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.  

For the past several quarters, the market has seemingly ignored communications from the Fed, particularly the point that interest rates will continue to rise and remain elevated for as long as it takes to restore inflation to their 2% target. This trend persisted up until August in the aftermath of Chairman Powell’s Jackson Hole speech and the subsequent September Federal Open Market Committee (FOMC) meeting. After over a year of repetition from Chair Powell, the market finally appears ready to listen to sentiment coming from the Fed. 

Successful childhood tug-of-war matches typically rewards the side with the best anchor. In a quest to predict the future, both the economy and the Fed have entered into a game of tug-a-war, with the market as the rope. Good news is no longer good news, rather, good news is bad news, and bad news is good news. The market hates uncertainty and must predict whether the Fed will raise rates again and, perhaps more importantly, when they will begin lowering. Good news signals that the Fed can continue increasing rates and likely prolongs the duration that rates must remain elevated. Conversely, bad news signals conditions are softening, and the Fed is likely done raising rates, with a pivot to rate cuts shortly to follow. The struggle is finding a better anchor than the side wielding the most power – the Fed. Hence why they said, ”Don’t fight the Fed.” With this constant push-and-pull between monetary policy deployed by the Fed and economic reality, it is hard to predict what will happen next. 

Market Recap

Equities – The combination of stronger economic data and revised projections from the Fed has finally gotten through to market participants. The Fed does not intend to repeat the mistakes made during the Volcker regime. The Fed will keep rates elevated longer to stifle inflation and ensure prices do not reverse course and reaccelerate. The market acceptance of the Fed’s thesis, coupled with higher Treasury yields, has finally chinked the armor of the interest rate ‘sensitive,’ tech-heavy NASDAQ-100.  

While the index was flat for the quarter, the NASDAQ-100 was down 6.61% since the yield on the 10-Year U.S. Treasury first began to surge on July 31st. This effectively erased the gains the index enjoyed during the quarter’s first month, bringing the index’s 2023 return to 34.51%.      

On the other hand, recent performance of the S&P 500 has been characterized by the ten largest stocks, which currently comprise more than 30% of the overall index. In fact, 90% of the benchmark’s return has been driven by those large constituents, which are mostly Big Tech. This is the highest level of concentration the index has seen with data going back to 1990. 

Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. The top 10 S&P 500 companies are based on the 10 largest index constituents at the beginning of each month. As of 9/30/2023, the top 10 companies in the index were AAPL (7.0%), MSFT (6.5%), AMZN (3.2%), NVDA (3.0%), GOOGL (2.2%), TSLA (1.9%), META (1.9%), GOOG (1.9%), BRK.B (1.8%), XOM (1.3%), and UNH (1.3%).  Guide to the Markets – U.S.

Through three quarters, the S&P 500 is up 11.68%, while the average stock, represented by the S&P 500 Equal Weight ETF (RSP), is up a mere 0.17% through September.  Elevated rates, tighter financial conditions, and more stringent lending standards continue to dampen the outlook for smaller companies, as the small-cap Russell 2000 index sold off 10.89% amid the late July 10-Year U.S. Treasury yield surge, bringing the small company gains to 1.35% for the year. 

Talk of the most anticipated recession has quickly evaporated, and a ‘soft landing’ is all but expected. The market appears to have accepted the ‘higher for longer’ mantra the Fed has been telegraphing all year. Participants are digesting the data and reacting counterintuitively to the good news is bad news and bad news is good news drum.  As we enter what is traditionally a strong quarter for equity markets, investors in the fourth quarter will look for clarity from the Fed as they start to shift focus and position portfolios for 2024.

Bonds – As yields spiked, bonds continued their downward trend, adding to losses accumulated since August 2020.  On the heels of a U.S. credit downgrade from Fitch and stronger-than-expected economic data, the demand for U.S. Treasury securities continues to wane, failing to absorb supply and forcing yields much higher. The U.S. Department of Treasury’s spending spree of nearly $1.7 trillion in U.S. debt since early June is also adding to the supply glut and forcing yields higher. The yield on the 10-Year U.S. Treasury surged 0.78% in the third quarter, seeing its highest yield since 2007. Bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, fell 3.23% in the third quarter, dragging the performance for the year to -1.21%. 

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, expectations have quickly gone from a certain recession to a high expectation that the Fed will successfully pursue a ‘soft landing’, avoiding a recession altogether. While the data has continued to surprise to the upside, many growth metrics continue to moderate.  

Economy: Still Waiting on that Recession? 

Defying expectations, the last week of September delivered the final, unchanged revision to second-quarter GDP growth of 2.1%.  The September GDP reading saw strong fixed business investment of 7.4%, and upward revisions to inventories and net exports to help offset an unexpected slowdown in consumer spending. Early projections for second-quarter growth saw personal consumption cut in half as consumer spending was revised from 1.7% to 0.8% — the weakest advance in our nation’s primary economic driver in over a year. While consumer behavior is important to monitor, the slowdown does not appear troublesome to the Fed.  After reaching 5.8% in mid-August, the Atlanta Fed’s GDPNow model for the third quarter was pushed lower to a robust 4.9%, signaling continued economic strength.

