Investment Update Q1 | 23
Q1 Investor Letter
Following a year of broad-based declines across virtually every asset class, equity and fixed income markets recovered in the Q1 with the S&P 500 Index advancing 7.5% and bonds rising close to 3.0%.
Labor market resilience, a marked drop in interest rates and expectations that the Fed might pause and could reverse its aggressive tightening policy all contributed to a more constructive posture during the quarter. Even the riskiest assets participated, with bitcoin turning in the best performance across assets during the period, rising 68% to $28,013, though still down over 50% from the November 2021 high.
In terms of style, large-cap dominated with the S&P 500 Index outperforming its equal-weighted counterpart by 500 basis points during the quarter and the Nasdaq 100 Index advancing close to 20% - sharp rebounds in beaten down tech stocks including Apple (up 32%), Microsoft (up 20%), Nvidia (up 94% and Facebook (up 69%), powered these gains. Growth outperformed value as did consumer discretionary, technology and communications services stocks while more defensive names in healthcare lagged. Financials declined as heightened concerns surrounding the stability of the banking system following the collapse of Silicon Valley and Signature Bank chilled sentiment.
On a regional basis, US and international equities turned in comparable performance with Europe outperforming both Asia-Pacific and emerging markets.
Currently, the S&P 500 Index is trading at 17.7 times the current 12-month forward earnings forecast, representing an earnings yield of 5.6%. This compares to the ten-year treasury yield of 3.3% and implies an equity risk premium of 220 basis points, lower than in recent years but above the long-term average of 160 basis points; a reversion to the long-term average would suggest a fair value of around 20 times forward earnings and a near-term price target of 4692 for the S&P, 14% higher than current levels.
Credit Markets and Inflation
Over the past year, credit markets have been roiled by both a concerted effort to reduce the money supply as well as a series of aggressive rate hikes that reversed a long period of policy accommodation.
Money Supply (M2) Hasn’t Contracted Since 1960
Effective Fed Funds Rate (%)
The Feds efforts to contain inflation follow not only a period of monetary policy accommodation but extreme fiscal stimulus designed to mitigate the negative impact of pandemic-related disruption. These twin forces drove inflation to its highest level since the early 1980s.
Rising interest rates increase the cost of borrowing, dampen growth and reduce demand which should lower inflation over time. Recent trends suggest that inflation is indeed moderating - CPI peaked at 9.1% in June 2022 with most recent readings trending below 6.0%. At the same time, commodity costs have fallen with crude oil down 30% over the past year, natural gas off 80% and economically sensitive inputs like shipping rates and lumber down between 50-80%.
A Primer on Owners’ Equivalent Rent (OER) and Inflation
Most of us relate to inflation by noting price changes in the things we buy frequently. Changes in food and gas prices, for example, are particularly noticeable because they can be quite volatile month to month and good substitutes don’t generally exist for eating or driving to work. The Bureau of Labor Statistics estimates price changes across 200 commodities in eight major groups mostly by checking prices, calling thousands of retail stores, service establishments and the like to assess price changes in the various market baskets.
Shelter is a little different. This category has, by far, the largest weighting of any CPI basket, accounting for 34% of the Index, about equal to apparel, autos, food and medical care commodities combined. It includes rent and a measure called “Owners’ Equivalent Rent.” This last component accounts for 25% of total CPI and is derived from a survey of homeowners who are asked
"If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?"
That’s how 25% of the CPI is determined. OER is both the most important contributor to inflation and perhaps the most subjective. From our point of view, while the housing market has remained remarkably robust in the face of eroding affordability, high consumer debt levels and record low personal savings rates, we see rate headwinds and general economic malaise dampening optimistic assessments of rent potential, which should serve to reduce inflation further.
