January 2024 Market Update: A Swift Rebound in Equity Markets at Year End

1. Global equity markets rallied for the second straight month in December.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The two-month rally was swift and strong. Small cap equities led the way in the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

3. Global equities had an excellent year, led by the so-called magnificent seven U.S. mega-cap stocks. China was the big laggard.

4. From a factor perspective in the U.S. equity market, high beta stocks were the outperformers in December and for full year 2023, while low volatility stocks were the laggards.

These charts show the performance of SPY (SPDR S&P 500 Index ETF in purple), SPHB (Invesco S&P 500 High Beta ETF in green), and SPLV (Invesco S&P 500 Low Volatility ETF in red).

5. Treasury yields declined sharply over the last two months of the year, following the historically unusual bear steepening from mid-July through the end of October.

Source: www.treasury.gov, Two Centuries Investments

 6. As we repeated throughput 2023, what lies ahead for financial markets will likely be driven by the path and composition of inflation.

The concern about inflation has likely contributed to the bear steepening of the yield curve. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2% above pre-pandemic levels.

7. Despite the Federal Reserve raising the federal funds rate by 5% over the last twenty months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

8. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Over the last several months, United Airlines, American Airlines, and Southwest Airlines pilots were able to negotiate approximately 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

9. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy and the multi-month bear steepening of the yield curve.

At year end 2023. high yield bond spreads had settled around 1.5% below long-term averages and well below recent peaks.

10. Overnight reverse repurchase agreements continue to decline. These agreements have served as a source of financial market liquidity. We are concerned financial market volatility may rise once the amount of these agreements outstanding approaches zero.

October 2023 Market Update: The Unholy Trinity Surfaces

1. The global equity market weakness continued in September.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The unholy trinity of rising oil prices, increasing U.S. interest rates, and a strengthening U.S. dollar is pressuring asset prices.

Since July 13, crude oil prices have risen approximately $12 per barrel (14% price increase), the U.S. dollar has risen approximately 7%, and the ten-year U.S. Treasury note yield has risen 83 basis points. In a world accustomed to low-cost energy, dependent on a cheap reserve currency for facilitating global trade, and addicted to low interest rates for financing, simultaneous increases in the levels of these three financial variables is a threat to global economic activity and asset prices. Stocks, bonds, and gold have responded negatively to the rise of the unholy trinity.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), WM (iShares Russell 2000 ETF in grey), GLD (SPDR Gold Trust in yellow), TLT (iShares 20 Plus Year Treasury Bond ETF in red), CO1 (Brent crude oil futures contract in black), TBX (ProShares Short 7-10 Year Treasury ETF in light blue), and DXY (U.S. Dollar Index in green).

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has risen the last two months.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2.5% above pre-pandemic levels. A sticky core inflation rate might compel the Federal Reserve to keep raising short term interest rates in an attempt to dampen economic demand and push inflation back towards its 2% target. More tightening of monetary policy risks a severe economic downturn.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last eighteen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

The Atlanta Federal Reserve Bank’s GDP Now estimate of 4.9% real economic growth for the third quarter 2023 lends credence to the view that GDI will rise to close the gap to GDP.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years. Currently, the UAW (United Auto Workers) is demanding a 46% pay deal and FedEx pilots are demanding a 30% pay rise.

The unemployment rate remains nears its lows over the last four decades.

6. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy.

High yield bond spreads remain near long-term averages, and 2% below the most recent peak of 6% in July 2022.

September 2023 Market Update: Inflation Remains Sticky

1. The global equity market rally stalled in August.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels as food and energy costs have declined.

This chart shows the price of a barrel of WTI crude oil (source: CNBC).

Energy costs appear to have bottomed as crude oil prices have risen $18 per barrel over the last two months, making further declines in headline inflation dependent on the trend in services inflation.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and almost 3% above pre-pandemic levels.

3. Despite the Federal Reserve raising the federal funds rate by 5% over the last seventeen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data points to an economic slowdown.

The Atlanta Federal Reserve Bank’s GDP Now estimate of 5.6% real economic growth for the third quarter 2023 lends credence to the view that GDI will rise to close the gap to GDP.

4. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. Currently, the UAW (United Auto Workers) is demanding a 46% pay deal and FedEx pilots are demanding a 30% pay rise.

The unemployment rate remains nears its lows over the last four decades.

5. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy.

High yield bond spreads remain near long-term averages, and 2% below the most recent peak of 6% in July 2022.

August 2023 Market Update

1. July was the second consecutive strong month for global equity markets.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

U.S. small-cap stocks were the star performers for the second consecutive month.

2. While the year-to-date outperformance of U.S. large cap equities remains intact, U.S. small cap and emerging markets equities have closed the gap over the last two months.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

We would not be surprised if U.S. small cap, non-US developed markets and emerging markets equities continue to outperform U.S. large cap equities. Over the last five years, U.S. large cap has outperformed both U.S. small cap and non-US developed markets by around 50% and has outperformed emerging markets by over 70%.

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate is now only 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains almost 3% above pre-pandemic levels.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last sixteen months, real economic growth has not collapsed, though it remains muted.

According to the "advance" estimate from the U.S. Bureau of Economic Analysis, real gross domestic product (GDP) even picked up from its recent trend, increasing at an annual rate of 2.4% in the second quarter of 2023.

Real gross domestic income (GDI) data for the second quarter is not yet available. The GDI data diverged from the GDP data in first quarter and pointed to an economic slowdown. These data series will converge, the question is in which direction.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. Currently, the UAW (United Auto Workers) is demanding a 46% pay increase deal and FedEx pilots are demanding a 30% pay rise.

