After experiencing zero in 2023, the S&P 500 took more than two years before making a new all-time high. Fast forward to the end of the first quarter, witnessing the S&P 500 march its way to 22 new all-time high levels, on pace for the most ever. While much uncertainty surrounding monetary policy still exists, the equity markets brushed off the noise, experiencing minimal volatility. The quarter’s maximum S&P 500 drawdown of -1.7% would mark the smallest drawdown in history if the year ended as of March 31. Even gold and Japan’s stock market joined the all-time highs party, with the latter doing so for the first time since 1989.

Unlike recent quarters, chinks in the armor of the Magnificent 7 appeared to form, as three of the seven constituents (Apple, Alphabet, and Tesla) failed to outpace the broad index return of 10.8%. Ten of the eleven S&P sectors turned in a positive return. On the other hand, Nvidia continued its AI-fueled meteoric ride on way to a Q1 return of more than 82%, and we witnessed a reawakening of the meme stock mania as traders poured into the Reddit Inc., Trump Media, and Technology IPOs.

A year removed from the collapse of Silicon Valley Bank, we were reminded of the stress that higher rates have applied to the balance sheets of small and regional banks. New York Community Bank reported surprise losses on their multifamily commercial real estate loan portfolio, reminding investors that there could still be another shoe to drop. Regional banks tend to have a very large percentage of commercial real estate loans on their books, with many experiencing a high number of defaults, though the market quickly shrugged off the news and risks. 

Highlighted last quarter, we felt the bond market got ahead of itself and overpriced the timing and magnitude of Fed rate cuts. Entering 2024, the market anticipated the U.S. central bank would cut six times, resulting in a projected 1.50% (150 basis points) in rate reductions, starting as early as March. As the market reassessed the Fed’s rhetoric and repriced their expectations, market yields for longer dated bonds rose sharply by 0.46% before the 10-Year U.S. Treasury rate settled and ultimately ended the quarter at 4.20%.  

Market Recap

Equities – 2023 witnessed a positive correlation between yields on longer dated bonds and equity prices, which resulted in higher equity levels as yields fell and downward pressure as yields rose. This was particularly highlighted over the final two months of 2023, when the yield on the 10-Year U.S. Treasury fell from nearly 5% to 3.88% and ignited the ‘everything rally.’ The largest benefactors were asset classes like small caps and technology, which tend to be the most sensitive to higher interest rates. In contrast to last year, 2024 has seen a significant decoupling of the relationship between equities and bond yields. Fueled by AI-driven enthusiasm, expectations of Fed cuts, and unexpectedly robust earnings, the S&P 500 surged 10.8% for the quarter. This performance marks the best first quarter for the U.S. large-cap index since 2019, delivering consecutive quarters of double-digit returns.

Conversely, higher yields continue to plague smaller companies with today’s higher cost of debt marring their outlook. As the market reassessed monetary policy and rates rose in the first quarter, the small-cap Russell 2000 index experienced turbulence to start the year, but ultimately eked out a 5.18% YTD return. 

With a ‘soft landing’ to ‘no landing’ all but expected, the market appears to have accepted the Fed’s latest projections and are closely observing economic data for signals the Fed has the green light to lower rates. As important indicators surrounding inflation, jobs, and overall economic health flood the market, we expect the market to continue reacting counterintuitively to good news, treating it as bad news, while reacting to bad news as though it is good news. Should core inflation remain sticky and economic data remain strong, we would not be surprised to see volatility return as investors start to extend expectations surrounding a June Fed pivot. 

Bonds – As yields reversed course, bonds kicked off 2024 adding to their multi-year downward trend. With stronger-than-expected economic data and Fed uncertainty, the market repriced Fed expectations and the yield on the 10-Year U.S. Treasury shot from 3.88% to as high as 4.34% in mid-March. While the market has appeared to reprice monetary policy changes, robust U.S. debt issuance and the demand for U.S. Treasury securities continues to wane, failing to absorb supply and applying upward pressure on yields, exemplified by the Bloomberg U.S. Aggregate Bond Index falling 0.78% over the quarter.

Source: YCharts. The Bloomberg US Aggregate Index was used as a proxy for Bonds; the Bloomberg US High Yield 2% Issuer Capped Index was used as a proxy for High Yield Bonds; the Russell 2000 Index was used as a proxy for Small Cap Equities; and the MSCI ACWI Ex USA Index was used as a proxy for Foreign Equities. 

With stronger economic data, base case expectations call for the Fed successfully achieving a ‘soft landing’ and avoiding recession. However, as data has continued to surprise to the upside, many growth metrics continue moderating. 