While real GDP may be growing moderately, several factors have the potential to push growth lower. Battling 40-year high inflation has applied pressure to consumers. According to Bloomberg, outside of the wealthiest 20% of Americans, the consumer has run out of extra savings. Consumers have less cash on hand than they did when the pandemic began. Adding to budgetary constraints, 40 million people collectively owe more than $1.6 trillion in student loans, and these individuals are starting to make payments on student debt for the first time since the onset of the pandemic. Given the lack of savings, the payments of $300 on average are causing concerns that discretionary spending will continue to trend lower. Not to mention, credit card debt has risen to record highs, exceeding $1 trillion and underscoring the severity of this consumer strain. With approximately 70% of our growth tied to the consumer, their financial health should be seen as a harbinger of what could unfold. 

Inflation & Interest Rates

Inflation remains elevated, though the downward trends are welcome. August’s headline Consumer Price Index (CPI) came in at 3.67%, while core CPI (excluding energy and food) remained above the 4% threshold, registering 4.39% year-over-year. The once persistent pricing pressure on core services, particularly, shelter, appears to have finally broken lower. Shelter represents about 1/3 of CPI, making the variable impactful on the overall basket of goods. Given the Fed’s focus on core inflation, the downward trend is seen as positive. However, dampening excitement is the sharp reversal of energy. Gasoline and energy rose 5.6% and 10.6%, respectively, in August, from the prior month, forcing headline inflation to reverse course and go higher.

While the downward trend in CPI is a reason for optimism, we are more concerned with the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE). After remaining mostly flat at 4.62% for the first half of the year, the gauge finally broke below the 4% level, to 3.88%. Breaking through the 4% milestone has many economists and market participants anticipating the possibility that the Fed is done raising rates for the year. 

Just like the debt ceiling negotiations consumed headlines through June, the government shutdown dominated chatter leading up to the close of the government’s fiscal year on September 30th. Like the debt ceiling, the proverbial can was kicked down the road, avoiding a shutdown at the eleventh hour. While negotiations were essentially a non-event, one of the most meaningful outcomes has been the U.S. government’s subsequent issuance of new debt, which has been ongoing since June 5th.   

Following the debt ceiling extension, markets anticipated the issuance of $1 trillion in new Treasury securities by the end of the third quarter, however, their estimates were off the mark. Surpassing expectations, the U.S. Treasury has issued approximately $1.7 trillion of new debt just since June 5th, pushing the nation’s deficit beyond $33.125 trillion. Issuance of new securities floods the market with new supply and, with few buyers, this massive issuance serves as additional quantitative tightening to support higher yields. 

‘Higher for Longer’  

The Fed is undoubtedly committed to doing whatever is necessary to bring inflation back to its long-term target of 2%. After embarking on their most aggressive tightening cycle in March 2022, the Fed has raised rates eleven times over eighteen months, bringing the target range for the Fed Funds rate to 5.25% to 5.50%. During this period, Federal Reserve Chairman Jerome Powell additionally led a $95 billion monthly balance sheet reduction. This reduction shed nearly 11%, equivalent to $960 billion, off the federal balance sheet, illustrating that the Fed is willing to deploy any and all tools in their war on inflation. 

After pausing rate hikes in July, the September Federal Open Market Committee (FOMC) meeting marked the second time since March last year that the FOMC voted not to hike rates further. The decision to pause was all but expected, but revisions to the Fed Dot Plot and forward-looking expectations for the Fed Funds rate sent markets reeling. Their September projections adjusted what was previously 1.0% of rate cuts expected in 2024 to only 0.50% and subsequently raised their projections for rate cuts in 2025 by 0.50%. These upward revisions indicate to the market that the Fed intends to keep rates elevated and will plan to slowly lower them over time to ensure their fight to pull inflation back to their long-term target of 2% is successful.   

September’s FOMC release and updated economic projections show a target peak Fed Funds rate unchanged at 5.6%, indicating another 0.25% of increases in 2023, though the market is anticipating the Fed is finished raising rates for now. Following the Fed’s September decision and updated Dot Plot, the market is finally accepting our base case and listening to what the Fed has been saying: rates will remain elevated for the foreseeable future, and barring a catastrophic event, cuts won’t likely come until mid-2024.   

Source: Federal Reserve  

Unemployment    

One of the Fed’s primary concerns continues to be wage growth. Although wage inflation has been trending lower, it remains elevated at 4.3%, which at the time of this writing is now higher than both PCE inflation readings, causing some anxiety for the Fed. Strong wage inflation increases the risk of a wage-price spiral, increasing the likelihood of a reacceleration of inflation or at the very least, persistent, elevated inflation.  

