Market Memo March 2023

Summary

• In January, stocks rallied because many investors believed that inflation was defeated and the Fed was poised to reduce interest rates later in the year. Unfortunately, strong February economic data and a reacceleration in the inflation rate indicated that the Fed needed to raise interest rates higher and for longer to combat inflation. Like 2022, nearly all asset classes declined in February as interest rates rose sharply.

• While many investors thought the January rally indicated an improvement in the economic outlook, we believed it was a bear market rally. In our view, the rally was driven by favorable seasonality and market flows (corporate buybacks, retirement contributions, speculative positioning, and rebalancing) – not an improvement in the economic outlook.

• There is tremendous economic uncertainty. Inflation surged to a 40-year high, and the Fed has aggressively raised interest rates to weaken economic demand and reduce inflation. Unfortunately, the Fed has an almost perfect record – nearly all its tightening cycles lead to recession and an adverse credit event. We believe that a recession is likely this year because the Fed is ignoring the leading indicators of the economy and tightening into an economic slowdown.

• Market history shows that the Fed typically raises interest rates until something breaks. This week the Regional Bank Index plunged more than 15% as invested feared that small and mid-sized banks might face a liquidity crisis. Investors became concerned that problems at Silvergate Capital and Silicon Valley Bank (banks that respectively deal with crypto and venture capital customers) may spread to other regional banks. These credit issues are the unintended consequence of the Fed's tightening cycle.

• Stocks offer a very poor risk-reward since valuations are at historical highs and corporate profits are in a recession. Sharply higher interest rates drove stocks down last year, and we believe stocks are poised for another decline as the economy slows, and profits disappoint. Bear markets usually trough with the S&P 500 selling less than 14 times peak earnings. Since earnings peaked last March at $210, the S&P 500 could fall to 3000 -- an additional 20% decline.

• In this high-risk environment – economic uncertainty, risk of the Ukraine war escalating, and tension with China – we believe a nearly 5% risk-free rate is very attractive. We have a significant investment in a 2-year U.S. Treasury ladder, yielding around 5% and giving us a solid return until the headwinds are reduced, and stocks and bonds offer better risk-reward.

Market Review:

After a solid start to the new year, robust economic data pushed interest rates higher and stocks lower in February. In January, many investors believed that inflation was defeated, and the Fed was poised to reduce interest rates later in the year. Unfortunately, strong February economic data and a reacceleration in the inflation rate indicated that the Fed needed to raise interest rates higher and for longer to combat inflation. Like 2022, nearly all asset classes declined in February as interest rates rose sharply.

Financial Market Performance

The stock market was very strong in January. Many pundits crafted the narrative that the market's strength was because the Fed was successfully orchestrating a soft economic landing, i.e., inflation was receding while the economy was strong enough to avoid recession. The stock market's strong performance and the optimistic narrative created FOMO (fear of missing out) among retail investors who chased stocks higher. According to VandaTrack, retail investors contributed an average of $1.51 billion daily into the stock market in January, the highest amount on record.

We believed that the stock market's strength did not indicate a soft landing -- it was primarily due to seasonal flows into the market and short covering by CTAs and hedge funds. January is usually a strong month for the stock market because of favorable seasonality and large inflows into retirement funds. According to Vanguard, approximately 61% of retirement fund contributions are allocated to Target Date funds that invest in passive ETFs based on your age and not market fundamentals or valuation. Since passive ETFs now control nearly 50% of the stock market, the market is more inelastic, and large flows can significantly impact price.

Since the S&P 500 dropped by 6.1% in December, stocks were oversold, and many trend following strategies (CTAs) and hedge funds had significant short positions. Retirement flows, and target date funds rebalancing pushed stocks higher in January, which led to short covering by hedge funds and CTAs. To make sense of the flows-based rally, many pundits created a soft-landing narrative that fomented FOMO buying among many retail investors. If the stock market rally was discounting a soft landing, that fundamental change should have been reflected in the bond and commodity markets. Instead, as stocks rallied, the yield curve inversion worsened, and the oil declined.

The S&P 500 rallied more than 10% from its mid-December low to its February 2^nd high. While many believed that the stock market was signaling a soft-landing, the yield curve and commodity markets didn't confirm this narrative. We believe the market rallied due to passive flows, target fund rebalancing, and short-covering.

Source: Stockcharts.com

In February, stocks and bonds sold off sharply because strong economic data and a rebound in the inflation rate made it clear to investors that the Fed remained behind the curve and had to raise interest rates higher for longer to quell inflation.