Economy: The Consumer starts slowing 

After avoiding the widely anticipated recession of 2023, and growing approximately 2.5%, the U.S. economy continues to grind higher at a moderate pace. As of March 29, 2024, the Atlanta ‘Fed’s GDPNow model for the first quarter is projecting growth of 2.3%, with the largest contribution expected to come from consumer spending, once again, and net exports expected to detract from growth. 

Despite higher borrowing costs, the U.S. continues to outperform its global peers, largely due to a stable labor market that has consistently produced wage increases outpacing inflation for 10 consecutive months, through February. March’s labor report is due Friday, April 5 and wages are expected to continue to outpace pricing pressures for an 11th straight month, further supporting consumers’ ability to spend. 

Unemployment 

February’s Labor Market Report registered the 38th consecutive month of job gains. Estimates called for 198,000 jobs in February, and the market surprised to the upside with the addition of 275,000 jobs, though unemployment jumped 0.2% to 3.9%. 

February’s unemployment rate also marked the 27th consecutive month unemployment has held below 4%, which is the longest streak since the 1960s. The labor market continues to post robust results. While trending lower since peaking in 2022, job openings (JOLTs) have been a mixed bag from month-to-month, and still remain elevated at 8.86 million. This brings the ratio of job openings to those unemployed to 1.371. While the ratio of 1.37:1 is still considered elevated above levels historically witnessed, the ratio has fallen significantly from nearly two job openings for every job posting in 2022. This indicates slack is working itself out of the system and the labor market is showing signs of tightening. The number of open jobs has fallen, while the number of unemployed job seekers has trended higher, as evidenced by the additional 334,000 unemployed persons from January to February.  

For now, the strength and resiliency of the labor market has given the Fed the confidence to keep rates higher for longer. However, sticky wage growth continues to give the Fed anxiety, as this metric has been effectively stuck around 4.3% since October 2023. While persistent and elevated wage growth brings fears of an inflation resurgence, any break below the 4% threshold would temper those fears and be well received by the Fed.

Inflation 

The Fed appears to be winning their battle against inflation, as pricing pressures look to be tamed and headed towards the Fed’s 2% target – though it is still too early for the Fed to declare their victory lap. On the surface, all major inflation readings reside below 4%, with both PCE readings printing below 3% over the last year, through February. 

Shelter and gasoline represented approximately 60% of the monthly gain in Headline CPI in February, with additional pricing pressure from used cars, apparel, motor vehicle insurance, and airfares at the highest levels since May 2022. Boeing woes are forcing airlines to cut their flight capacity and we expect further pricing pressure on air travel over the next several months. Additionally, we anticipate continued upward pressure on energy prices, leading to volatility on the headline CPI numbers as we progress through the summer months.

Just as elevated wage growth remains troublesome to the Fed, the stickiness of core services, particularly shelter costs, supports their decision to exercise patience before cutting rates. The rolling three-month core CPI is running at an annualized rate of 4.2%, which is the highest since June 2023. 

Too Soon to Pivot

Defying market expectations of a March rate cut, the Fed met twice in the first quarter and left rates unchanged, illustrating their unflagging commitment to bring inflation back to its long-term target of 2%. Since initiating rate increases in March 2022, the Fed raised rates eleven times, bringing the target range for the Fed Funds rate to the current range of 5.25% to 5.50%. During this period, Fed Chair Jerome Powell has also been reducing the Fed’s balance sheet by $95 billion per month, resulting in a decrease in assets of nearly 16.5%, or approximately $1.48 trillion, since its peak in April 2022.  

The Federal Open Market Committee (FOMC) elected to keep rates unchanged in March for the fifth consecutive meeting. While the Fed’s decision was largely expected, the big news was the Fed’s changes, or lack thereof, to their Summary of Economic Projections. Of particular interest was their median projection for rate cuts, which policymakers held unchanged at three cuts in 2024. Only two Fed officials projected no cuts in 2024, while two anticipated only two cuts. Only one member voted in favor of more than three rate cuts in 2024, signifying a stark contrast to the Fed’s December 2023 projections where five members anticipated more than three cuts in 2024. We also saw the Fed lift economic projections, like GDP, for 2024, while also increasing their 2024 inflation expectations and revising their 2025 path of rate normalization.

Powell recognized that inflation has been stickier than anticipated the last couple of months, though the latest data “haven’t really changed the overall story, which is that of inflation moving down gradually on a sometimes-bumpy road towards 2%.” He further reiterated “we’re not going to overact…to these two months of data, nor are we going to ignore them.”