The Economy
Real GDP in the Q4 is estimated to have increased 2.6% with nominal GDP up 6.6%. We see growth decelerating in 2023 through 2024 as the moderating impact of Fed tightening becomes more pronounced. Falling commodity prices, a collapse in shipping rates, a PMI reading below 50 and a profoundly inverted yield curve all point to slower growth, if not recession.
Ten-Year Treasury Constant Maturity - Two-Year Treasury Contant Maturity
As shown above, an inverted yield curve has preceded each of the past six recessions since 1980 by an average of 15-18 months. This time around, the curve became inverted in June 2022, suggesting that a contraction in the economy could commence by year-end.
While we see the basis for economic weakness, we think any downturn will be mild. The job market remains strong, wages are rising, though both employment growth and wage gains have moderated somewhat from the torrid pace of 2022. The unemployment rate of 3.5% remains just a notch above the lowest level in over 50 years. Rising service employment, as pandemic-related job losses recover, offset widely reported layoffs in technology.
Consumer spending accelerated in January and February despite record debt levels and depleted savings.
Now What!
The financial sector sharply underperformed the market during the Q1, falling 5.5% and trailing the 7.5% gain in the S&P 500 Index by 1200 basis points. The quarter started off on a positive note - bank stocks rose 7% through February 15th but pulled back as liquidity concerns surrounding Silicon Valley and Signature Bank spread across the banking sector. While we don’t dismiss the potential for further fallout, we don’t see systematic risk spreading in a manner that might threaten the broader economy.
Silicon Valley and Signature Bank each had grown rapidly over the past decade by focusing on niche markets; Silicon Valley emphasized start-up companies - fully 60% of the bank’s $225 billion asset base were made up of loans to small, often profitless companies while Signature, also just shy of $250 billion in assets, carved out a niche serving the crypto community.
Note the asset level - $250 billion is the cut off for more stringent regulatory oversight and we don’t believe it’s a coincidence that these two swashbuckling management teams kept their asset base just below the trigger for greater scrutiny. First Republic Bank, another focus of concern, is at $190 billion.
Clearly, the system failed to detect Econ 101 mistakes; the rapid rise in interest rates caught both management teams off guard. They made long-duration investments in fixed income securities - mostly treasuries, MBS and corporate bonds - when rates were essentially zero; as rates rose, unrealized losses tied to these holdings ballooned, threatening liquidity and ultimately precipitating a bank run that led to their seizure.
The impact of this latest episode of misbehavior will be to drive market share to those Structurally Important Banks (SIBs) whose stronger capital ratios, diversified revenue streams and scale offer greater security and comfort to the many depositors who figured out for first time how unwise it is to have more than the FDIC-insured limit parked a in low-interest checking accounts.
Market Implications
We expect both the equity and fixed income markets to be range-bound over the next 3-6 months as conflicting economic signals drive sentiment. Equity markets are not terribly expensive but in the context of a potential economic downturn, selectivity will be key. With respect to the bond market, we think prices will continue to improve as inflation moderates along with rate expectations though we wouldn’t be surprised to see market expectations anticipating a pause in rate hikes at the next Fed meeting disappointed.
The rapid fluctuations in both equity and fixed income markets, make our style of active management essential. During the course of the past forty years, we’ve weathered numerous bull and bear markets, with the goal of delivering the best risk-adjusted returns for our clients.
During periods of ultra-low interest rates, for example, we did not view fixed income as a particularly attractive area so we looked for high-yielding alternatives like equities or partnerships. More recently, we’ve adjusted our exposure as rates have risen, especially for those clients contemplating retirement; corporate bonds with medium-term duration - 1 to 7 years - can provide a solid 4-6% yield, a far cry from the negative real yields of just a year ago.
While we’re appropriately focused on optimizing returns, we do so while managing volatility and risk. Roanoke’s agility and responsiveness to each clients specific needs, makes us a perfect partner to help you chart your financial journey and achieve your goals. If you’d like to learn more, please contact: clientservice@roanokeasset.com or call (201) 985-1111. We look forward to hearing from you.