August’s Labor Market Report registered the 32nd consecutive month of job gains, showing signs of optimism for the Fed. Estimates called for 170,000 jobs added in August. Instead, markets were hit with the addition of 187,000 jobs. Unemployment jumped 0.3% to 3.8%, matching the large monthly bounce in May. Perhaps the most comforting data point in August’s job report was the significant increase in the participation rate, which notched a 62.8% reading. When coupled with job openings (JOLTs) falling sharply below nine million, this data point brought the ratio of job openings to those unemployed to 1.5:1, a welcome reading from previous months. The Labor Force Participation is driven by two primary factors, the labor force, which is defined as those employed or actively seeking employment, and the working age population. More people entering the labor force coupled with fewer job postings means wage growth may not turn out to be a source of inflation. As supply continues to increase and demand for labor wanes, wage growth should start to subside; a welcome development by the Fed.

Centura’s Outlook  

As the Fed remains committed to battling elevated inflation, interest rates have spiked to levels not seen since before the Great Financial Crisis and will likely continue to trend higher, or at least stay elevated for the foreseeable future. The Fed’s goal to tighten financial conditions and slow the economy just enough to lower inflation back to their 2% mandate and avoid recession is now the base outcome expected by the Fed and most market participants. However, if rates continue to march higher, we believe it could turn into a matter of not if, but when something in the economy will break. 

Earnings for the second quarter were once again stronger than expected, leading many to believe higher rates and inflation aren’t wreaking as much havoc as initially feared. However, with consumer spending trending lower and margins being pressured by both inflation and higher rates, revenues were effectively flat and the -4.6% year-over-year contraction marks the third consecutive quarter of negative year-over-year earnings.   

According to FactSet, the estimated earnings growth for the S&P 500 in the third quarter has been revised higher from the expected -0.4% in June to -0.1%. The negative forecast highlights companies’ challenges over the last year to produce profits. Given that higher rates are expected to persist, a company’s ability to service debt will remain negatively impacted, adding sustained pressure over the coming quarters.     

Forward 12-month P/E ratios are approximately 17.9x, slightly above their ten-year average of 17.5x, indicating that equities are slightly overvalued.  The inverse of the P/E ratio is known as the earnings yield, which can be compared to the 10-Year U.S. Treasury yield to gauge the relative valuation of equities. A higher earnings yield would indicate equities are undervalued, while a lower earnings ratio indicates that equities may be overvalued, as equities should demand a risk premium above prevailing Treasury rates. With the earnings yield currently at 4.26%, versus the 10-year U.S. Treasury yield of 4.59%, equities appear slightly overvalued at this juncture, and additional drawdowns may be in store before equities become attractive from a valuation standpoint.    

With recent Federal Reserve rhetoric and inflation still elevated, we remain cautious. The market is pinned to the Fed’s monetary policy tightening and has become dependent on poor economic data: the worse the economic conditions become, the greater the likelihood the Fed will pivot from their current posturing. Many variables in the third quarter surprised to the upside, and looking backwards, conditions appear somewhat stable. However, as all investors should know, past performance is not an indicator of future returns. As we look forward, the potential deterioration of consumer’s financial health gives us pause, as does the impact of prolonged elevated rates on corporate balance sheets. We believe the two largest risks to 2023’s economic and market rallies are a misstep or abrupt change to the expected Fed outcomes and a potential resurgence of inflation, both of which are closely intertwined. As communicated in , until inflation breaks lower, we remain cautious and anticipate that equities will continue to experience turbulence, particularly if inflation resurges.   

We remain steadfast in our belief that markets are discounting the impact of the Fed’s aggressive monetary tightening actions. Defaults and bankruptcies continue to rise, and as rates go higher, we expect further stress on companies and consumers. However, the artificial intelligence craze led to robust gains in technology-based and growth-oriented companies, causing many investors to jump in the market for Fear-of-Missing-Out (FOMO) and creating a large disconnect between economic fundamentals and market technicals. Given these disconnects and overall uncertainty, we returned our portfolio allocations to their long-term neutral targets. In addition to removing our underweight to equities, we have been actively replacing underlying investments to enhance the focus on quality. To navigate the forward-looking environment, we have added actively-managed investments in asset classes where active management has a proven track record of delivering superior risk-adjusted returns relative to respective benchmarks. 

Asset classes we believe warrant active management in this phase of the market cycle include international equities, large cap value, and fixed income.        

Surging interest rates have hurt private real estate, with further downward valuation adjustments expected. We prefer to focus on real estate industries possessing favorable supply/demand imbalances, like multifamily and various types of industrial real estate. These imbalances should help mitigate losses relative to other real estate sectors not possessing similar disparities, though further paper losses are expected. Ultimately, we believe a focus on quality and conservative underwriting, coupled with diversification across real estate asset types, geography, and sponsors will only benefit client portfolios.

While higher rates negatively impact several financial markets, we continue to find great opportunities in private credit. Given private credit is predominantly floating rate with short durations, and generally lower price sensitivity to spiking interest, private credit should continue to deliver strong returns and high levels of income production over similar public credit instruments. Defaults are climbing but remain below historical averages. Our focus in private credit aligns with our focus across all major asset classes, which is a focus on quality and relative value, anchored in our core investing principles.

We recognize the uncertain backdrop may provide cause for concern. We remain vigilant in our process, with an emphasis on protecting clients’ wealth, while delivering value over multiple market cycles.

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.

 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.