Source: US Federal Reserve Summary of Economic Projections, March 20, 2024

Barring any resurgence of inflation, we believe the Fed has finished its rate-hiking campaign and are nearing their first rate cut. Given the Fed’s steadfast commitment to bringing inflation down, our base case assumptions from the last several quarters have not changed. We continue to believe the earliest the Fed will cut rates is June, which now aligns with current market expectations. However, any prolonged stickiness or resurgence of inflation would likely push our expectations for rate cuts into the third quarter of this year.

Centura’s Outlook

The Fed’s goal to lower inflation back to its 2% mandate and avoid recession is now the base outcome expected by the Fed and most market participants. The successful delivery of lower inflation and Fed policy normalization should bode well for both equities and bonds. However, we continue to believe the market appears priced to perfection, and investors should proceed with caution as any resurgence or sustained stickiness of inflation could result in monetary policy uncertainty and lead to bouts of market angst or volatility. 

In the face of higher borrowing costs, corporate profits have remained surprisingly resilient as the S&P 500 posted positive earnings growth for the second consecutive quarter in the fourth quarter of 2023, rising 4.2%. Interestingly, those companies with more than 50% of their revenue generated outside of the U.S., generated better profits than companies generating most of their profits domestically. As margins continue to face pressure, FactSet has witnessed revisions for first quarter earnings, dropping from 5.8% on December 31 to 3.6% as of March 28. 

Source: FactSet Earnings Insight

Forward 12-month P/E ratios are approximately 20.9x, above both their five-year and ten-year averages of 19.1x and 17.7x, respectively. This indicates that equities are slightly overvalued and thus priced to perfection. For further confirmation, the earnings yield relative to the yield on the 10-Year U.S. Treasury also indicates that equities are relatively valued today, as the S&P 500 earnings yield (Earnings/Price) is 4.30%, compared to the yield of on the 10-Year U.S. Treasury of 4.33% as of April 1. 

The market remains too dependent on the Fed, which has become dependent on poor economic data; with worsening conditions, the more likely the Fed is to pivot and cut rates sooner. However, we believe economic activity will continue to surprise to the upside, realistically extending the timing of the widely anticipated rate cut. Should expectations shift from June to later in the year, we would expect markets to react negatively, and volatility would ensue.

We entered the year with our allocations aligned with our long-term targets. While higher rates will continue to cause issues for some companies, earnings are expected to grow from 2023 levels in 2024. While equities generally produce a positive return during election years, we expect volatility will likely increase as we approach the election in the third and fourth quarters. However, the improving market breadth, as evidenced by the roughly 70% of S&P 500 companies trading above their 200-day moving averages, gives us optimism that markets should continue to grind higher. Outside of Fed policy-related market volatility, we are more fearful of potential exogenous events that are harder to predict.

As expected, yields rose to start the year as the market repriced its expectations surrounding Fed rate cuts. When yields reversed higher, we took the opportunity to further extend the duration of our fixed income allocations. While the path may be bumpy, ultimately, we believe yields should continue to grind lower over the course of the year, presenting attractive opportunities to produce asymmetric returns in bonds. Extending duration should allow investors to clip an attractive yield, while also providing them with the opportunity to experience capital appreciation for a total return exceeding what they will clip sitting in money market funds or short-term Treasury bills.

Elevated interest rates continue to punish private real estate returns, with further slight downward valuation adjustments expected from their previous marks. Real estate is an interest rate-sensitive asset class, meaning as rates move lower, we anticipate a pick-up in activity, and a subsequent reversal of valuations over the next several years. While we believe we are nearing the light at the end of the tunnel for several real estate sectors like multifamily and industrial, unfortunately, we believe more pain will be experienced, particularly with the underlying debt that real estate operators hold. There is a reason S&P Global just downgraded five regional banks based on their commercial real estate loan exposure. Like S&P Global, we anticipate a pickup in defaults across several real estate sectors, which will likely result in further pain across both public and private markets. 

Private credit presents an opportunity to earn attractive returns, given private credit is predominantly floating and tied to a base rate such as the Secured Overnight Financing Rate (SOFR), closely linked to the Fed Funds overnight rate. Yields on private credit should remain at their current levels until the Fed begins to cut rates. Even as the Fed cuts rates, the floating rate on private loans does not adjust immediately. Rather, there is a delay before the loan terms reset lower, typically every three months. Barring a catastrophic event, the Fed is likely to lower rates more methodically than they hiked them, supporting higher yields in private credit. Fortunately, private companies have weathered the elevated rate storm better than anticipated. As Cliffwater recently shared with us, borrowers demonstrated strong performance, as evidenced by the 15% year-over-year revenue growth and 13% EBITDA growth. Lower rates should support improved health of borrowers and support attractive returns, relative to traditional fixed income going forward. Combining traditional bonds with private credit should produce a balanced and diversified approach toward income production and total return in 2024. 

