Market Update - April 2023 | |
This is an authentic tweet from Silicon Valley Bank's twitter feed before it was pulled down following their bankruptcy. This is my evidence of tone-deaf HUBRIS by the executives at Silicon Valley Bank. Were there other causes for its failure? Sure, but having the gall to post this even as insiders sold stock while observing the exodus of depositor cash, that is insulting. | |
- During March, stock and bond markets rose following the failure of 3 major banks. Stocks are anticipating Federal Reserve stimulus, while bonds are anticipating slower growth and lower inflation.
- Economic data continues to be mixed. The service economy is doing great, the consumer is spending, but manufacturing is slowing down. Employment remains very strong.
- Our view is that stock market in the middle of another bear market rally. The Fed is still raising rates, inflation is high, employment is strong and bad news is coming out slowly. We believe a new banking crisis has commenced. Conversely, the slowing of the economy is pulling down inflation which should be bullish for bonds.
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Table 1: Market performance estimate as of 3/31/2023 (LIMW) | |
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During March, all major markets rose except for small caps and crude oil. How could bonds and stocks both go up during the month? This reaction seems to contradict the news that 3 major banks failed, requiring the Fed and FDIC to step in and bail out the depositors of Silicon Valley Bank and Signature bank. The stock market reacted quite positively to the immediate injection of cash into the banking system and is anticipating broad support from the Federal Reserve in the form of quantitative easing (QE) and lower interest rates if developments get worse.
Similarly, the bond market is also reacting rationally to the news. A bank crisis implies a sharp contraction in lending activity is imminent and that economic growth will slow as a result. Slower growth means lower inflation; lower inflation means lower interest rates.
The problem is one of timing and uncertainty. The stock market is correct that the Fed will slash interest rates if we have a severe recession and serious bank crisis. The problem is that the Fed is still focused on inflation and the banks were bailed out. This implies rate cuts are not imminent.
There was a similar strong equity rally in the weeks after Bear Stearns failed in 2008 as investors hoped the worst was over. Unfortunately, the crisis was just starting.
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How long did the banks think depositors would sit on cash earning 0%? Apparently, a long time, because that cash was invested poorly with minimal hedges for long periods of time at many banks.
What is the root of today's banking problem? During the Financial Crisis, the federal government changed bank accounting rules in March 2009 to help save the financial system. This one step was critical in stopping the panic among depositors and bank investors. Essentially, losses on bonds "Held to Maturity" would not have to be recognized until they were sold. This little change put a stop to fears that the banking system would fail with massive losses and changed the outlook for the whole sector.
During the 2010s, banks became used to investing in bonds with little yield and high valuation. As long as there was no inflation, no problem. However, the inflation created by the pandemic stimulus developed into an environment of rising interest rates. Bond investors not paying attention got clobbered with losses in 2022. Under the new accounting rules, as long as deposits didn't flee, no losses need be recognized, however.
Some banks like Goldman Sachs implemented hedges and changed their portfolios for the new environment. Goldman currently has minimal losses on their investment portfolio. Other banks, like Silicon Valley didn't hedge or take action resulting in massive unrecognized losses. Once depositors began to fear bank failure, the rational step was to withdraw their money.
The FDIC has recently disclosed the size of these losses in the US banking system. They are enormous and well beyond the ability of FDIC insurance to bail out. To allow this situation to develop is evidence of massive incompetence by bank management teams and the regulators supervising them.
Is there anyone in the country that didn't know about our inflation problems and rising interest rates in 2021? Apparently so, as there are a lot of banks with a profile similar to that of Silicon Valley Bank. If you have money in one of these institutions, consider the FDIC insurance limit of $250,000.
In our view, the pressure on bank deposits is going to be a problem during this cycle. Money market funds are yielding 4.6% and bank depositors are actively moving their cash to greener pastures. We expect this to put a crimp on bank lending, bank profitability and economic growth.
Figure 1: Bank losses in the US banking system are enormous (FDIC, FDIC Congressional testimony)
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Table 2: Silicon Valley Bank's lack of hedging activity through December 2022 is glaring and obvious incompetence. Not one futures contract; not one options hedge. (FDIC) | |
First response by Federal Reserve: create a new emergency program | |
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To the Fed's credit, they didn't hesitate to roll out a new program to help the regional banks with potential liquidity problems. One of the central bank's critical roles is to provide loans to member banks with short-term liquidity problems. This doesn't mean the Fed will bail out their losses, just provide banks loans against their current bond portfolio.
However, we are faced with a new bank crisis and it is helpful to examine how much the bank system is relying on the Fed at this time. Currently, there is tremendous demand for help. Emergency loans from the Federal Reserve now exceed the peak of the Financial Crisis in 2009.
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Figure 2: Federal Funds rate v. Fed Emergency Loans (LIWM) | |
The corporate bond market started to worry in mid-2022 | |
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In most recessions, corporate bonds underperform treasury bonds. During the Financial Crisis, they dramatically underperformed, so it is important to see if there are any similar precursors to this type of bond market tantrum.
We see spreads began to widen in mid-2022 (the difference between corporate and treasury bond yields is called a spread). We don't view this as alarming yet, but we are monitoring the situation.
If the bank crisis broadens, it will be critical to understand this relationship because corporate bonds are major components of the bond benchmarks.