Adding to the challenge facing the Federal Reserve is the demand for mortgage loans is contracting at a much slower pace. The rapid rise in mortgage rates in 2022 crushed mortgage loan issuance and appeared to be putting the brakes on housing construction. As housing construction remains an important driver of economic activity, any sustained strength in construction activity will contribute to inflationary pressure.

Lastly, crude oil prices have risen recently. Continued strength in oil prices will put upward pressure on headline inflation, potentially make core inflation stickier, and further complicate the Federal Reserve’s balancing act.

6. Corporate earnings growth in the second quarter 2023, while better than expected, was still the weakest growth in almost three years.

With 84% of the companies in the S&P 500 Index having reported quarterly earnings, earnings declined 5.2% and revenues declined 0.6%, year over year.

7. While most of the world is dealing with inflationary pressures and many central banks are still raising short-term interest rates, in contrast China is facing the risk of a credit crisis and deflation.

This chart shows the People’s Bank of China one-year medium term funding rate versus the U.S. Federal Reserve’s federal funds rate (overnight rate)

China’s central bank, the PBoC, once again cut its one-year medium-term lending facility (MLF) rate, to 2.50% on August 15th, as it seeks to support economic growth weighed down by a deepening property crisis and muted consumer spending.

Country Garden, a real estate developer with $194 billion in liabilities at year end 2022, missed payments of $22.5 million on two of its offshore dollar bonds. Trading in eleven of its onshore bonds was suspended. A default appears to be a foregone conclusion.

China Evergrande, once China’s largest property developer by sales, filed for Chapter 15 bankruptcy in New York on August 17. Its meltdown began in September 2021 and triggered a chain of failures across the Chinese property sector, which is estimated to represent as high as 30% of China’s GDP. We discussed Evergrande in our December update (December 2021 Market Update).

How the Chinese government navigates the real estate crisis bears monitoring for two reasons.

• The Chinese economy is a significant source of demand for commodities.

• Any large depreciation of China’s currency, the renminbi, could have a large impact on global trade and financial flows.

July 2023 Market Update: Strong Equity Rebound Continues...What Lies Ahead?

1. June was a strong month for the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in green).

In June, U.S. equity markets outperformed non-US equity markets. U.S. small cap stocks outperformed U.S. large cap stocks after lagging their larger cap peers since the regional bank crisis in March.

2. Year-to-date trends remain intact, with large cap U.S. equities leading the way and emerging market equities as the laggard, dragged down by China.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in green).

3. The powerful rally in U.S. growth stocks has propelled the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWF (iShares Russell 1000 Growth ETF in blue), IWD (iShares Russell 1000 Value ETF in orange).

Year-to-date, U.S. large cap growth stock universe has generated a 30% return.

4. Year-to-date, other asset classes have provided modest returns.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWM (iShares Russell 2000 ETF in green), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in blue), GLD (SPDR Gold Trust ETF in yellow), and TLT (iShares 20+ Year Treasury Bond ETF in orange).

5. An examination of performance over the last 18 months is a sober reminder financial markets have not fully recovered from the carnage of the first nine months of 2022.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWM (iShares Russell 2000 ETF in green), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in blue), GLD (SPDR Gold Trust ETF in yellow), aTLT (iShares 20+ Year Treasury Bond ETF in orange), IWF (iShares Russell 1000 Growth ETF in red), IWD (iShares Russell 1000 Value ETF in gray).

6. What lies ahead for financial markets will be likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation (and deflation) has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs, thus boosting corporate profit margins.

Producer prices have already declined back to pre-pandemic levels.

Consumer prices have continued to decline but remain around 2% above pre-pandemic levels.

Wage growth remains strong in many segments of the labor market. The stickiness of higher wage growth remains a headwind to profit margins.

7. Global trade volumes are declining and manufacturing surveys point ot continued weakness.

Source: John Kemp (Reuters)

8. Corporate earnings reports for the second quarter are just around the corner. The results and management commentary will provide some clarity on the economic outlook, now that the pandemic related distortion of economic collapse / economic surge / economic normalization is entering the rear view mirror.

The results from early reporter FedEx Corp. (ticker: FDX) were not reassuring. All three FedEx segments (Express, Ground, Freight) experienced volume declines and management is forecasting “flat to low-single-digit-percent revenue growth year over year” for fiscal year 2024.

9. While manufacturing and global trade exhibit sustained weakness, consumer spending on services and most of the service sector have chugged along.

What could disrupt this consumer momentum, outside of the obvious job losses, which is a lagging indicator?

(1) Refinancing risk for loans, especially mortgages, either in the form of higher interest rates (compared to 2021) and tighter bank lending standards, likely driven by the aftershocks of the March 2023 regional bank crisis.

Source: treasury.gov, Two Centuries Investments

(2) Higher energy prices, namely higher crude oil prices.

Source: John Kemp (Reuters)

Crude oil prices remain well below the recent 2022 peak.

June 2023 Market Update: Large Liquid Mega Caps, Large Language Models, and Long Lag Monetary Policy

1. On the surface, May was a quiet month for U.S. financial markets.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), TLT (iShares 20 Plus Year Treasury Bond ETF in green), LQD (iShares iBoxx $ Investment Grade Corporate Bond ETF in red), HYG (iShares iBoxx $ High Yield Corporate Bond ETF in orange), IWM (iShares Russell 2000 Index in blue), and GLD (SPDR Gold Trust in yellow).

U.S. large cap equities, US small cap equities, U.S. high yield debt, U.S. investment grade debt, long maturity U.S. Treasury bonds, and gold all generated returns in a narrow band between +1% and -1% in the month of May.

