Written as of April 14, 2023.
View the Nicola Wealth Investment Returns: March 2023
Highlights this Month
- Mixed messages in the market: Lower interest rates boost tech, but risk perception worsens.
- Credit market shows defensive trend and rising concern for systemic risk.
- Fed rate hikes spark bank failures and depositor runs.
- Identifying potential triggers for the next market crisis.
- Taking a closer look at private equity and private debt.
- The future of monetary policy and its impact on market scenarios.
- Market may be overlooking key factor in Fed rate cuts and stock performance.
March in Review
In March, the markets performed well, and traders were pleased to see positive returns across most asset classes in the first quarter of 2023. Cryptocurrencies, particularly bitcoin, saw significant gains of nearly 70%, while more traditional asset classes such as stocks, treasuries, and high yield credit also had a strong start to the year. However, the U.S. dollar and commodities experienced some losses during the first three months of the year, with the exception of gold which was up, gaining almost 8% in March and finishing the quarter up by a similar amount.
Regarding stocks, most exchanges ended the quarter with gains, but the results varied. Canadian equities had a total return of 4.6% (in Canadian dollars) for the first quarter, although they lost a little ground in March when the S&P/TSX Composite Index fell 0.2%. On the other hand, large-cap U.S. stocks performed better, with the S&P 500 gaining 3.7% in March (in U.S. dollars) and finishing the quarter up by 7.5%. Large-cap tech stocks had an even stronger performance, with the NASDAQ-100 gaining 9.5% in March and 20.7% year to date.
Large-cap tech stocks played a crucial role in supporting the market last month. The equal-weighted S&P 500 index experienced a loss of 0.9% in March, and the small-cap Russell 2000 declined by 4.7%. A chart prepared by the S&P and CPRS shows that only 25% of stocks are outperforming the S&P 500 on a 21-day trailing basis. Strategas also highlighted that a mere 10 stocks, all of which are technology-centric, accounted for 90% of the S&P 500’s return so far in 2023.
The disparity in performance was not limited to individual stocks, as it was also evident at the sector level. The difference between the best and worst-performing sectors was over 20%, which is twice the average seen over the past 20 years.
Mixed messages in the market: Lower interest rates boost tech, but risk perception worsens.
Last month, the technology sector outperformed thanks to falling bond yields. This helped higher duration assets like technology, whose earnings tend to be higher growth and discounted further into the future. With rates moving lower, investors were less concerned about higher leveraged companies. Goldman Sachs highlighted that stocks with weaker balance sheets outperformed those with stronger balance sheets in late March.
However, the market has been sending mixed messages. While higher leverage seemed to be acceptable, investors' perception of risk worsened last month as Bank of America's Global Fund Manager Survey showed a decline in the survey's Financial Market Sustainable Risk Indicator, despite the rise in the S&P 500. Additionally, semiconductor stocks rallied while two-year bond yields and oil fell.
Although semiconductor companies are part of the technology sector, they are considered to be more cyclical than growth/high duration stocks, rising and falling with economic growth. In contrast, falling two-year bond yields and declining oil prices are more consistent with a market worried about a recession. There is a similar inconsistency when comparing the volatility of stocks versus bonds. Stock volatility appears quite tranquil, while bonds tell a different, perhaps more dire story.
Determining the future path for markets will depend on the future path of interest rates and corporate earnings. We will explore these mixed messages and more to gain deeper insights into the market.
Credit market shows defensive trend and rising concern for systemic risk.
To better understand the markets and its message for investors, we can start by looking at the credit market. In March, Bank of America observed that money was moving out of credit and into government bonds and money market, which suggests a defensive trend. Bank of America's Global Fund Manager survey reveals that the "systemic credit event" is now listed as the biggest tail risk facing markets, surpassing concerns of high inflation and hawkish central banks. While recession and inflation remain the top two concerns for credit investors, bank stresses have emerged as a strong third last month.