Thank you for your continued confidence and support. If you have questions or concerns, please contact your Centura Wealth advisor.   

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. 

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.  

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such. 

Centura Wealth Advisory is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura Wealth Advisory and its representatives are properly licensed or exempt from licensure. 12255 El Camino Real, St. 125, San Diego, CA 92130.  

Move over, FAANG! The Magnificent Seven have taken over the markets. Representing the seven largest companies in the S&P 500, Alphabet, Apple, Meta, Microsoft, Amazon, Tesla, and Nvidia have been anointed by investors as leading the market and tech rally. 

The first half of 2023 was powered by mega-tech stocks, with the rest of the companies in the S&P 500 contributing an incremental amount to the indices’ return. The NASDAQ Composite registered its strongest first-half performance in 40 years, with Apple stock paving the way for an all-time high closing price on June 30, 2023 of $193.97, becoming the world’s first $3 trillion company. 

Like the dot-com euphoria, artificial intelligence (AI) has offered tailwinds for the tech industry. AI has sparked big investments by companies and investors wanting to capitalize on the Generative AI race. Meanwhile, the June 1st debt ceiling ‘deadline’ was practically a non-event. The final agreement passed by the House and Senate suspended the debt limit until after the next presidential election and restricted government spending through 2025. However, that hasn’t stopped them from increasing the deficit. As the markets look past signs of economic cooling, indices push higher in the year’s second quarter.

Market Recap  

Equities – The Fed has remained steadfast in its fight against inflation, and the prospects of higher interest rates for longer have been unable to derail the tech-heavy NASDAQ 100 momentum, on its way to a second quarter return of 15.16%, bringing the index’s 2023 return to 38.75%.  

Driven primarily by the returns of the index’s largest constituents, the S&P 500 has rebounded more than 20% since bottoming in late 2022, joining the bull market rally with the NASDAQ 100. Higher rates coupled with tighter financial conditions and more stringent lending standards have dampened the outlook for smaller companies. The small-cap Russell 2000 index has only gained 7.24% for the year, more than half of that occurring in the last week of the quarter. 

While market participants expect the Fed to continue lifting rates and no longer anticipate a pivot this year, recent economic data and stronger earnings have given bulls optimism that a recession might be avoided. For now, with an eye on the future, it appears the market is discounting the lagged impact of monetary policy; gravitating to AI-centric companies; pushing interest-rate-sensitive equities higher; and creating a larger gap between market technicals and economic fundamentals.

Bonds – Bonds, on the other hand, have been sending conflicting signals. Driven by fears of a US government default and potential Fed-induced recession, bond volatility continued in the year’s second quarter, posting a -0.84% return; bringing the overall return on bonds to 2.09% in 2023.  The current climate reminds us that while investing in ‘safe-haven’ Treasury securities removes credit risk, investors are still very much exposed to interest rate risk and ensuing volatility from changes in yields. Experiencing swings ranging from as high as 4.10% to as low as 3.37%, the yield on the 10-Year U.S. Treasury Note sits at 3.81%, or a mere 0.07% below where it started the year.  

 Source: YCharts. The Bloomberg US Aggregate Index was used as a proxy for Bonds; the Bloomberg US High Yield 2% Issuer Capped Index was used as a proxy for High Yield Bonds; the Russell 2000 Index was used as a proxy for Small Cap Equities; and the MSCI ACWI Ex USA Index was used as a proxy for Foreign Equities.

Despite declines in economic growth and activity, the economy has remained resilient as economists contend whether we are currently in or headed towards a recession.

Economy: What recession?

The economy continues to defy expectations and march higher in an environment with one of the most anticipated recessions in history. The last week of June delivered the final revisions to first-quarter GDP growth from 1.3% to 2%. Major gains came from robust consumer spending and surging exports, likely supported by the nearly 9% cost-of-living adjustment for Social Security participants. The 4.2% rise in consumer spending, as measured by personal consumption expenditures, was the fastest pace since the second quarter of 2021, and exports rebounded sharply, up 7.8%.  

While Real GDP may be growing at a decent pace, several indicators point towards further contraction or possible recession.   

