Your Money, Your Update
A Quarterly Review of Investment Trends and Strategy From Our Investment Committee
Quarter 1, 2023
Join Bob Brown, CFP® and John Burke, two of Stone House's Managing Partners, as they discuss major market happenings heading into the second quarter of 2023, including interest rates, global bank stress, the probability of a recession, and the next bull market. They also offer perspective on long-term investment strategies amidst day-to-day uncertainty.
*Filmed on March 30, 2023
Intro: Despite a new crisis in banking, we finished the second positive quarter in a row for both US stocks and bonds. While there is always new news to digest in the financial markets, the latest wrinkle in bank failures has many investors on the edge of their seats as we come to the close of the quarter, asking if there is an escalating issue for banks. We’ll talk more about that.
Interest Rates
John: We’re starting month sixteen of this current bear market with stocks off about 15% from the all-time highs back on January 1st, 2022. The Federal Reserve raised interest rates again by 0.50%, twice at 0.25% each, in the first quarter with many forecasting that they will soon pause future hikes. Even though short-term rates set by the Fed increased in Q1, interest rates beyond one year in length dropped. This is common when we see economic slowdowns or recessions.
The common financial term for today’s yield curve is that it’s inverted; and it’s been that way for months. Normally we’d expect if we lent money for a longer period, we’d get compensated for that time. In this case, interest is higher for the first few years and then drops. That’s because the markets are expecting that the Fed will be cutting rates in the future. These rate cuts were expected a bit more into late 2023/24 until the recent banking issues caused those forecasted cuts by the bond market earlier in 2023. In this graph, we’re comparing the yield curve at the end of 2022 to near the end of March. It dropped at all maturities after about nine months. Whether we get those rate cuts or not remains to be seen as well as if we’ll have a recession. Historically this inversion of the yield curve has signaled a recession, but false signals have also happened.
Bob: I think that’s important to keep in mind that no matter who is telling the story, data can be manipulated to fit the narrative they’d like. For example, it’s true that every time the stock market crashed it was on a day that the sun rose. However, anyone with common sense would know that that is weak data, and that there are certainly many other factors that caused that effect. Predicting the direction of the market is very complex. We have to look at many factors. and base our decisions on probability. One signal or indicator is interesting, but a number of them becomes a trend and we’re of course monitoring that.
Global Bank Stress
John: So, let’s talk a little more about the current global bank stress. This started with the failure of Silicon Valley Bank (SVB) on March 10th. In layman’s terms, this was triggered like an old-fashioned bank run, though nobody had to stand in line to get their deposits since money transfer happens quickly on electronic devices. Deposits quickly left the bank just before collapse, likely caused by a tight knit network of venture capitalists at SVB. It’s likely somebody got wind that the bank didn’t do a very good job of matching deposits to loans and therefore set up doubts that customer deposits were safe. FDIC insurance only covers up to $250,000 per depositor, per registration, and a good portion of these deposits were well over that FDIC threshold. So, in fear of possibly losing that money, customers quickly moved their money.
Over the past few years, SVB had quickly grown their deposits and, because interest rates had been so low for so long, those leading SVB extended their investments out too many years on the yield curve. This extension over the years was aimed at gathering just slightly higher interest rates by locking in longer-dated bonds (5-20 years for example). Then, when interest rates rose sharply in 2022, those bonds lost value; the longer the bond the bigger the loss. So, when the bank run occurred, SVB was forced to liquidate many of their investments at sharply lower prices and then subsequently fell short on ability to meet their obligations.
Source: Bloomberg & https://twitter.com/biancoresearch/status/1639004727001358339/photo/1
Emphasis (red circle) applied by Stone House.
Bob: I’ve been doing this for over 25 years now, these are the things we talk about in our investment committee meetings while we’re managing portfolios for our clients. And although the specific set of things happening in today’s markets are unique to today… there does tend to be some common threads that occur over time. One of those that we talk about in our investment meetings is what we’ve been seeing now with the dramatic rising rates. In short, any time you see a substantial move in a very short period of time, that is an outlier or an anomaly, compared to how that particular data point moves during normal times, it almost always has a ripple effect. Knowing that rates have been climbing in an unprecedented way, it makes sense that certain industries will need to adapt; and the one that’s in the headlines right now is the banking industry.
John: There are many layers to the banking issue, and it is likely to be some uncovered in the future until things fully stabilize. The largest banks here in the US, those like JP Morgan, Wells Fargo and Bank of America, have been undergoing stress tests post 2008 to make sure they can handle upsets in the economy. Those smaller and regional banks like SVB did not have the same regulation. But there has been some discussion that even if SVB was stress tested, they would have passed. That’s because the stress tests don’t include bond duration; something I’m guessing we’ll see changed. In addition, lending standards and bank health are not the same globally as Credit Suisse had been rumored to have had issues for many years until they finally were bought by UBS. The Swiss government basically mandated the buyout to bring ease to their sovereign banking system. One of the side effects of this current crisis is that it’s likely to tighten financial conditions further – which is what the Fed is trying to do to lower inflation. So, while the Fed may pause rate hikes soon, it’s possible that banks, especially regional banks, with less lending could help the Fed with a lower inflation rate. In general, less lending is less inflation due to taking money out of circulation. If we take a look at the chart below, we see that credit standards generally tighten and peak just before or during a recession. We’ve seen quite a rise in this measure lately leading to those wondering if that recession is around the corner.
Recession
John: Now we’ve talked about the word ‘recession’ a few times in the past year or so. I think most investors know in general what it means, John, but can you put a little bit more definition behind it so people get an idea of what we in this industry are referring to?