2. However there was considerable dispersion within the U.S. equity markets.

This chart shows the price performance of IWF (iShares Russell 1000 Growth ETF in purple), SPY (SPDR S&P 500 Index ETF in yellow), RSP (Invesco S&P 500 Equal Weight ETF in green), IWD (iShares Russell 1000 Value ETF in blue), and SPYD (SPDR Portfolio S&P 500 High Dividend ETF in orange).

Growth stocks outperformed value stocks by more than 8%. The market cap weighted S&P 500 Index outperformed an equally weighted index of S&P 500 constituents by more than 4%. High dividend stocks were the worst performing style (factor), underperforming the S&P 500 by over 8% and underperforming growth stocks by over 12%.

This chart shows the price performance of IWF (iShares Russell 1000 Growth ETF in purple), SPY (SPDR S&P 500 Index ETF in yellow), RSP (Invesco S&P 500 Equal Weight ETF in green), IWD (iShares Russell 1000 Value ETF in blue), and SPYD (SPDR Portfolio S&P 500 High Dividend ETF in orange).

The year-to-date performance dispersion is even more stark. Growth stocks have outperformed high dividend stocks by an astounding 32%.

3. Large liquid mega cap stocks remain the standout performers.

This chart shows the returns for the following stocks. NVDA = NVIDIA Corporation; META = Meta Platforms, Inc.; TSLA = Tesla Inc.; AAPL = Apple Inc.; AMZN = Amazon.com, Inc.; GOOGL = Alphabet Inc.; MSFT = Microsoft Corp.

These seven mega cap stocks were under performers for most of 2022. All are also considered beneficiaries of trend towards Artificial Intelligence, the most well known applications being autonomous driving systems and ChatGPT with its large language model.

4. The Artificial Intelligence business opportunity has also been a tailwind for certain computer hardwire providers, including some semiconductor stocks.

This chart shows the returns for the following stocks. NVDA = NVIDIA Corporation; AMD = Advanced Micro Devices, Inc.; SMCI = Super Micro Computer Inc.

5. U.S. equity market valuations look expensive at current levels of economic growth and inflation.

Source: Yardeni Research

6. Real economic activity has remained muted over the last four quarters.

This chart shows the year over year change in real gross domestic product.

The good news is the much ballyhooed recession has not materialized. The concern is real economic activity below a 2% growth rate will not translate to the strong corporate revenue growth needed to offset profit margin pressure, especially with no economic growth tailwinds from China and Europe.

7. Producer prices have already declined back to pre-pandemic levels. Consumer prices have remained stickier and well above pre-pandemic levels. Wage growth remains strong in many segments of the labor market.

A continued decline in inflation will ease the pressure on corporate profit margins. However, lower wages represent a trade-off, namely lower consumer spending but lower costs for companies.

8. The boom in federal government spending is behind us.

The pandemic related federal government spending boom supported corporate profit margins and likely delayed the full impact of monetary policy tightening on the economy.

9. Commercial banks are tightening credit standard for loans. The tightening started before the bank crisis in March and has picked up steam since then.

Tightening credit standards for loans is a lagged impact of tighter monetary policy. It will be a headwind for economic growth.

10. What happens going forward for both the economy and financial markets will depend on the continued emergence of the “long and variable lags” of monetary policy. The fog is starting to lift.

May 2023 Market Update: Bank Stress Takes the Front Page from Inflation

1. Despite the failure of a third large U.S. bank, the U.S. equity market rose in April.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

2. April continued the year-to-date trend of non-US developed market equities leading the way higher, while emerging market equities continue to lag.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

3. While the US equity market has risen almost 10% year-to-date though the end of April, there has been massive performance dispersion within the market.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), XLK (Technology Select Sector SPDR ETF in green), and KRE (SPDR S&P Regional Banking ETF in red).

Technology stock prices have bounced higher, with the sector generating a year-to-date return in excess of 20%. On the other hand, the bank crisis has crushed regional bank stocks, which have crashed by more than 25% year-to-date through the end of April.

4. The regional bank crisis has yet to be resolved, highlighted by the failure of First Republic Bank and its sale at a discounted valuation to JP Morgan Chase & Company.

First Republic Bank was a large regional bank, with $165 billion in deposits as of December 31, 2022.

As we noted in last month’s update, over a two-year period ending in early 2022, many banks experienced rapid balance sheet growth due to an influx of deposits. The banks invested the deposits to earn higher interest income, but took significant interest rate risk in the process. In 2022, the spike in interest rates across the yield curve led to unrealized losses on securities and loans and reduced the capital (solvency) of most banks.

Adding to the solvency concerns for regional banks is rising delinquencies for commercial real estate loans, especially office and retail loans.

On the other side of the balance sheet, the spike in short term interest rates exposes the banks to disintermediation (deposits being withdrawn and moved to money market funds) and to higher funding costs to replace lost deposits. Together, these factors reduce the future net interest income (earnings) needed to replenish the capital.

Worst of all is uninsured depositors who travel in the same personal and professional circles. Silicon Valley Bank (SVB) and First Republic Bank (FRB) had well above average exposure to these “hot money” depositors.

Not only aren’t they “sticky” depositors, they don’t act independently and their behavior is highly correlated. Their risk profile is reminiscent of the subprime borrowers of the 2008 Global Financial Crisis, a group whose default behavior was highly correlated once stress hit the financial system.

Once these depositors initiated large and rapid deposits withdrawals, the fates of SVB and FRB were sealed. Selling a large percentage of assets with unrealized losses crystallizes insolvency. Replacing a large percentage of existing deposit funding, even with Federal Home Loan Bank (FHLB) secured borrowing available, is near impossible and will result in negative earnings for the near term as funding costs will exceed interest on assets.