May marks the 14th consecutive month that the Conference Board’s Leading Economic Index (LEI) contracted, an early indication that a recession is all but certain. Senior Manager of Business Cycle Indicators at The Conference Board Justyna Zabinska-La Monica said: 

“The US Leading Index has declined in each of the last fourteen months and continues to point to weaker economic activity ahead. Rising interest rates paired with persistent inflation will continue to further dampen economic activity. While we revised our Q2 GDP forecast from negative to slight growth, we project that the US economy will contract over the Q3 2023 to Q1 2024 period. The recession likely will be due to continued tightness in monetary policy and lower government spending.”    

While Treasury Secretary Janet Yellen, President Joe Biden, and the Fed all believe a recession will be avoided, the question is not whether we will enter a recession but, rather, when and how deep the recession will be.

Inflation & Interest Rates  

April and May’s headline Consumer Price Index (CPI) came in at 4.93% and 4.05%, respectively, while core CPI (excluding energy and food) registered 5.54% and 5.33% year-over-year readings over those same periods. The persistence of pricing pressure on core services, particularly shelter, has proven problematic. Shelter represents about 1/3 of CPI and has remained elevated, increasing 8% over the last year. Although the Fed’s restrictive monetary policy appears effective in bringing year-over-year inflation off its June 2022 peak of 9.06%, price pressures have proven painstakingly resilient and remain elevated more than the Fed prefers.  

On a positive note, rents are coming down and home prices are off their June 2022 peak, indicating lower inflation readings ahead. While the downward trend in CPI is reason for optimism, we are more concerned with the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE), which has remained relatively flat at 4.62%, the same level reported in December 2022.  

As highlighted in the previous quarterly market overview, uncertainty regarding the Fed’s inability to dampen inflation while avoiding an economic contraction has led to an almost certain harbinger of a recession: an inverted yield curve. Inverted yield curves occur when yields on longer-dated bonds are lower than yields on short-term notes and have proven to be solid predictors of recessions. 

Debt ceiling negotiations, or lack thereof, consumed headlines through June. While the negotiations were essentially a non-event, one of the most meaningful outcomes has been the US government’s subsequent issuance of new debt since June 5th, which received little recognition in the media.   

It was anticipated that a whopping $1 trillion of new Treasury securities would be issued by the end of the third quarter. Surprisingly, those estimates were off. The U.S. Treasury has already issued approximately $800 billion of new debt in less than a month, pushing the nation’s deficit beyond $32 trillion. Issuance of new securities serves as additional quantitative tightening to support higher yields and may lead to an equity pullback and widening of credit spreads according to both Citigroup and JPMorgan.

Don’t Expect a Pivot

True to their word, the Fed is committed to doing whatever is necessary to bring inflation back to its long-term target of 2%. In March 2022, the Fed embarked on its current Quantitative Tightening (QT) cycle, resulting in ten consecutive rate hikes over fifteen months and a federal funds rate of effectively 0% to 5%. During this period, Federal Reserve Chairman Jerome Powell additionally led the $95 billion per month balance sheet reduction, shedding approximately $625 billion since assets peaked in April 2022.

June’s Federal Open Market Committee (FOMC) meeting marked the first time since March last year that the FOMC voted not to hike rates further. The decision was telegraphed and highly anticipated. The Fed also conveyed that they are likely not finished raising rates, further tightening is likely required to lower inflation, and their June decision should be considered nothing more than a pause.  

June’s FOMC release and updated economic projections showed a target peak Fed Funds rate of 5.6%, indicating another 0.50% of increases in 2023. Following the Fed’s June decision and updated Dot Plot, the market finally accepted our base case and what the Fed has been saying all along: rates will remain elevated to ensure inflation is under control. Barring a catastrophic event, no Fed pivot is expected in 2023. The first rate cut is now expected in early 2024.  

Source: Federal Reserve

Unemployment  

One of the Fed’s primary concerns is wage growth. Although wage inflation has been trending lower, it remains elevated at 4.3%, which worries the Fed. Strong wage inflation increases the risk of a wage-price spiral that could prolong elevated inflation. While May’s CPI print showed headline CPI back below wage growth, core inflation measures remain higher, indicating that earnings are not keeping pace with cost-of-living increases.  

The labor market remains robust, despite some conflicting signals. May’s Labor Market Report registered the 29th consecutive month of job gains, though it showed signs of tightening. Estimates called for 195,000 jobs added in May and the market surprised to the upside with 339,000 jobs. Unemployment jumped 0.3% to 3.7%, marking the largest monthly bounce since April 2020. More than 440,000 people entered the unemployment market in May, also matching the largest monthly loss since the onset of the pandemic.  

Surprisingly, as measured by the JOLTS, job openings unexpectedly reversed course and surged back over 10 million. Due to the higher number of unemployed, the ratio of job openings to those unemployed remained relatively flat at 1.65:1.  