A recession is defined as two quarters of shrinking output and is normally delayed in knowing its existence due to a huge amount of aggregated data. The decline in 2022 of stocks was not associated with a recession but odds of one coming have been rising with the new wrinkle of banking stress. As previously mentioned, many market forecasters use the inverted yield curve as one way to predict. From this we see an elevated risk of recession in 2023-2024. Normally the latter part of a bear market is associated with this recession and company earnings are revised down about 10-15%. We haven’t yet seen those earnings revisions as employment and demand have remained relatively resilient.
Source: Board of Governors of the Federal Reserve System (US) - fred.stlouisfed.org
Emphasis (red circle) added by Stone House.
Emphasis (red circles) added by Stone House.
Employment Rates
John: Recessions are normally not associated with solid employment prospects and that’s a place where the economy has remained quite strong. There are likely some structural reasons helping the unemployment remain so low such as a reduced labor pool with the huge number of recently retired baby boomers and lower birth rates. Many factors are involved, but they’ve led to unemployment being at historically low levels.
Bob: That’s a compelling chart. Obviously, the elephant in the room on that chart is the spike during Covid when most of the country was forced to stay home for a brief time. One thing to keep in mind here’s that almost every country on the globe has a spike like that, so excluding that anomaly, you can see that it didn’t take long to come right back down to the trend line.
John: This is the second part of the Fed’s dual mandate of full employment and price stability (low inflation). It does seem like these are a bit contradictory in that the Fed has mentioned many times that they need the labor pool to soften – a fancy way of saying people get laid off – before inflation will return to their 2% target.
The Next Bull Market
John: With all that said, it’s likely the next bull market will be forming as we get to the later part of 2023. That’s because any excesses in the system are likely to be flushed out and the Fed will be able to return to a more normal monetary policy (lower rates if we achieve lower inflation). It’s rare for stocks to have back-to-back negative years. They do happen but are normally characterized by what’s called a structural bear market. That is a larger negative event where something breaks in market structure and/or the economy—examples shown in the chart in gray were the Great Depression, WWII, Oil Crisis of ’73-74, and the Dot com bubble burst. Other negative years are normally less than two-year events.
Graph Source: (Morningstar as of 12/31/2022. US stocks are represented by the S&P 500 Index from 3/4/57 to 12/31/22 and the IA SBBIU,S, Lrg Stock Tr USD Index from 1/1/26 to 3/4/57, unmanaged indexes that are generally considered representative of the U.S. stock market during each given time period. Past performance does not guarantee or indicate future results. Index performance is for illustrative purposes only. You cannot invest directly in the index.
Emphasis (red rectangle) added by Stone House.
In addition to what is likely better stock news in the future, the bond portion of an investor’s portfolio is earning interest not seen since 2007. We’ve been in a period of ultra-low rates for many years and now a more conservative investor is earning 4-6% on the money markets and bond funds they own. That should help with future market volatility as it’s likely bonds will perform better also after back-to-back negative years in 2021 – 2022.
Our Portfolio Management
John: With all that happening around us, how are our portfolios positioned and what changes have we been making?
We’ve been running a reduced stock concentration in our core portfolios for almost a year due to the heightened risks around us. We have pre-defined circumstances we’re looking for before returning to our target stock allocation but haven’t reached them yet. Our flex portfolios moved out and back once this past quarter and we’re in the stock market with that active sleeve of stocks as we finish the quarter.
In our core portfolios we eliminated our inflation hedges as we’ve seen the path of inflation look more favorable. While it’s higher than the Fed’s 2% target, it’s trending in the right direction. Our inflation hedges such as inflation linked bonds and commodities generally work best in a rising inflationary environment vs. falling which is why we eliminated them. We also increased our tech stock allocation on our Diversidex® Platform as that sector has been perceived so far as a “safe haven” and we’ve seen money flow into it even during periods of stress in the banking sector. We’ve also further increased our international stock allocations since they currently have a more favorable valuation vs. US stocks and the dollar strength has abated. A softer US dollar value vs. other global currencies generally favors stock outside of the US. In addition, we’ve raised the quality of both stocks and bonds. An example of this for stocks is a reduced small company exposure in favor of larger companies with focus on healthy balance sheets (less debt as rates continue to be high). With bonds, we reduced riskier areas such as emerging markets and short-term high yield bonds in favor of US treasuries in case we see banking stress continue.
Our platforms continue to be positioned for what we see as a “late cycle / recessionary” outlook. We will adjust positions as new data unfolds.
If you have questions about your portfolios or our positioning, please contact your advisor.
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Previous Video Market Updates
*These videos reflect the trends and worldly events taking place at the time of filming.*
Quarter 1, 2023
Quarter 3, 2022
Quarter 2, 2022
Quarter 1, 2022
Quarter 4, 2021
Quarter 3, 2021
Meet the Stone House Advisor Committee
Your Experienced Team of Financial Advisors
Robert J. Brown, CFP®
Partner
Raymond "Scott" Stone
Partner
John Burke
Partner
Kirk Lunger
Partner
Christine Slusark
Financial Paraplanner
Sherri Roberts, Qualified Professional™
Financial Paraplanner
Barbara Grimaud, Esq.
Lead Advisor
Chad Taake
Lead Advisor
Ben Robinson, WMS℠
Advisor
Ryan Vassil, WMS℠
Advisor
Mike Cravath, WMS℠
Advisor
Have you tuned in to our weekly video podcast, Blue Collar Wealth Presented by Stone House™?
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