The market is concerned about the Fed continuously raising rates. Last month, Silicon Valley Bank (SVB) and Signature Bank suffered the second and third largest bank failures in U.S. history, with only Washington Mutual having more assets those banks when it failed during the 2008 financial crisis. Banks typically get into trouble when their loans turn sour, and depositors fear the bank’s solvency is at risk, prompting them to ask for their money back en masse. Depositors at SVB, however, withdrew their deposits in favor of higher-paying money market funds, given the rapid increase in short-term interest rates. In order to make good on their customers demanding their deposits back, SVB was forced to sell some of their government bonds portfolio, which were now under water given the rapid increase in yields. Once it became apparent SVB was in trouble, a bank run quickly materialized. Signature Bank’s story was a little different, but the end result was the same, namely a run on deposits. Private equity manager, Apollo believes over $600 billion in deposits have left the banks since the Fed has started to raise rates. Smaller banks have come under the most pressure, with the largest 25 banks in the U.S. gaining $120 billion in deposits in the days after the SVB failure, while all other banks lost a cumulative $108 billion in deposits.
Fed rate hikes spark bank failures and depositor runs.
There are concerns that more banks could fail due to rising interest rates, but the recent failures of Silicon Valley Bank and Signature Bank were exceptional cases. Most banks manage their interest rate risks well since their basic business model is to borrow short and lend long to earn a profit. However, banks face difficulties when rates move up quickly or when the yield curve is inverted. Banks usually hedge this risk, but the exposure of Silicon Valley Bank indicates a failure in risk management and proper bank oversight by regulators, especially since Wall Street Journal reported that the bank was without a Chief Risk Officer for most of 2022.
While there might be other banks that have mismanaged their interest rate risk, it is unlikely to lead to another financial crisis. However, the events at Silicon Valley Bank expose a future vulnerability for banks in general. Banks earn profits by paying little interest to depositors, but depositors now have choices and technology has made it easier to find higher yields. Banks may lose deposits or have to pay higher yields to retain them, which could put pressure on banks to tighten their lending standards, leading to tighter financial conditions and economic growth slowing down.
According to Strategas, U.S. banks pay an average of 0.37% on savings accounts while money market yields nearly 4.5%. This means banks may need to pay higher yields to keep deposits or face losing them, which could lead to financial conditions tightening. The bad news for banks is typically bad news for the economy and stock market since banks play a crucial role in the availability of credit and borrowing.
Identifying potential triggers for the next market crisis.
One potential area of concern for the next market crisis could be individuals or entities that have taken advantage of low interest rates and have high leverage. This has led to increased interest in commercial real estate and private equity investments. A recent survey conducted by Morgan Stanley indicated that 35% of respondents believe that commercial real estate could be a contributing factor to the next crisis, while private equity and leveraged loans combined totaled 16% of respondents. Although exchange traded REITs have faced challenges, private valuations have declined less depending on the type of property, as Bridgewater highlights.
Higher interest rates have had an impact on the real estate market, with two key effects worth noting. Firstly, the increase in rates has caused valuations to appear more stretched. While rents or lease rates may have also increased, they have not kept pace with the rapid rise in interest rates, resulting in real estate appearing less attractive by comparison. According to MSCI Real Assets, Refinitiv, even commercial apartment properties have seen their cap rate spread over the risk-free rate decline to approximately 1%, significantly below the pre-pandemic average of over 3%. Secondly, most real estate investments are leveraged, and the cost of that leverage has risen. Additionally, the major lenders to commercial real estate are mid-sized firms that are also facing the challenge of tightening lending standards due to pressure on their deposit bases. This pressure is evidenced in the commercial mortgage-backed security (CMBS) market, where credit spreads for triple-B issues have increased, with a Wall of Maturities set to come due over the next several years.
While there are some concerns regarding the impact of rising interest rates on the real estate market, it is important to note that not all types of real estate are affected equally. Investor concerns are primarily focused on office vacancies and declining retail demand. The National Council of Real Estate Investment Fiduciaries reports that while operating income growth for office and retail has declined over the last four quarters, industrial and apartment revenue has remained strong. JLL has also reported that demand for industrial real estate remains high, with 500 million square feet of new construction completed over the last two quarters. It is worth highlighting that despite the increase in interest rates, there have been no widespread defaults on real estate loans to date. Additionally, UBS reports that institutional investors and wealthy family offices are continuing to allocate new funds to both private real estate and private equity, which is encouraging from an investment perspective.
Taking a closer look at private equity and private debt.