Centura’s Outlook

The Fed remains resolute in combatting 40-year high inflation, despite ‘pausing’ for a break, not letting concerns of a potential recession derail its tightening efforts. Interest rates remain at levels not seen since the Great Financial Crisis and will likely move higher over the next couple of months. The Fed’s goal to tighten financial conditions and slow the economy just enough to lower inflation back to their 2% mandate is a move that will likely force a recession.  

Earnings for the first quarter were stronger than expected, leading many to believe higher rates and inflation aren’t wreaking as much havoc as initially feared. However, higher rates for longer periods spells lingering bank liquidity concerns and potential economic recession have prompted analysts to revise earnings forecasts lower.  

According to FactSet, the estimated earnings growth for the S&P 500 in the second quarter has been revised lower from the expected -4.7% in March to -6.8%. If accurate, this would represent the largest decline the index delivered since the second quarter of 2020 of -31.60%.   These negative revisions highlight companies’ challenges in 2023 to produce profits. Given that higher rates are likely to persist, additional pressure may be applied over the coming quarters.    

A company’s ability to service debt is negatively impacted by elevated rates. The road ahead will likely remain a challenge given the increased cost of labor and companies’ struggle to pass increased cost of goods onto consumers.  

Forward 12-month P/E ratios have risen to approximately 18.9, slightly above their five-year average of 18.5. This indicates that equities are slightly overvalued and additional drawdowns may be in store before equities become attractive from a valuation standpoint. When banks kick off earnings season in mid-July, executive managements’ comments on the health of their companies’ and consumers’ balance sheets should prove insightful, particularly as it pertains to banks’ revisions to loan loss reserves. This should provide an indication of the direction and magnitude of companies’ future expected defaults, which we expect to increase.    

Until inflation breaks lower, we remain cautious and anticipate that equities could experience turbulence in the second half of the year, particularly if inflation remains elevated or resurges.  We also believe the market is discounting the impact of the Fed’s aggressive monetary tightening actions. Bankruptcies are quietly rising, and defaults are starting to tick up. As rates go higher, we expect further stress on companies and consumers. 

Conversely, we also recognize that the market is forward-looking, often pricing in future economic recoveries before they occur and that investors are irrationally exuberant. While we do not subscribe to, or make investment decisions based on FOMO (Fear of Missing Out), it exists and can often be the catalyst a market needs to continue to push higher. Through our experience, we have found when a large disconnect between economic fundamentals and market technicals exists, we should consider shifting allocations towards our neutral strategic allocations. 

Like many institutional investors, our cautious outlook has guided our allocations and we remain underweight to respective equity targets in client portfolios. [MT3] [CO4] Our quality bias, which served investors well in the angst of 2022, has served as a headwind in the first half of the year. Given the strength of the equity market recovery since late last year, we began bringing some of our equity positioning back toward our long-term target allocations. We intend to exercise caution while also monitoring opportunities to capitalize on any future market dislocations.    

Our fixed-income allocation has seen a reduction in non-traditional fixed-income investments that served portfolios well, as interest rates rose sharply. With end-of-rate increases in sight, over the last several months, we have been extending duration and increasing the quality of underlying bonds, emphasizing U.S. Treasury and investment grade fixed income securities. At this stage in the cycle, we believe this positioning should provide long-term benefits to portfolios and be benefactors of a ‘flight to quality’ that may ensue with any equity market volatility.   

We continue to succeed in improving returns and reducing risk by incorporating many private and liquid alternative investments into our allocations. Spiking interest rates have impacted private real estate, and we expect additional downward valuation adjustments across many sectors and markets. Our focus on real estate industries possessing a largely favorable supply/demand imbalance, like multifamily real estate, should help mitigate losses relative to other real estate sectors not possessing similar disparities. Despite the expected challenges in the real estate market, we maintain our dedication to exercising patience and selectivity in our decision-making process. For example, we are finding great opportunities in private credit. Most private credit is floating rate, possessing short durations and experiencing lower price sensitivity to spiking interest rates than similar public credit while also delivering a high-level of income production. We are beginning to observe defaults increase in the market, though they remain well below historical averages. With higher rates expected, additional pressure on borrowers’ ability to service debt will be applied. As such, our focus is on partnering with high-quality managers who have a proven track record of reducing loss. While we face significant uncertainties, we remain anchored by our core principles. Thank you for your continued confidence and support. If you have questions or concerns, please contact your Centura Wealth advisor.   

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. 

