and hospitality hiring stayed strong. Retail jobs declined showing the ongoing trend after COVID shutdowns. We haven’t had a downsize surprise jobs report since March’s report last year. Jobless claims went up a bit but these are still not significant increases.

ISM (Institute for Supply Management) manufacturing and services data have come in weaker and show an economy that is certainly slowing, although maybe not enough for the Fed’s target inflation goal. A tight labor market is helping to stave off a collapse in growth yet does indeed fuel inflation. A “stagflationary” environment calls for a defensive posture in stocks and an overweight to high quality fixed income, which we have had. Cash flows and quality balance sheets are now paramount, and we like strategies that invest in firms with growing dividends, robust cash conversion cycles, and organic growth with the least amount of reliance on leverage.

Looking forward, we are focused on March’s inflation report and first quarter earnings, especially banks, who report in mid-April. We have an important FOMC (Federal Open Market Committee) meeting in early May which will be a pivotal decision-making point in the interest rate cycle. Structurally, rates are going to be higher in the near term and we will closely follow how higher rates start to impact real assets. The latest inflation and jobs data have pointed to an economy that is still running too hot in certain areas yet showing cracks and weakness. Overall, underwhelming earnings and guidance metrics may continue to weigh on risk sentiment. Margins are under pressure with high input costs (specifically labor costs) and weaker demand.

While uncertainty has only gotten stronger in recent months, our philosophy and strategy are based on long term thinking, while keeping in mind our timing in the business cycle. Asset allocation is extremely important in these moments. Defensive positioning is where we have been and where we will stay for the near future – and it pays to be with higher available dividend and bond yields. Fortunately, there are many opportunities for higher total return for less risk than in years past and we maintain focus on them for you and your financial future. Spring is here and we are here for you if you have any questions or concerns!

*Source: FactSet

**Source: The Wall Street Journal

***Source: Bloomberg

Disclosures

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Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.

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