Private equity buyout funds have traditionally used leverage as a fundamental element of their investment strategy, enabling them to generate significant returns for their investors. However, the opaque nature of leveraging in the private marketplace has led some managers to use it at both the fund and company levels. Despite valuations in the private marketplace generally lagging those of public markets, private equity remains an attractive option for investors seeking to diversify their portfolios and access potential long-term growth opportunities.
Private debt, on the other hand, is more complex. While Bank of America's recent fund manager survey identified shadow banking as the most likely source of a systematic credit event, private credit is also well positioned to benefit from the reduction in lending by banks. Unlike banks, private debt doesn't have a mismatch in duration between their assets and liabilities, making them a secure source of funds for private debt managers. As lending terms tighten, private debt is expected to benefit from an increase in spreads. However, this assumes that managers have not used too much leverage at the fund level, are able to maintain their leverage, and are not forced to liquidate assets. Even if there are defaults in their portfolio, good managers can prosper from them if they purchased a loan at the right price and have good covenant protection.
In commercial real estate, private equity, and private debt, the skill of the manager is critical in determining the ultimate result for investors, given the wide dispersion of returns in these markets. The difference in pricing between the public and private marketplaces is just one of the many inconsistencies facing investors. It's possible that private markets are just lagging behind public markets and will eventually discount the decline that public markets have endured. Alternatively, public markets could be more volatile, and a new bull market could bring exchange traded stocks back in line with private market valuations.
The future of monetary policy and its impact on market scenarios.
The future path of monetary policy could have a significant impact on determining the outcome of different market scenarios, especially since it appears that the Fed has begun to "break things." The U.S. is leading the way in terms of rate tightening, with overnight interest rates having increased by 475 basis points since September 2021. However, according to Apollo’s Torsten Slok, Fed Funds were effectively pushed 1.5% higher after SVB failed, which the market seems to agree with. Fed Funds futures for January 2024 were trading close to 5.5% before SVB failed, but now trade closer to 4%, indicating that the market is still pricing in much lower rates than what the Fed is projecting. The Fed’s March forecast showed Fed Funds peaking in May at 5.125%, staying there for the rest of the year, but the futures market now sees Fed Funds peaking in June at around 5% and falling to around 4.5% by December (and 4.0% by Jan 2024). This view seems inconsistent unless the market also believes that the economy is headed for a hard landing, in which case the Fed may quickly change course and start cutting rates.
Last month, there was a possibility that only a severe financial crisis could cause the Fed to shift gears and start cutting rates in 2023. The uncertainty in the banking sector was evident through the wild swings in Fed Futures. According to Bloomberg Economics, in an extreme financial stress scenario, they forecast Fed Funds falling 50 basis points by the end of 2023. However, Fed Funds fell 75 basis points at one point in March. Bloomberg Economics points out that the Fed has rarely had to tackle high inflation and a bank crisis at the same time, making it a tug of war between the two. The Fed cannot fight both at the same time, which means it becomes a matter of which will win out.
Powell is focused on reducing inflation, but he is also cautious not to damage the banking system or the economy. Although an inverted yield curve typically precedes a recession, historical data shows that the curve often becomes less inverted, or even positively sloped, before a recession. In early March, 2-year yields dropped almost 50 basis points in just two days, leading to a steeper yield curve. While JP Morgan predicts a 90% chance of a U.S. recession in the next 12 months based on the current yield curve, other financial indicators paint a less severe picture. Credit spreads suggest a 29% chance of a recession, while the S&P 500 predicts a 45% probability. However, if a recession does occur, there is still room for equities to decline and credit spreads to widen. Economists' opinions on the probability of a recession in the next year vary widely, with Bloomberg's estimate at 65% and Goldman Sachs at 35%.
The strategists are keeping their year-end S&P 500 target steady for the third consecutive month, but it's about 3% lower than where the index ended the first quarter, indicating a moderate outlook. Similar to economists' forecasts for GDP, strategists hold differing opinions, with the widest spread between the highest and lowest target in two decades. The same is true for their outlook on corporate earnings, with sell-side analysts' dispersion increasing while the forecasts for S&P 500 2023 earnings per share remain relatively stable since before the banking crisis.