Figure 3: Corporate High Yield and Investment Grade bond spreads over treasury bonds (LIWM)
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The yield curve is predicting a hard landing for the economy | |
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There is an elaborate dance between the bond market and the Fed when it comes to short-term interest rates and policy changes. Typically, the market is trading ahead of the Fed, so it is interesting to see the 10-year/2-year interest rate spread begin to correct upwards. Historically, this spread has moved dramatically positive just before recession and a dramatic change in Federal Reserve policy.
In March, we saw the 2-year Treasury yield fall dramatically indicating a potential change in Fed policy later this year. Looking over past cycles, we can see that as the Treasury 10-year minus 2-year yield spread falls, it indicates the Fed is raising rates trying to slow the economy. When the spread rises, it indicates the Fed is cutting rates due to recession or crisis. This market is usually a leading indicator as we saw in 1989, 2000, and 2007.
You may notice that this measurement is the most negative it has been since the 1980 inversion created to stop the 1970s inflation.
Figure 4: The difference between short-term and long-term interest rates helps to predict recessions (LIWM)
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Did the Fed raise rates high enough to avoid a repeat of the 1970s? | |
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Every investor fears a re-run of the 1970s. Rising inflation, three severe recessions and many policy failures by our government leaders made that decade very difficult.
One key metric that is used to evaluate the Fed's willingness to slow economic growth and inflation is the difference between the Fed's policy interest rate (the Federal Funds rate) and the 10-year Treasury yield. When the 10-year Treasury yield is well below the Fed's rate, the yield curve is considered "inverted."
During the 1970s, there were three periods of yield curve inversion as the Fed tried to stop the runaway train of inflation. All three inversions caused recessions and after the third one in 1980, inflation finally peaked and began to head down for good.
Unfortunately for us, the modern Fed under Chairman Powell has not inverted the yield curve as much as our leaders in the 1970s. This may create longer term problems with sticky inflation.
Figure 5: Rehabilitating Fed Chairman Arthur Burns (he ran the Fed 1970-1978) (LIWM)
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In February, inflation readings resumed their decline | |
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As the economy decelerates, inflation rates continue to decline. Headline Consumer Price Index rose 6.04% in February, compared to its peak of 9% last year. At the same time, the core inflation rate of personal consumption expenditures (Core PCE) that the Federal Reserve follows closely came in at 4.67%, down from its high of 5.42% last year.
While these incremental declines don't sound like much, at least they are lower than what we experienced last year. That's the good news. The bad news is that the core inflation rate is proving to be very sticky as it falls, reflecting tremendous wage and housing inflation.
Why is this important? If the Fed remains focused on core inflation, they are less likely to slash interest rates as we enter recession. The bond market believes this the case because we see 10-year bond yields at 3.5% and 1-year bonds yields at 4.6%, even after 3 major bank failures in March.
Figure 1: Core PCE Index and rate of change year-to-year (LIWM)
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Earnings estimates continue to fall | |
One way to evaluate economic health and the trend in general growth is to look at broad measurements of earnings. One data point is the aggregate earnings of the S&P 500. By adding up all the profits and losses of the S&P 500 companies and weighing them by the company's weight in the index we generate a view of how corporate America is doing.
Earnings estimates for the S&P 500 are a lagging indicator, but they give you a sense for the progression of economic contractions or expansions. So far, the data indicates the peak in earnings occurred last year and now we are in the process of regular downgrades. In most recessions, broad earnings fall 20-40%. So far, 2023 estimates have fallen 12% from their high. We will start getting a lot of earnings during the month of April.
Notice that 2023 estimates are equal to 2022 estimates, so there is no anticipated earnings growth this year.
Figure 5: S&P 500 earnings estimates by year (Ed Yardeni)
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Current market commentary | |
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Equities remain in a bear market that began in January 2022. It is our view that the bear market will continue until four key factors are aligned:
- Falling inflation
- Falling employment
- Falling earnings
- Falling interest rates
So far, we have only seen modest weakness in inflation and earnings from the peak in 2022. Employment and interest rates are still rising.
Many analysts recently noted that the current bear market rally has been going on for about six months now. That is an unusual length of time that indicates a possible new bull market in stocks. After all, a key characteristic of bull markets is that prices refuse to fall even in the face of bad news. Additionally, there are numerous technical indicators that support the new bull market thesis.
In our view, it is still too early to declare a bottom. The bullish analysts are fighting the Fed and the Fed is fighting inflation. We expect stocks and economic growth to get worse before getting better. This view is exactly why we are bullish on bonds.
Figure 6: Current equity market situation (LIWM)
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Bonds may have completed a bear market that began in 2020, almost three years ago. Bond investors focus on two things: inflation and defaults. With record low defaults, we can conclude that the weakness in bonds is all about the Federal Reserve's policy to let inflation run hot. It is our view that inflation in this cycle peaked in June 2022 and that the bond market bottomed in October 2022 with the peak in yields.
Figure 7: Current bond market situation (LIWM)
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We are in the midst of a difficult bear market in stocks and bonds. The Fed is still raising rates, inflation is high but falling, earnings are weakening, and employment remains strong. We expect the Fed to continue raising rates to 5.25% in May, which will result in problems for the stock market and economy. Conversely, this may be positive for the investment grade bond market if inflation falls as the economy slows.
We remain underweight equities and overweight bonds. The current bear market rally is getting stale and the Fed is unlikely to back off their tightening policy in coming months.
If you are concerned about your situation and would like to speak with us, please reach out to us at the phone numbers below.
We look forward to hearing from you!
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
| Lloyds Intrepid LLC is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from Lloyds Intrepid LLC with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis. | | | | |