The chart below, from Moody’s Analytics, shows the banking system funding stress has reached 2008 Global Financial Crisis levels.

The chart below shows the build up of deposits in smaller banks during the pandemic, driven by the massive government stimulus programs, and the recent accelerated decline.

5. Even if the bank crisis gets resolved in the near term, the events of March and April will lead to risk aversion by many banks. Combined with rising credit provisions, banks will continue to tighten lending standards, creating a headwind for economic growth.

Source: federalreserve.gov

Source: federalreserve.gov

According to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, banks have been tightening lending standards on loans since July 2022.

The tightening of credit standards is running into increased demand for loans from U.S. consumers.

6. The bank funding stress has yet to show up in the high yield debt market as credit spreads remain quite muted relative to prior recessions and crises.

7. Corporate earnings season confirmed businesses are still dealing with cost pressures, though the pressure is moderating.

With 85% of S&P 500 companies having reported earnings, year over year revenue growth was a modest 3.9%. However, earnings declined 2.2%, though less than the 4.6% decline in the prior quarter. Operating profit margins are below their recent peak, and have stopped their rapid decline. With companies facing moderating top line growth and a higher cost of capital, the path of profit margins will assume increased importance.

April 2023 Market Update: Bank of Charts, pun intended

1. Despite the failure of two large U.S. banks, the equity market rose in March.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), KBE (SPDR S&P Bank ETF in purple), and KRE (SPDR S&P Regional Banking ETF) in orange.

In March, bank stocks experienced sharp declines as three well known banks failed, namely Silicon Valley Bank, Signature Bank, and Silvergate Bank. Silicon Valley Bank had over $200 billion in assets and Signature Bank had over $100 billion in assets as of December 31, 2022.

Over a two-year period ending in early 2022, many banks experienced rapid balance sheet growth and increased interest rate risk to earn a higher return. The spike in interest rates in 2022 led to unrealized losses on securities and loans and damaged the solvency of most banks.

That said, Silicon Valley Bank was an outlier and will serve as a case study on how not to do interest rate risk management.

To the extent the banks do not experience a rapid rise in credit losses, akin to what happened during the Global Financial Crisis of 2008, a banking crisis is highly unlikely. Most banks can access financing from the combination of the capital markets and the Federal Reserve as they deal with the unwind of rapid deposit growth.

Source: Bloomberg

The current decline in bank deposits and corresponding rise in money market fund assets looks like a replay of the late 1970s / early 1980s.

Source: @MaxfieldOnBanks, The San Francisco Examiner - December 27, 1981

2. Certainly, the events of March will lead to higher financing costs for banks. Combined with rising credit provisions, banks will continue to tighten lending standards, creating a headwind for economic growth.

Source: federalreserve.gov

According to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, banks have been tightening lending standards on Commerical & Industrial loans since July 2022. Even more severe has been the tightening the Commercial Real Estate loans.

Source: federalreserve.gov

After a period of decline from the pandemic peak, commercial mortgage loan delinquency rates have started to creep up. The special servicing rate (loans that have been modified due to default) has been rising since mid 2022.

This chart shows delinquency. special servicing, and grace rates for CMBS (commercial mortgage-backed securities).

The delinquent loan rate has started to rise before the outstanding balance of delinquent loans returned to pre-pandemic loans.

3. Despite some signs of stress in the loan market, the high yield debt market remains sanguine. Credit spreads remain below the the highs of 2022, and well below crisis peaks.

4. The yield curve has become more inverted since the beginning of the year, signaling increasing concerns about future economic growth.

Source: treasury.gov, Two Centuries Investments

5. U.S. manufacturing activity is already contracting. Manufacturing output is more volatile than service sector output and typically leads the services sector.

ISM Manufacturing PMI (Purchasing Manager Index)

Source: March 2023 Manufacturing ISM® Report On Business®

New orders remain weak.

ISM Manufacturing PMI: New Orders component

Source: March 2023 Manufacturing ISM® Report On Business®

6. China’s manufacturing activity is rolling over, a surprising outcome given China only fully reopened its economy late last year.

The weakness in both US and China manufacturing activity is concerning.

7. Inflation continues to decline and is currently running at a 6% annual rate after peaking at 9% in mid 2022.

The big unknown is whether the decline in the inflation rate will continue to be symmetric to its rise. We suspect it will be over the next few months, but are concerned the rate will plateau near 4%.

8. A continued moderation in inflation will benefit businesses who have faced declining profitability during the recent two year period of above historical average inflation.

March 2023 Market Update: Waiting Patiently

The title says it all. We are waiting patiently for more data, especially inflation data. Inflation has peaked, but its rate of decline has slowed, and where it settles is what matters most.

1. February was a weak though uneventful month for global equity markets.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

2. Corporate earnings season confirmed businesses are still dealing with cost pressures.

With 99% of S&P 500 companies having reported earnings, year over year revenue growth was solid 6.3%. However, earnings declined 4.6%. Profit margins declined in eight of the eleven sectors. The energy, industrials, and real estate sectors were the three exceptions.

3. The tightness in many segments of the labor market will continue to be a headwind for profit margins. Our bigger concern is the Federal Reserve’s reaction function if inflation remains sticky above a 4% level.

On March 1, Minneapolis Federal Reserve Bank President Neel Kashkari commented, "I think my colleagues agree with me that the risk of undertightening is greater than the risk of overtightening”.

If the Federal Reserve resumes more aggressive monetary tightening, the risk of a policy error will jump and a recession in the near term will be the likely economic outcome.

February 2023 Market Update: Stranger Things (in the U.S. Equity Market)

1. The composition of the U.S. equity market performance in January qualifies as one of the stranger things I have seen in my career.