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Centura Wealth Advisory is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura Wealth Advisory and its representatives are properly licensed or exempt from licensure. 12255 El Camino Real, St. 125, San Diego, CA 92130.

It is not the strongest or the most intelligent who will survive but those who can best manage change.

-Charles Darwin

Recap

The investment landscape is constantly evolving. 

Over the last 6 weeks, we’ve experienced 3 of the 4 largest US Bank failures in history, with First Republic Bank the being most recent domino to fall. JPMorgan Chase quickly acquired the majority of First Republic’s assets, and assumed the deposits and certain other liabilities of First Republic Bank from the Federal Deposit Insurance Corporation (FDIC) for $10.6 Billion, with FDIC providing 80% loss coverage of First Republic’s single-family residential mortgages for 7 years. The fair value of the single-family residential loans is ~$22 Billion, with an average LTV of 87%.

In previous communications, we stated we did not anticipate further bank contagion following the demise of Silicon Valley Bank and Signature Bank. We have since adjusted our outlook and acknowledge the possibility of more regional banks failing in the near term. While we shift our outlook and advise clients to consider limiting regional bank deposits to FDIC-insured amounts of $250,000 (or your bank’s threshold as several banks possess multiple charters, allowing for more than the standard $250,000 limit), we believe larger national and international banks maintain much more resilient capital structures and controls in place which offer greater safety in deposits. 

Hike rates until it Breaks!

The Fed has an abysmal track record playing their part in several former crises. They generally tighten until something breaks.

The Savings & Loans (S&L) Crisis

In the early 1980s, the Federal Reserve increased interest rates to combat inflation, which made it more expensive for S&Ls to borrow money. Many S&Ls had funded their investments in real estate and other ventures with borrowed funds, so the interest rate hikes increased their borrowing costs and squeezed their profits. At the same time, the S&Ls were offering fixed-rate loans to homebuyers, which meant that they were locked into low interest rates and couldn’t adjust their rates to match the higher borrowing costs. When the real estate market declined in the late 1980s and early 1990s, many S&Ls were left with significant losses and were unable to repay their debts, leading to a wave of bank failures and government bailouts. The historic interest rate hikes contributed to the S&L crisis by increasing borrowing costs for the S&Ls and reducing their profits, which led to risky investments and fraudulent practices^[1] to try to recoup losses. The crisis resulted in the closure of over 700 S&Ls and cost taxpayers over $100 billion in bailout funds.

The Dot Com Crash

From the late 90’s to early 00’s, investors engaged in speculative investing in internet-related companies which led to a market crash. At the time, many of these companies relied on debt financing to fund early expansion. Companies were able to sell ideas to investors through the novelty of the dot-com concept, most of which were unprofitable. 

The Fed’s rate hikes to combat growing inflation pressures made it more difficult for companies to obtain financing and led to a decline in investor confidence, which subsequently followed with a stock market sell-off. Although greed served as the main driver of the crash, the Fed’s hiking cycle served as a catalyst.

The Great Financial Crisis

The hiking cycle of interest rates played a significant role in causing the Global Financial Crisis (GFC) of 2008. In the years leading up to the crisis, the Federal Reserve had lowered interest rates to stimulate economic growth following the dot-com crash and the September 11 terrorist attacks. These low interest rates, combined with lax lending standards, led to a housing boom as many people took advantage of the easy credit to buy homes, invest in real estate, and even take second and third mortgages on their homes. However, in 2004, the Federal Reserve began to raise interest rates to combat inflation stemming from cheap money. This made borrowing more expensive and slowed down the housing market. At the same time, many of the homeowners who had taken out adjustable-rate mortgages (ARMs) found themselves unable to make their payments as the interest rates on their mortgages increased. This led to a wave of foreclosures This, in turn, led to a credit crunch, as banks became reluctant to lend money to each other or to other borrowers, exacerbating the economic downturn. The hiking cycle of interest rates played a key role in causing the GFC by slowing down the housing market, leading to a wave of foreclosures. This, in turn, created a chain reaction of losses and defaults throughout the financial system, ultimately leading to a credit crunch and a global economic downturn.

Current Day

The current hiking cycle of interest rates to combat 40-year high inflation is creating a regional bank crisis. Banking institutions, heeding the Fed’s guidance that inflation was transitory and rate hikes would not occur in the near future, searched for ways to increase yields on excess deposits invested in fixed-income securities. Many banks began increasing duration, reducing convexity^[2], and taking greater interest rate risk to capture a positive return on investments. When the Fed began aggressively increasing interest rates, these investments lost value, and institutions holding these investments began to experience stress on their capital stack. Simultaneously, bank deposits continued to yield nearly zero. Regional banks with the most exposure to these investments have experienced significant outflows, and in some cases, failure. 

