Written by: Cliff Corso | Advisor Asset Management
Watching the sharp ups and downs in interest rate moves during the 1st quarter (Q1) certainly could cause some neck pain and dizziness; the classic symptoms associated with whiplash. Why the whiplash? A crash occurred in the regional banking sector jolting the markets causing the Fed to rush in and perform triage to stem the hemorrhage of deposits bleeding out of the regional banking system before the sector reached cardiac arrest.
Ironically, it was the Fed’s higher rate medicine that caused neck-snapping volatility as higher Treasury yields caused the retirement of “TINA.” This encouraged a flood of outflows from near-zero rate bank deposits, which then caused regional banks to sell underwater held-to-maturity assets to meet those redemptions. As fear of a systemic run on banks grew, the Fed quickly applied a tourniquet to reduce the “swelling” expectations of systemic economic shock. The combination of the Fed injecting liquidity into the bank system and the market’s recalibration of slowing economic growth also alleviated the “swelling” expectations of a possible 6% Fed Funds terminal rate which was being priced in earlier in the quarter. In response, Treasury yields spiked and then plummeted the most in 35 years. The 2-year Treasury rate — a maturity sensitive to Fed Funds expectations — started the year at 4.4%, peaked at 5.05% on March 7 and plummeted over 123 bps (basis points) 10 days later to 3.81%. As of this past Friday, that rate still sits close to 4% as fears over recession now begin to grow.
To put it all in perspective, the speed and amplitude of the rate move we saw was the largest since the “Black Monday” stock market crash of 1987.
Equities reacted a bit more tamely but were not completely immune as they were being jerked up and down by the rate moves and systemic fears. Although finishing the quarter up 7%, the S&P’s ride was also non-linear. After starting off January up 6% on hopes of a Fed pivot to lower rates in 2023, a blowout jobs report for January caused a repricing of the Fed rate path higher in February thus knocking the S&P down 2%. This quickly reversed course as the regional bank crisis rapidly unfolded when Silicon Valley Bank (SVB) and Signature bank went bust the weekend of March 11. The Fed’s action to stem the crisis by way of the quick injection of a multi-billion-dollar liquidity facility for banks and guarantees of all of SVB and Signature Bank deposits calmed the markets and led to another recalculation of the Fed’s path once again, toward a pivot lower. The drop in rate expectations helped propel stocks back up. Growth stocks swung in tune with rate moves but at a higher amplitude than the S&P with the Nasdaq rising, falling and rising again and ending the quarter up 17%. Looking at the quarter, we find the dramatic move to lower rates and higher move in stock prices incongruent.
While the banking crisis has been calmed for now, we caution against relying on a continuation of the leadership trends witnessed in both equities and fixed income (particularly the growth besting value trade in stocks). In our judgement, assuming a continued blind rally in equities built on the expectation of a quick and durable pivot toward lower rates misses the bigger point; a pivot lower would highly probably only accompany a recession or worse, a much wider and deeper systemic risk to the economy. This would not be the condition supporting current earnings or elevated P/E (price-to-earnings) ratios. The other key point is that even in a mild recession it is likely, in our view, that inflation continues to remain sticky, which handcuffs how aggressive the Fed can be in lowering rates before it needs to begin the next rate increase. At a minimum, this is a recipe for continued market volatility. Our market outlook remains that we will face a recession this year, which view is only further strengthened in our minds by the additional contraction of credit we see borne from the regional banking crisis. Below, we outline our asset allocation strategy in light of the events this year and given the additional information learned in Q1.
What’s New? The Fed Tightened and Something Broke
There has been a key change in information since the start of the year. We now know the Fed’s rapid rate rise began to break the regional banks. The aftermath will result in tighter credit conditions and the possibility for more systemic strain implying a major recalculation for Fed policy. In January the Fed was most concerned with inflation and a resilient jobs market stoking the heat in wages. Now, Fed policy needs to contend with both financial system stability and inflation. This is a complex calculus and Fed Chair Jerome Powell is among the first to admit it. While the crisis has calmed, the reverberations in terms of reduced lending and increasing regulation will further throw a wet blanket on the economy. How much will this contribute to a potential recession and lower inflation? On the former point we believe it is meaningful as small and mid-size banks make up over 50% of the lending in the U.S. On the latter point (inflation), it is helpful, however, our view is there are secular forces that will keep inflation at or above 3 % for years and forms the continuation of our Regime Change thesis. These pernicious secular forces include a systemic labor shortage due to aging demographics (Friday’s jobs report still shows average hourly earnings up 4.2%), slowing globalization, supply shortages in energy, select metals and commodities among other inflation drivers.
What else is new? We are nearing terminal Fed Funds Rate. “Hike & Hold” still our view but at a lower terminal rate than expected in March.
On a positive note, the second thing that’s “new” as we end the quarter is that the real Fed Funds rate is getting close to positive (it already is positive if we use the Fed’s preferred measure of Core PCE (Personal Consumption Expenditures)). During March, Forwards priced in a terminal rate close to 5.75% staying there until early 2024. Now, Forwards show a peak of 5% with a first cut of 25 bps in Q2 of this year followed by further cuts. We agree the Fed is almost done. Where we still differ from the market is how quickly and forcefully the Fed might pivot and how long they might keep rates low. We will see, but in this regard “good news” on the economy is likely bad news for the markets as it would allow aircover for the Fed to hold rates higher for longer. To recap, we do believe there is a possibility for one more hike and the Fed “Hikes in May and Goes Away” but that a pivot may be further out toward later in the year. But, our key point here is that the real Fed Funds rate will finally be positive which is needed to achieve a meaningful reduction in inflation.