In January, the U.S. equity market market rose 6.3% (as proxied by the S&P 500 Index). I wasn’t surprised risk assets started the year with a strong upward bounce as the U.S. equity market declined 18.1% in 2022. Nor was I surprised high beta stocks outperformed low volatility stocks after underperforming low volatility stocks by 15.7% in 2022, though the degree of outperformance, by 19.3%, was a bit surprising. Some mean reversion was likely for both the market overall and for underlying equity factors. Risk on.

What was “Upside Down”, given the aforementioned mean reversion in both the overall market and high beta vs. low volatility, was the lack of mean reversion in the performance of growth stocks vs. value stocks. Growth underperformed Value by 1.4% in January after underperforming by 24.2% in 2022. Pure Growth did even worse on a relative basis, underperforming Pure Value by 7.9%.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance in January 2023, using the S&P DJI factor methodology.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance for the calendar year 2022, using the S&P DJI factor methodology.

Even stranger was the growth vs. value performance when considering history. Value stocks typically underperform growth stocks in risk on markets. January 2023 was definitely an anomaly, especially for pure value vs. pure growth. A supernatural force at work?

Source: S&P Dow Jones Indices LLC.

2. January was a banner month for all major asset classes.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), GLD (SPDR Gold Trust ETF in dotted yellow), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in dashed light blue), TLT (iShares 20+ Year Treasury Bond ETF in dashed light blue) and IEF (iShares 7-10 Year Treasury Bond ETF in dashed red.)

3. Inflation as measured by CPI-U may be moderating, but businesses are still dealing with cost pressures that have resulted in earnings declines despite revenue growth.

With 50% of S&P 500 companies having reported earnings as of February 3, year over year revenue growth is estimated to be a modest 4.3%. However, earnings are estimated to decline 5.3%. Only the energy, industrials, and real estate sectors are showing both revenue growth and earnings growth.

4. The paths forward for the U.S. equity market and the U.S. economy remain encased in heavy fog, a view introduced in last month in our 2023 year ahend outlook commentary.

From my perspective, the two debt market charts below encapsulate the divergent messages being sent to investors.

The Treasury yield curve remains inverted, and is even more inverted than it was at year end. Interest rates, via the inverted yield curve, are signaling economic weakness and maybe even deflationary pressure is on the horizon.

Source: treasury.gov, Two Centuries Investments

On the other hand, the credit markets remain sanguine. High yield credit spreads fell 51 basis points in January, are 120 basis points below their most recent peak at the end of September, and are 169 basis points below their 2022 peak in early July.

Credit markets are signaling the U.S. economy is weathering the large and rapid tightening of monetary policy.

If credit markets are correct, the question will become at what level inflation settles. If the level is too high, the Federal Reserve will likely be forced to resume more aggressive monetary tightening. The risk of a policy error and an ensuing recession would become likely.

At this stage, we are monitoring for economic and financial market data for clues.

January 2023 Market Update & Year Ahead Outlook: Credit Risk Takes the Wheel

1. Inflation risk and interest rate risk drove financial market performance in 2022, not just for bonds, but also for stocks.

In its November 3, 2021 statement, the FOMC asserted “…Inflation is elevated, largely reflecting factors that are expected to be transitory.” Inflation, as measured by CPI-U, proved less transitory than the Fed thought, rising an additional 3.6% from 5.4% to a peak of 9% in June 2022.

In 2022, the FOMC raised the target range for the Federal Funds Rate by 425 basis points to 4.25% - 4.50% in an attempt to dampen inflation.

Source: Forbes Advisor

For the first four months of the year, the Treasury yield curve steepened, signaling continued Fed rate increases, higher inflation, and a shift in demand for Treasuries relative to the supply of Treasuries. In the back half of the year, the yield curve flattened and finished the year slightly inverted, signaling slower economic growth on the horizon.

Source: treasury.gov, Two Centuries Investments

Because of their higher interest rate sensitivity (higher duration), long maturity Treasury portfolios experienced large declines, in the neighborhood of 30% drawdowns.

This chart shows the price performance of IEF (iShares 7-10 Year Treasury Bond ETF in purple) and TLT (iShares 20+ Year Treasury Bond ETF in blue).

The long duration equivalent in the equity market, namely growth stocks, declined by a similar percentage, also near 30%, as measured by the performance of the Russell 1000 Growth Index. The growth stock headwind dragged down the performance of the U.S. equity market, with the S&P 500 Index barely avoiding a 20% drawdown for the year.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), and IWG (iShares Russell 1000 Growth Index ETF in blue).

2. As we enter 2023, inflationary pressures are moderating. Interest rates for longer maturity Treasuries are likely approaching a peak.

Global supply chain issues have lessened, especially in the global shipping network. The prices of many goods are falling as the pandemic induced demand bounce has ended. Shipping container rates have plummeted towards pre-pandemic levels.

Source: Flexport

Prices have fallen rapidly for used passenger vehicles and computer hardware as previously spiking during the pandemic. Housing rents are rolling over, though the impact has yet to appear in the shelter cost component of CPI-U. The housing market faces the headwind of higher mortgage loan interest rates. Food price increases have likely peaked and energy prices have fallen, though we would caution against expecting further energy price declines.

With inflation moderating and no large tailwind for real economic growth, we suspect interest rates are approaching a peak.

3. Service sector inflation and wage pressures, along with de-globalization trends, will likely put a higher floor under inflation in the near term.

The labor market remain tight, largely due to the supply side. In particular, many older workers left the labor force during the pandemic and are not expected to return. The number of unemployed persons per job opening is at a low level relative to both recent history and the entire post World War II period.