Investors may be ignoring the outlooks of both strategists and economists due to the allure of future rate cuts by the Federal Reserve and other central banks. The market seems to believe that significant rate cuts are imminent, and that this is a signal to buy stocks. According to Zero Hedge’s Simon White, the Fed typically starts cutting rates about six months after inflation has peaked, which he believes happened nine months ago. S&P 500 performance 12 and 24 months after the Fed starts hiking rates is heavily influenced by the pace of hikes, according to All Star Charts. The S&P 500 underperformed during past tightening cycles, and even in the current fast tightening cycle's tail end, it continues to underperform. Fidelity's recent chart shows that the direction of stocks following the last tightening is anything but clear cut.
Market may be overlooking key factor in Fed rate cuts and stock performance.
Strategas provides insights into the direction of stocks after a tightening cycle. The S&P 500 typically increases by 5% over the next 100 days after the Fed stops hiking rates, but falls 3% over an average of 278 days during the period between the first and last rate cut. This period can be turbulent, with an average drawdown of -23.5% over 195 days after the Fed starts cutting rates. Strategas points out that a pause in rate hikes is good for stocks, while a rate cut is not. They use the examples of the Nikkei and Nasdaq bubbles to illustrate this relationship. The Nikkei rallied after the Bank of Japan paused their rate hiking cycle in 1990 but continued to decline after they started cutting rates. The same thing happened to the Nasdaq in 2000. Stocks rallied into the pause, but crashed once the Fed started cutting rates, despite falling 10-year yields. This is an inconsistency in the market as traders are waiting for the Fed to start cutting rates, but they are ignoring the circumstances that would prompt the Fed to cut rates.
The current market environment poses a threat to corporate earnings, yet the market seems to be pricing in an inconsistency. Despite predictions of declining GDP for every consecutive quarter in 2023, quarterly S&P 500 earnings are expected to increase continuously, according to Bloomberg's survey data. The current consensus of S&P 500 earnings for the next twelve months has only been revised down by 1.8% in 2023, yet Goldman Sachs predicts a year-over-year fall of 7% in Q1 and 6% in Q2, with a rebound in Q3 and Q4.
In our opinion, to see a rise in earnings estimates, a soft economic landing and stable profit margins are needed. Large-cap companies in the technology sector, such as Microsoft and Apple, may be the most resilient. Deutsche Bank identified a group of tech-related companies, including Microsoft, Apple, Amazon, Google (Alphabet), Facebook (Meta), Visa, Mastercard, Nvidia, Netflix, Adobe, and Tesla, which have experienced an uptrend in earnings for an extended period. Although these stocks have outperformed the S&P 500 this year, they recently experienced a pullback, which could present an opportunity for investment. Deutsche Bank predicts that these companies' earnings will continue to exceed expectations, maintaining their long-term earnings trend, and potentially performing well as a defensive option if the soft landing scenario fails to play out. In a low growth environment, companies that can still increase earnings will become increasingly valuable.
We feel that investors have become accustomed to bullish conditions and the fear of missing out on the market's best days can make it difficult to step away from well-performing stocks. In fact, according to JP Morgan, investors who missed just the 10 best trading days over the past 20 years saw their total portfolio values 54% lower compared to those who stayed fully invested. Additionally, the timing of the calendar could be in favor of investors. Historically, April has been a strong month for stocks and during the third year in the presidential cycle, the first half of the year has been kind to stocks, according to Carson Investment Management. Furthermore, the S&P 500 has gained over 5% for two consecutive quarters, which has resulted in a positive outcome 20 out of 23 times, with an average gain of 13.5% a year later. Considering these factors, it is understandable why it may be difficult to sell now.
Investors should exercise caution as the S&P 500 has traded within a narrow range since May 2022, but as Bloomberg recently pointed out, this is unlikely to last for long. The market believes that the Fed will cut rates this year, but the Fed disagrees. If the Fed does cut rates, it would suggest that the economy has taken a sharp downturn, leading to a significant decline in earnings estimates. High rates are putting pressure on the financial system, and the Fed seems poised to continue fighting inflation, even if it means "breaking" things. Economists and strategists are divided on the implications of these developments. Despite State Street highlighting the extreme bearishness of the so-called "smart money," the market has continued to move higher. Welcome to the second quarter. Enjoy the ride.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions. All values sourced through Bloomberg.