CPI=Consumer Price Index
A Sharp Economic Slowdown/Recession is Likely.
The Fed’s recent forecast shows they expect annual GDP this year will be barely positive at 0.4%. According to the Atlanta Fed’s GDP Now forecast, the first quarter is expected to clock in at an annual rate of +/-1.7%, as of this writing. Following simple math, going forward, zero or negative growth would need to occur to land close to the Fed’s forecast. The Fed has been clear it needs economic activity and the hot jobs market to slow for inflation to drop meaningfully. The economy has remained resilient due to a “consumer cushion” of excess savings and increased borrowing but a softening jobs market, tightening credit and higher rates will likely exhaust that cushion in the next two quarters.
Implications for Asset Allocation
Taking a step back, our view of the bigger picture has not dramatically changed. The Regime Change borne by sticky inflation that lingers for longer and a Fed that has now gone further and faster brings us to a new phase as the dramatic rate increases from 2022 begin to bite and the Fed nears completion of rate increases. Our not-too-pleasant thesis of a Fed tightening until something breaks has now put the Fed in a tougher position. While that contributes to the narrative of completing the rate increases, the job of killing inflation is likely not done. Holding here as long as they can is likely their modus operandi now. But that likely will be tested heavily as the economy slows and certainly so, if systemic risk rears its head again. If that forces a pivot quickly as the market now has priced in then the question is, “Will inflation remain even higher down the road (‘stop and start’ scenario)?” If they hike and hold, do they risk more “breakage” and further unintended consequences? The market is pricing in a pivot at the risk the disinflation journey lasts another cycle. There still is a wide range of uncertainty but what is clear is that we should expect volatility to remain elevated for the balance of the cycle given the complex dynamics borne from the regime change we have been talking about for the past two years.
The three investment themes we created at the end of last year were meant to be a durable guide on how to position for this next phase of the regime change. We believe these themes remain germane, by design. And with the recent rally in equities — and particularly strong rally in growth stocks — we suggest this is an opportunity to act on repositioning portfolios toward resiliency throughout the next phases of the regime change.
As a reminder, our core three investment themes are:
- Mitigating an Era of Elevated Volatility
- Expect continued volatility, muted returns.
- Overcoming Persistent Inflation/Higher rates that “Linger for Longer”
- Inflation remains sticky – at a 3–4% level this year/the Fed is finally near its terminal rate of 5–5.25%.
- Mitigating the Impacts of a Slowing Economy
- Fed tightening leads to an economic stall, U.S. dollar ultimately weakens.
We believe the key focus to creating resiliency in portfolios is to emphasize quality, cashflow/income generation and predictable sources of return (such as dividend payers and growers), portfolio diversity (e.g., international markets which have a much bigger margin of safety in valuations) and active management. Within fixed income, we believe allocating to shorter maturities which represent the peak of the yield curve, exhibit lower rate volatility and where one is “paid to be patient.” Here are a few additional thoughts and considerations:
Active Management and Sector Selection Matter — Equites Remain “Rich” with a Slim Equity Risk Premium
Equity indices are still rich in the context of a slowing economy, elevated P/Es and higher interest rates:
Past performance is not indicative of future results.
We believe that a slowing economy will challenge earnings and result in the potential for lower stock prices. But, below the index level we see opportunities.
It is now “A Market of Stocks, Not a Stock Market”
Today, a simple allocation to broad index exposure with generic market Beta may leave portfolios concentrated and exposed. When rates were rallying over the last decade, a blunt index allocation worked as P/E ratios expanded along with lower rates and “everyone was a winner.” Conversely, it is important to point out that while the S&P 500 is up 7% this year, the return has been dominated by a few large cap growth stocks. If we correct for this concentration, the average stock is up only 1%. In addition, if we simply remove the top 20 names from the S&P 500 (which is heavily tech weighted) the resulting forward P/E drops from an above-historical average of 18X much closer to historical averages. So, active management below the surface of the index can help position for better returns.
To emphasize, the strong rally in long duration stocks on the hope yet again, of a pivot to lower rates seems misplaced as an actual pivot would likely be the result of an economy in recession, earnings dropping and volatility increasing. History also shows that thin leadership is a hall mark of a late cycle and results in a fragile market compared to a market with wider breadth of stocks participating.
Favor Value Over Growth
This consideration remains in line with our expectation of stickier inflation and rates along with higher volatility in markets. We favor steady and current cashflow generators which is a characteristic of the value sector. Emphasize quality companies and steady dividend payers. There is “value in Value” as the margin of safety in the Equity Risk Premium (ERP) of value is much greater than for growth stocks as illustrated by the chart below (white line shows ERP for Value is well above historical average vs Growth):
Source: AAM, Fact Set. 10-year ERP for Russell 1000 Growth vs Value (earnings yield vs 10-year Treasury) | Past performance is not indicative of future results.
Here we can see, the ERP for Growth (blue) is significantly compressed at 1% and below its 10-year average of 3% while the ERP for Value (orange) is closer to 4% (nearly 4x the cushion vs Growth) and close to its 10-year average of 4.6%.
In sum, we believe last quarter’s rally is an opportunity to reposition portfolios to create better outcomes in the New Regime. The heightened volatility is also a reminder that building in resiliency can help cushion a portfolio against whiplash markets and provide the necessary buoyancy and dry powder to take advantage of opportunities we will see emerge as we move through the balance of the year.
Related:A Macro Regime Shift Requires a Portfolio Allocation Shift