Geopolitical tensions, especially with China, mean supply chains will be adjusted, resulting in higher costs. In addition, the massive influx of low cost Chinese labor into the global economy is over. China’s population has likely peaked. Wages in China have risen significantly over the last decade.

4. While U.S. equity market valuation multiples have contracted, the market is facing profitability headwinds due to higher expenses.

Much higher labor, materials, and equipment costs have reversed the trend of increasing operating profit margins. Higher interest expense and higher taxes will be additional headwinds to net income margins and earnings per share growth.

Source: spglobal.com, Two Centuries Investments

Non-US developed markets equities and emerging markets equities appear more attractive. Europe is facing energy related cost pressure due to the Russia-Ukraine conflict and China is facing a real estate crisis as it emerges from its zero-Covid economic activity restrictions, but valuation multiples outside the U.S. embed a lot of bad news already.

Source: Yardeni Research

5. The path forward for the U.S. equity market is encased in heavy fog. We suspect the path will be inseparable from the path of credit risk.

The heavy fog is due to several factors.

• The new floor for inflation is impossible to predict.

• The lagged effect of a sizable and rapid tightening of monetary policy on economic activity is difficult to predict.

• The Fed’s reaction function is difficult to predict as the Fed balances inflation risk vs. recession risk.

• China’s new trend line of economic growth is difficult to predict.

• The damage done to the European economy from the Russia-Ukraine conflict and the accompanying energy crisis is difficult to predict.

If the Fed leans too hard in the direction of crushing inflation, an economic downturn is a near certainty and will manifest itself in rapidly rising credit risk.

On the consumer front, we are monitoring credit card delinquencies. We do know consumers are running down the savings they built up during the pandemic.

Note: Data from July 1, 2012 to July 1, 2022

Credit card balances increased by over 10% annualized in the second and third quarters of 2022.

Source: New York Fed Consumer Credit Panel/Equifax

On the business front, we are monitoring corporate credit spreads, especially for below investment grade debt.

Leveraged loans (floating rate loans for lower quality issuers) experienced over 300 basis points in rate increases (higher interest expense) in 2022.

Source: Eaton Vance, data through September 30, 2022

Higher operating expenses and interest expense are starting to take a toll on some companies as the percentage of distressed loans has increased. However, the percentage is well below crisis levels.

Source: Eaton Vance, data through September 30, 2022

High yield debt spreads have risen 175 basis points from post pandemic lows, but still remain well below crisis levels.

6. Increased credit risk will translate to higher U.S. equity market volatility, even if a recession is not a near term outcome. We suspect the odds favor non-US equities, Treasuries, and gold relative to U.S. equities in 2023. Within U.S. equities, robust business models are the likely winners, with strong and sustained free cash flow growth, strong intangible assets, and / or revenues tied to commodities with structural supply issues.

December 2022 Market Update: Markets Rally, Cryptonite Captivates

1. In November, almost every class exhibited a reversal of trend. Global equities rallied, led by non-US equity markets. Long maturity U.S. Treasuries rose in price and the U.S. dollar declined modestly.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

Year-to-date, equities and long maturity Treasury portfolios remain significantly underwater.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

2. In October, U.S. inflation rate (as measured by CPI-U) fell to 7.7% from September 8.2% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

The moderation in inflation was likely a contributor to the reversal of the trend of asset class performance. If inflation continues to moderate at the pace experienced in October, it will facilitate an earlier end to the tightening of monetary policy.

3. While equity risk, interest rate risk, and inflation risk have hammered asset class performance this year, credit risk remains muted. We anticipate the trend in credit risk will drive financial market performance over the course of the next year.

While high yield credit spreads have risen almost 150 basis points year-to-date as of November 30, the level of credit spreads remains quite low compared to the last 25 years. From our perspective, the big question going forward is whether the combination of inflationary pressures, tighter monetary policy, and economic imbalances precipitate a credit crisis.

4. Is the lack of container ship backlog at the Ports of Los Angeles and Long Beach the proverbial canary in the coal mine?

Source: Freightwaves.com

As we noted late last year and earlier this year, strong demand for goods, supply chain issues, and global shipping network challenges led to an unprecedented container ship backlog at the Ports of Los Angeles and Long Beach. The backlog has evaporated. On November 22 and 23, there were no container ships waiting offshore at the ports.

Certainly, the global supply chain has adjusted as pandemic related economic restrictions have been removed. Certainly, there was a pull forward in demand for goods, so there will be a period of below trend demand. However, the labor, equipment, and warehouse issues at the ports have not been resolved. Thus, our concern is the lack of a backlog may be signaling economic weakness.

5. Credit risk has emerged in a few pockets of the economy. most notably in the cryptocurrency industry. The FTX bankruptcy filing was the latest and biggest outbreak of credit risk in the industry. As with almost every credit crisis these days, the cryptonite was financial engineering.

In last month’s monthly update, I noted “Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.”

Part of the financial engineering revolved around the concept of yield farming, whereby cryptocurrency owners could lend their cryptocurrency and receive a high interest rate, much higher than rate in a commercial bank savings account or the yield on a money market fund.

This concept befuddled me, as cryptocurrencies do not generate cash flows, so it seemed much riskier than traditional securities lending (applied to stocks and bonds).

Many cryptocurrency companies engaged in yield farming also held low amounts of equity capital, i.e., they were highly levered. Commercial banks are required to hold higher equity capital and the banks even have the benefit of access to the Federal Reserve’s discount window.

In addition, the so-called cryptocurrency exchanges did not operate like traditional stock, commodity, and derivative exchanges, by managing counter-party (credit) risk tightly via daily, and often high, margin requirements.

