1st Quarter, 2023
Risks associated with regulatory disintermediation need to be examined.
THE MARKETS
Global financial markets continued to follow a pattern of heightened volatility during the first quarter of 2023. An unusually broad spectrum of economic growth forecasts, varied corporate earnings guidance and reactions to interest rate volatility were dominant themes and contributed to the unsettled environment. Sector returns reversed trends from 2022: technology, up 21.8%, lead the way and energy, down 4.7% was second worst, only outpaced on the downside by financials, which lost 5.6%.
The US dollar, which peaked last fall, moved modestly lower, largely in response to higher global policy rates.
In credit markets, the pendulum of sentiment swung sharply from the hope that Federal Reserve (Fed) policy might be near the peak of the elusive new neutrality to the fear that the Fed’s determination to quell inflation implied greater and more persistent rate increases. The battle of these two extremes played out repeatedly and often on an intra-day basis. To say the quarter was marked by high volatility is an understatement.
The last two weeks of the quarter heralded the hatching of a black cygnet in the form of largely unanticipated distress in the banking sector. This sidelined most previous market concerns about earnings and inflation and unleashed a tsunami of global financial risks, featuring old-fashioned bank runs, closures, insolvencies, and shotgun mergers of major financial institutions. The warp speed transmission of these events opened eyes to the virulence of disruptive news in the digital age, which can unleash new market turmoil with great efficiency.
Despite many challenges, the world’s major central bankers and political leaders appear resolute regarding the imperative of global financial stability. However, their determination is not immune to countervailing forces from significant sums of speculative capital, a meaningful amount of which is outside the realm of regulatory supervision. Speculative trading may well put additional pressure on some local and regional banks by disrupting their historic sources of deposit funding. However, we note that the Fed has other tools such as margin regulation, which can be employed as necessary to dampen excess leverage if it is used in speculative fashion against traditional financial institutions.
Following the collapse of Silicon Valley Bank (SVB) and the Swiss government-forced merger of Credit Suisse into Union Bank of Switzerland (UBS), both equity and fixed income markets have fixated on credit risk, looking for the next shoe to drop. Notwithstanding the assertions of central bankers and political leaders that global financial stability remains strong enough to weather the storm, we expect to see more speculative challenges to their actions and thus continued market volatility. The release of first quarter corporate earnings results and inflation data could provide some dispersion to market sentiment, which would hopefully temper volatility.
Tighter credit standards emanating from recent bank failures, in conjunction with rates staying “higher for longer,” dampen growth prospects. We believe that prevailing risks are not fully priced-in at current market levels, which implies that investors would be well served by standing fast.
THE ECONOMY
Economic growth forecasts are being updated with increasing frequency as central banks continue to pursue inflation containment policies. At this writing, 65% of economic forecasters predict a recession in the US before year-end 2023. The Conference Board’s most recent survey suggests that the economy will continue to weaken at an increasing rate with the expectation of the US entering a recession in the third quarter of 2023 and returning to a growth phase by the second quarter of 2024.
Although economic growth has been stronger than expected so far in 2023, forecasters have only pushed back expectations for the onset of recession by about 3 months. Thus, 2023 economic growth will come in a bit stronger than earlier forecasts. While the economy is still technically expanding, overall growth in 2023 is now estimated at just 0.7%, and the recovery in the second half of 2024 is only expected to produce about 0.9% growth in 2024.
The impact of recessionary forces and the timing and strength of a subsequent recovery will be complicated by 2024 being a presidential election year. A Republican House will have scant motivation to initiate major spending programs resulting in ongoing fiscal drag in 2024. Simultaneously, we will have to watch the progress of the Fed in its efforts to cap inflation at 2% and achieve the new neutral rate. Historically, the Fed has been loath to tighten monetary policy as an election nears. If inflation remains elevated, it may have no choice but to leave restrictive rate policies in place.
There are too many unknowns at play to predict a textbook post-WWII recovery. Geopolitical shocks can swiftly arise from the Russian aggression in Ukraine, Chinese ambitions on Taiwan, or regime change in the Middle East. Contradictory energy policies can cause energy disruption, which in its mildest form will be inflationary. Additionally, the persistence of inflationary forces outside the US suggests that non-US central banks will pursue tight monetary policy longer than the Fed.
From a global perspective, the expectation is that China, in its post-COVID recovery, will lead global growth with 5.3%, other ASEAN growth should reach 3% plus, while Europe and the US will likely exhibit similar recessionary characteristics depending largely on the success of their efforts to anchor inflation. Latin America is likely to remain constrained by deficits and inflationary pressures.