We believe that we are in a very high-risk environment with significant uncertainty. Despite a bear market decline last year, the stock market remains overvalued, and earnings expectations seem unrealistic. Additionally, most Fed tightening cycles lead to recession because the Fed primarily focuses on coincident economic indicators to implement monetary policy. The problem is that changes in monetary policy can take 18 months to affect the economy and inflation, so monetary policy is essentially implemented through the rearview mirror. This tightening cycle is more complicated because the pandemic shutdown may have adversely impacted the economic data (especially in the labor market).  

Though the labor market is strong, and inflation remains elevated, the leading indicators of the economy – the yield curve, the money supply, LEI, housing permits and starts, and ISM new orders less inventories -- indicate that a recession is likely this summer or early fall.

Market history shows that the Fed typically raises interest rates until something breaks. This week the Regional Bank Index plunged more than 15% as investors feared that some smaller and mid-sized banks might face a liquidity crisis. Investors became concerned that problems at Silvergate Capital and Silicon Valley Bank (banks that respectively deal with crypto and venture capital customers) may spread to other regional banks. These credit issues are the unintended consequence of the Fed's tightening cycle.

Regional banks pay a small yield on customer's deposits and then lend or invest the funds for a higher rate to make a profit. Silicon Valley Bank used its customer's deposits to buy long-term government and mortgage-backed bonds. Recently, depositors pulled their money from the savings accounts, forcing SIVB to sell some of its bond investments at a large loss.

Since many regional banks bought bonds when yields were significantly lower, they have large unrealized losses on their balance sheet. In theory, these losses are only on "paper" because the bank can hold the debt until it matures, and they receive 100% of its principal. The problem is that the Fed lifted short-term interest rates to nearly 5%, and savers are pulling their deposits to earn a higher risk-free yield. As deposits are removed, the bank is forced to sell its investments at a loss, which could lead to a capital shortfall. The contagion risk is that significant losses and capital shortfalls could create fear among savers and lead to bank runs.

The Regional Bank Index plunged 15% this week, as fleeing deposits would lead to large, realized portfolio losses and capital shortfalls. Credit events are typical at the end of a tightening cycle.

In Sum

The overvalued stock market is vulnerable to another decline as the economy slows and corporate profits disappoint. Also, the stock market is at significant risk if there is an escalation in the Ukraine war or if China sends weapons to Russia. While the stock market has a very poor risk-reward, we believe that short-term U.S. Treasuries (two years and less) that yield more than 5% are very attractive. We think it's prudent to "lock in" a 5% risk-free for the next two years until much of the economic and geopolitical uncertainty is resolved.

Economic Outlook:

In February, the Bureau of Labor Statistics reported that 517k jobs were created in January, and the unemployment rate fell to 3.4%, which was the lowest level since 1969. Stocks and bonds sold off sharply because the Fed believes that a strong labor market leads to inflation -- so the good employment news was bad news for stocks.

Inflation surged to a 40-year high because the government and the Fed provided massive monetary and fiscal stimulus to support the economy during the pandemic shutdown. When inflation surged in 2021, the Fed failed to remove its emergency monetary measures because it incorrectly believed that inflation was "transitory." Finally, inflation reached 8.9% last June, and the Fed embarked on its most aggressive tightening cycle in over 40 years.

The Fed believes in the Philips Curve, which is a theory that unemployment and inflation have an inverse correlation – i.e., a low unemployment rate leads to inflation. Accordingly, the Fed must reduce economic demand by increasing unemployment to reduce inflation. The Fed is currently forecasting that it will increase interest rates to 5.25% by December, which will push the unemployment rate to 4.55%, creating a loss of 1.85 million jobs.

In our view, this approach to monetary policy, which creates unemployment to reduce inflation, makes no sense.

• First, the theory doesn't always work. In the 1970s, inflation and unemployment were both very high (from 1974 to 1980, the unemployment rate averaged 7.1%, and inflation averaged 8.7%), and in the period between the Great Financial Crisis and the Pandemic, both inflation and unemployment remained low (from 2014 to 2020, the unemployment rate averaged 4.7%, and inflation averaged 1.6%)
• Secondly, the Fed uses coincident and lagging data (employment and inflation) to make policy decisions that don't fully impact the economy for at least 18 months. This process of making monetary policy decisions in the rearview mirror is why most tightening cycles lead to a recession and, typically a credit event.

Most Fed tightening cycles led to a recession. Since 1965, every time inflation rose above 5%, a recession occurred.

Source: FRED