Lastly, there seems to have been an incestuous relationship between several cryptocurrencies and cryptocurrency companies, meaning the cryptocurrencies and businesses were highly correlated.

Note 1: I am ignoring the allegations of fraud and focusing only on the structural problem of financial engineering, since it relates to my concern about credit risk lurking below the surface of the economy. While frauds can be large, they will be contained. Credit risk in systematic form is the big danger; it is hard to contain.

Note 2: Not all cryptocurrency industry players engaged in financial engineering, as some act as true custodians of customer assets, supported by compliance, risk management, and audit systems.

November 2022 Market Update: WhatsUpp with Financial Markets, META, and Crypto

1. In October, global equity markets rebounded, with the big exception being China, which weighed on emerging markets performance. Year-to-date, equities remain significantly underwater.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

The Chinese stock market was the big outlier, reacting poorly to the outcome of the Communist Party Congress. Chinese Premier Xi Jinping will remain as leader for an historic third five-year term and be surrounded by loyalists in the Politburo. This concentration of power raised the concern China will be less focused on economic growth and more focused on domestic wealth inequality and national security issues. Zero-Covid policy, with associated activity restrictions, will also remain intact.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

Has the sell-off in stocks finally ended? We doubt it for two reasons.

First, we haven’t witnessed the widespread investor despair that typically accompanies equity market bottoms. Second, the Federal Reserve will need to continue to tighten monetary policy to lower inflation to a more acceptable level.

That said, to the extent a credit crisis does not develop, we don’t anticipate anything like the equity market carnage we witnessed in the 2008 Global Financial Crisis.

2. In September, U.S. inflation rate (as measured by CPI-U) barely fell to a 8.2% from August’s 8.3% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

We anticipate inflation in the U.S. to moderate as the demand for goods continues to ease post pandemic. However, labor market challenges, structurally higher energy prices, and supply chain challenges emanating from China will put a floor on the intermediate term range for inflation.

3. US interest rates continued their rise, wreaking havoc on all major asset classes, as the Federal Reserve raised the Federal Funds Rate target by 0.75% in October. The Fed has raised the rate by 3.50% so far in 2022.

Source: treasury.gov, Two Centuries Investments

4. Corporate earnings season highlighted the impact of rising expenses on earnings growth for many companies. Ex-energy, earnings growth will be negative for the S&P 500 for the second consecutive quarter.

As of November 4, 85% of the companies in the S&P 500 had reported quarterly earnings results for the third quarter of 2022. No surprise, the energy sector continues to be the star performer. Notably, the industrial sector also has shown strong revenue and earnings growth. The communication services, financials, and materials sectors have experienced double digit earnings declines, year over year.

While revenues grew 10.5% year-over-year, earnings growth only grew 2.2% as higher expenses lowered profit margins.

Labor cost growth is the primary culprit and is currently running about 200 basis points higher than its pre-pandemic trend.

5. Many companies with seemingly robust business models have performed poorly this year. Below, I briefly discuss the issues facing META, a company which scores highly in the “brand” category of our Focused Quality equity model. I use a discounted cash flow model framework.

META, which owns Facebook, Instagram, and WhatsApp, reported earnings on October 26 after the stock market close. On October 27, META's stock price declined 24%. Year-to-date through the end of October, the stock price had declined 72%. What happened to META, a company which is one the big three, along with GOOGL and AMZN, in the growing and oligopolistic digital advertising industry?

Certainly, higher interest rates have contributed to a higher equity discount rate (all else equal, namely the equity risk premium). This factor has impacted higher growth stocks, which have longer "durations", as more of the cash flows to equity shareholders are further out in the future. GOOGL was impacted similarly. Think of it as a contributor to valuation multiple compression.

The boost in digital advertising during the pandemic has ended. The economy is also slowing and advertisers are reducing all forms of spending. META faced the additional headwind of AAPL allowing iPhone owners to change their privacy settings to limit tracking by advertisers. In other words, revenue growth has slowed.

Higher operating expenses, including higher labor costs, reduced profitability as profit margins declined. Lastly, META committed to maintaining much higher capital expenditures (over $32 billion in 2022) to develop the "metaverse" and expand their artificial intelligence capabilities. There is no guarantee these expenditures will produce anywhere near the high Return on Invested Capital (ROIC) produced by META’s core advertising business.

Comparing 3q2022 to 3q2021...

Revenues declined from $29.0 billion to $27.7 billion.

Net Income declined from $9.2 billion to $4.4 billion.

Cash Flow from Operations declined from $14.1 billion to $9.7 billion.

Capital Expenditures increased from $4.3 billion to $9.4 billion.

“Free Cash Flow” declined from $9.8 billion to $0.3 billion.

In summary, lower revenues, higher operating expenses, and valuation multiple compression hit the stock, like they have hit other growth stocks this year. But two other META specific issues have led to additional underperformance, namely AAPL’s business decision and META’s decision to spend aggressively to build a new business at as time when most companies are spending cautiously due to emerging economic growth headwinds.

6. As I was writing this monthly update, news broke about the failure of FTX, one of the largest cryptocurrency exchanges. While we await more details, I will highlight a few principles, likely applicable to the FTX situation and which we articulate to our clients who are considering investing in crypto.

1) Know the protections available, or not available, with the safekeeping of your assets.

2) Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.

3) Be wary of a financial market exchange that has not subjected itself to the rules and best practices governing public financial market exchanges. In the FTX situation, FTX engaged in a related party transaction with the hedge fund Alameda Research.

4) Research the legal framework and creditor status that will be applicable if an insolvency occurs.