Fed tightening cycles tend to have a way of exposing weaknesses formerly masked by easy money environments; similar to the economic environment investors have enjoyed since the GFC.  When the Fed starts raising rates, the impact generally takes months before working through the system and affecting markets.  We’re now witnessing the impact of the Fed’s most aggressive tightening cycle in four decades, and stress is being felt throughout the financial system.

What is happening now, and why did we adjust our outlook?

On Wednesday, May 3rd, the Fed continued its war against inflation and raised the target Federal Funds Rate (FFR^[3]) by 25 bps to a target range of 5.00% – 5.25%. In 14 months, the Federal Reserve has increased rates 10 times, for a total increase of 500 bps.  While the Fed will likely hit the pause button on rate increases in future meetings, they intend to keep rates elevated, adding additional pressure on banks and the debt service on corporate balances sheets.

Unlike their national and international counterparts, regional banks typically have less diversified business lines, less hedging (hedging is quite expensive and requires expertise), and more operational risk. Cracks within the foundation of Regional Banks subsequently began to appear during the current hiking cycle when depositors, unhappy with their meager deposit yield (most savings accounts were yielding <1%, while checking accounts were paying 0.01%) began withdrawing deposits and allocating funds to higher-yielding instruments like US Treasury Bills and money market funds. For example, from Q1 2022 to Q4 2022 (when the hiking cycle began), Money Market Funds total assets grew from 5.032T to 5.223T^[4]. To free up liquid capital to maintain capital adequacy requirements from bank outflows, regional banks were forced to sell financial assets. Most fixed-rate bonds have lost value, forcing these banks to realize losses. Because banks are highly leveraged businesses, it doesn’t take much for a bank to get wiped out if it experiences an exorbitant amount of excess deposits invested in fixed-rate bonds during an extraordinary rising interest rate environment. We saw this with First Republic Bank (FRC).

By providing the concessions to JPMorgan Chase in the FRC deal discussed earlier, the Fed set the blueprint for larger banks to wait for FDIC to seize a failing bank and subsequently purchase the institution for pennies on the dollar. If regional bank failures persist, we anticipate this trend will continue and large banks will be successful in consolidating market share. 

PacWest, a Beverly Hills, California-based bank is working to solicit interest in the sale of its lender finance arm to strengthen its balance sheet. Through May 9th, PacWest subsequently has lost approximately 75% of its value in 2023. Hence why we believe PacWest, among other regional banks are suffering the wrath of the Fed and lack of consumer confidence.  

We continue to monitor the situation closely and assess possible contagion to other sectors of the economy.  We do not believe that regional banks are out of the woods quite yet as they are one of the primary lenders to commercial real estate operators, and we expect that they will remain under pressure as they look to navigate the billions of dollars in maturing commercial real estate loans this year and next.  At the current level of interest rates, we expect to see defaults across commercial real estate increase in the coming quarters, particularly for those operators using primarily floating-rate debt to finance their operations.

Further, we recommend clients review their banks’ FDIC limits and proceed with caution if choosing to hold cash above the insured amounts.  While many banks have started to increase the rate they pay on savings accounts, we would still caution against holding above-insured limits, and encourage clients to explore options such as holding excess funds in investments like Treasury Bills, government-backed money market funds, or even brokerage CDs to name a few.  We are happy to discuss which options would be optimal for you.  We encourage you to reach out to your advisor to make appropriate changes.  

If you have any questions, please do not hesitate to contact us. 

[1] One example of Securities fraud was the chairman of Lincoln Savings and Loan, Charles Keating. Keating used his position and influence to engage in fraudulent practices that ultimately led to the collapse of Lincoln Savings and Loan. He convinced depositors to invest their savings in high-risk junk bonds issued by his own company, American Continental Corporation (ACC), which was the parent company of Lincoln Savings and Loan. Keating misrepresented the quality and risks associated with these bonds, assuring investors that they were safe and would provide high returns. In reality, these bonds were high-risk and lacked sufficient collateral. Keating used the funds from these investments for personal gain, supporting an extravagant lifestyle and making political contributions.

[2] Convexity is a measure of the curvature in the relationship between bond prices and interest rates. It reflects the rate at which the duration of a bond changes as interest rates change. Duration is a measure of a bond’s sensitivity to changes in interest rates. It represents the expected percentage change in the price of a bond for a 1% change in interest rates.

[3] Federal Funds Rate. The target interest rate range set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

[4] Taken from Fred Economic Data

General Disclosures

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

 All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

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