In the US and Europe, corporate earnings will remain under pressure but may vary considerably by sector. Energy and technology should fare better, while consumer driven sectors will be buffeted by changes in sentiment and its impact on the propensity to spend beyond food, clothing and shelter, i.e. entertainment and leisure. Banks, facing new regulatory challenges, will have to pay for the costs of the industry's failures, pay up for deposits, and endure tighter lending criteria.
INVESTMENT STRATEGY
Maintaining fixed income portfolios of very short duration for the past several years has served clients well in the face of a rapidly changing interest rate environment. The strategy has provided liquidity and a rising stream of income.
Although a new equilibrium level of rates is highly uncertain, progress toward it has been meaningful. As a result, we consider it prudent to extend durations cautiously. We expect inflation in excess of the Federal Reserve’s target to persist, perhaps into 2025, but observe that their diligent efforts are starting to bear fruit.
The recent banking turbulence and heightened fear of recession have contributed to a widening of credit spreads. This provides an opportunity to enhance portfolio yields by use of high-grade corporate bonds while also being compensated for the increase in credit risk over Treasuries.
The present environment for equities remains challenging, with multiple factors holding sway over investor sentiment. Markets are continually being tested by large pools of capital using derivative strategies whereby a small sum can be used to trigger a long tail response in the underlying equity. Recent market activity in Deutsche Bank shares is a case in point. Following the insolvency of Silicon Valley Bank, the forced merger of Credit Suisse and UBS, and the global selloff in the banking sector, a market participant targeted Deutsche Bank as being the next to fall. Using an outsized derivative trade, the movement appeared to trigger broader fears and the listed shares dropped by nearly 15%. This prompted an aggressive response by the German government, whose strong defense of the bank helped the shares to rebound. Such speculative activity is unhelpful to long-term investors and illustrates the kind of behavior that leads us to maintain our strategy of standing fast in well-capitalized and well-managed businesses that generate significant free cash flow.
Over the past year, market sentiment has been particularly mercurial. Concerns such as the Ukraine war, the slide of the dollar, the debt ceiling deadline, declining Treasury receipts, the effect of interest rates on autos and housing and the increasing odds for a recession in the second half of 2023 are swirling but are not fully priced in. Thus, market risk and continued volatility remain on the table.
The stocks of high-quality companies are not immune to a litany of risks that are compounded by market and economic uncertainty. However, this can be viewed in a positive context - good entry points are created by difficult markets. We remain focused on companies with durable businesses, financial strength, excellent management teams and the ability to generate strong cash flows. Companies with above average dividend growth are particularly desirable for their ability to protect and grow the purchasing power of our clients’ portfolios.
RISKS ASSOCIATED WITH REGULATORY DISINTERMEDIATION NEED TO BE EXAMINED
One of the consequences of the prolonged period of cheap and easy money has been the gradual growth of a shadow banking system, in which the regulatory touch is either light or nonexistent. Following the Great Recession and subsequent enactment of the Dodd-Frank Act in 2010, a new and significant regulatory regimen was established in the US and several other G7 nations. The objective was to enhance identification and monitoring of banks deemed systemically important to the health of the banking system and economy as a whole. At the same time, government, through the Treasury and Federal Reserve, embarked on a cheap money policy with the objective of economic stabilization and reorienting GDP growth. Out of these spigots came trillions of dollars of cheap money, which in turn was used in many ways to enhance financial leverage.
Over time, numerous non-bank financial firms came into being, focused on financial engineering to generate so-called excess returns. Typical deals utilized minimal capital to support leveraged transactions. When funding was cheap, leverage went up, and with it the financial risk to many of these new ventures was heightened. Demand for this type of capital grew much faster than what could be provided by the regulated banking industry, thus we experienced a boom in unregulated shadow banking.
Now that our economy is transitioning to a more normalized cost of capital, we are facing a tale of two cities: one where the risks subject to strict regulation are reasonably well grounded and the other where risks can easily be shrouded in opacity.
Thus, we now find ourselves with a growing category of risk, namely pools of assets with leverage employed, in which that leverage is often not readily apparent. Although risk can be transferred, it remains real. Shadow banking has caused a disintermediation of capital, which has been disruptive and in most cases is well beyond the grasp of those charged with maintaining capital adequacy in our financial system. A good forensic examination of shadow banking now may well prevent the arrival of a future Black Swan migration.