June 2022 Market Update: Waiting for the Fog to Go

Where is the inflation rate ultimately headed? Financial market action during May reflected the lack of clarity on inflation’s future path. Corporate earnings season highlighted the consequences of the government policies that have facilitated higher inflation. Our optimism inflation will moderate is tempered by our concern about a potential energy crisis.

1. The US stock market eked out a small gain in May. Stocks have returned -12.8% year-to-date as proxied by the S&P 500 Index. Higher expenses due to labor and supply chain issues, tighter financial conditions driven by Federal Reserve actions to squash inflation, and burgeoning concerns about decelerating revenues remain headwinds to stock prices.

Before a bounce during the last week of May, US equity prices had declined over 18% from the start of the year.

This chart shows the price performance of SPY (the SPDR S&P 500 Index ETF in blue).

While nine of the eleven equity sectors have negative returns year-to-date, most of the damage has occurred in the consumer discretionary, communication services, and information technology sectors, which have returned -24.3%, -22.3%, and -19.1% respectively. Combined these sectors constituted 51.9% of the S&P 500 Index at the beginning of the year.

This chart shows the price performance of SPY (the SPDR S&P 500 Index ETF in blue), XLK (the Technology Select Sector SPDR Fund in yellow), XLC (the Communications Services Select Sector SPDR Fund in orange) and XLY (the Consumer Discretionary Select Sector SPDR Fund in purple).

2. First quarter 2022 earnings were solid but revealed two big challenges facing most businesses. First, higher expenses are eating into profitability. Second, uncertainty about the composition of demand has made planning and inventory management more difficult. Consumer spending preferences have shifted post pandemic and inflation has constrained budgets for non-discretionary items.

With 97% of companies having reported earnings, S&P 500 revenues increased 13.6% year-over-year. Nine sectors saw revenue growth above 7.5%, an outstanding but likely unsustainable result.

Unfortunately, expenses increased faster than revenues for many companies, so S&P 500 earnings only increased 9.2%, a 440 basis points haircut to revenue growth. In other words, profit margins declined, a result investors are worried will become a trend.

Year-over-year, net profit margins decreased for 50% of the S&P 500 companies. The financial and consumer discretionary sectors experienced the largest declines in profit margins.

Three of the best managed consumer companies, namely Amazon, Walmart, and Target, acknowledged inventory issues, in addition to rising costs. The excess inventory will have to be marked down in price. The composition of consumer spending has shifted rapidly, particularly away from big ticket goods to services, like travel and entertainment. In addition, the rising prices of certain non-discretionary items, especially gasoline and foods, and rising home mortgage rates have put the squeeze to consumer budgets.

This chart shows the price performance of AMZN (Amazon.com, Inc. in green), WMT (Walmart Inc in purple), and TGT (Target Corporation in blue).

3. In May, the ups and downs of the bond market (interest rates and credit spreads) reflected the uncertainty about inflation’s path, the Fed’s potential reaction function, and the implications (recession?) if the Fed backs up its tough talk with substantial interest rate hikes.

The ten-year Treasury yield spiked 23 basis points in the first week of May to 3.12%, representing an 160 basis point increase from the beginning of the year. That pace of increase was unprecedented, was not sustainable, and began to raise fears of monetary tightening induced recession. By month end, the ten-year Treasury yield had settled at 2.85%, just below where it ended April.

Source: treasury.gov

Credit spreads acted similarly to US equities and interest rates, moving rapidly in one direction at the beginning of the month before reversing direction. High yield spreads spiked 100 basis points from the beginning of the month through May 24, before giving back 70 basis points of the rise during the last week of the month.

The combination of rapidly rising interest rates and rising credit spreads has translated to one of the worst historical periods for bond market returns. Even US Treasuries, which outperform during recessions and crises, have generated negative returns. The worst performing segment has been long-maturity Treasuries, often considered the flight to quality asset. Depending on the benchmark, long-maturity Treasuries have generated returns in the neighborhood of negative 20% year-to-date.

A rebound in long maturity Treasury yields was not surprising given the easing of pandemic related economic restrictions, the spike in inflation, and the Federal Reserve’s stated monetary tightening plan, i.e., Fed Funds rate increases and the ending of the asset purchase program. As long as inflation moderates, we suspect most of the increase in long maturity Treasury yields is in the rear view mirror.

This chart shows the performance of AGG (iShares Core U.S. Aggregate Bond ETF in purple), JNK (SPDR Bloomberg Barclays High Yield ETF in orange), and TLT (iShares 20+ Year Treasury Bond ETF in blue).

4. Our big concern for financial markets is energy prices, driven by the current energy supply crisis. In particular, if crude oil prices continue to climb, it may not be possible for the Federal Reserve to put the inflation genie back in the bottle without a severe recession. Even in a non-recessionary outcome, higher energy prices will weigh on corporate revenues, corporate profitability, and company valuations, outside of a small number of energy companies.

The price of crude oil continued its march higher in May.

This chart shows the price of WTI crude oil futures.

The price of US natural gas has doubled since the beginning of the year.

This chart shows the price of US natural gas futures in mmbtu (1 Million British Thermal Units) on the New York Mercantile Exchange.

Higher energy prices (a) feed into food prices, especially via higher fertilizer costs, (b) increase expenses for most businesses, (c) reduce non-discretionary spending for most consumers, (d) raise the cost of global trade, (e) make long term planning more difficult for businesses, thus reducing management’s proclivity for longer-term, productivity investments in R&D, plant, property, and equipment, and (f) arguably raise the cost of capital via higher risk premiums, thus reducing valuations.

Given some time, the US economy and most well-capitalized companies, especially those with valuable intangible assets, can adapt to shocks, including tightening monetary policy. There may be no such thing as successfully adapting to an energy crisis.