Broker Check

Second Quarter Memo: Cracks in the Armor

The first quarter is in the books and after a slow start – and one that looked promising – the stuff hit the fan in March.  When Silicon Valley Bank (“SVB”) failed, it caused a bit of a chain reaction of ‘banking crisis contagion.’  The culmination was the failure of Swiss banking giant, Credit Suisse, which was absorbed by fellow Swiss bank, UBS.


The turbulence in the markets was short-lived though the ramifications of the events are still with us today.  Despite that, stocks still finished the quarter up, with the S&P up +7.5%. 


The Federal Reserve continues to tighten up monetary conditions in order to constrain lending and restrain inflation.  They have made progress, but more work is needed to get to their target inflation of 2.0% per year.


So far in 2023, we have seen more of a “risk-on” price action.  We have considered this the last gasp of the economy as the full impact of prior policy tightening has yet to filter through to the real economy.


Ultimately, we see a recession, and not just in the US but a widespread global one, highly likely in the next 12 months.


We would implore investors to resist the lure of “FOMO” or the Fear of Missing Out in any of these bear market rallies. 


The banking crisis has accelerated the timeline to when we think a recession will start.  There are still so many unknowns at this point including the depth, duration, and magnitude of the downturn. 


The market’s appetite for risk remains a big concern for me as we think they are ignoring the Federal Reserve (“Fed”).  There’s a mantra that has gone back decades, “Don’t fight the Fed.”


This means that if the Fed is intent on having an outcome happen, that it will likely happen, so don’t bet against it.  The Fed right now is attempting to hit the brakes on the economy to combat generationally high inflation.  The likelihood of a recession is very high in this environment.


Just this past week we received the “Fed Minutes.”  This is a transcript of the members of the FOMC committee and the things they said in their meeting.  In the last meeting in March, several Fed officials considered pausing the rate-hiking program after the failure of two regional banks. 


In addition, near the end of the minutes there was a forecast slipped in this time that was not in prior minutes.  The forecast from Fed staff now has a base case scenario that the banking sector stress would tip the economy into recession.


However, they concluded that higher inflation remains so paramount that they pushed ahead with a rate hike despite that risk.  That is because the objective of the Fed- the so-called dual mandate- calls for them to maintain stable prices (inflation at +2%) AND maximum sustainable employment.


Right now, we have the opposite of stable prices, but we have a very strong labor market.  So, the Fed is okay causing a ‘mild’ recession and weakening the labor market some in order to achieve the goal of stable prices.  Remember, this is no stated unemployment rate objective like they have on the inflation side.  In other words, 4.5% unemployment could still be considered “maximum sustainable employment even though that’s nearly a point above the current unemployment rate and would mean 1.6 million people losing a job.


As we have discussed in the past, this dual mandate is paradoxical because a strong labor market typically results in higher inflation.  It is a delicate balancing act and why the Fed is often said to be ‘threading a needle’.


The Fed has raised rates from zero in the depths of Covid to a Fed Funds rate range of 4.75% to 5.00% today.  We think there will be one or two more hikes and then they will be done.  The problem we see is that they are likely to not adjust fast enough back to looser financial conditions because the economy slips into recession.


The market right now is NOT positioned for any type of recession, not even a mild one.  The market drop last year was entirely due to higher interest rates.  Recall how we walked through this.  Risk assets are valued based on discounted cash flows.  Those cash flows are discounted by a discount rate – or the prevailing rate of interest.  The higher that rate, the lower the value of that future cash flow and the lower the value of cash flow producing asset itself.


In a typical recession, earnings fall by 20% or more.  If a recession comes, we are likely to see S&P earnings fall from $220 to about $180 (or even lower).  That means that the S&P is well above fair value and is not incorporating any chance of a recession.

The chart below is illustrative. It shows what the bond market thinks the Fed will do with rates over the next year (orange line) and what the Fed is saying they will do (blue line).  There’s a slight difference.

Essentially, the Fed says they will raise rates once more and then hold for a while whereas the bond market says they will raise a bit more and then almost immediately start cutting.  In fact, they think they will end up cutting by 100 bps over the subsequent 6 months. 


That normally only occurs in a recession.

While investors are not happy with the results of their investments over the last couple of years, as both bonds and stocks have fallen, the outlook has not improved all that much.  Chart 2 on the next page shows the current valuation and the subsequent 10 year returns for stocks.  You can see that the valuation is a big predictor of that forward return for the next decade.


We started 2022 where the blue line is with future returns not that far off zero.  The drop in the markets moved the line left to where we are today (green line).  That indicates that 10-year equity returns are likely to be around 5.0%-6.0%. 



However, we can purchase investment grade corporate bonds, and in some cases, government sponsored entities, with yields of 5.5% to 7.5%.  Default rates for these bonds are very low.  In fact, for AAA, AA, A, and BBB-rated bonds, the probability of default is 0%, 0.38%, 0.39%, and 1.02%, respectively.


So, the chance of loss is low.


We think taking that low risk and securing that 5.5% to 7.5% yield is better than reaching for the potential additional return of stocks.  Don’t forget that going from bonds to stocks means you’re taking on roughly four times the risk.


The beauty of bond math (referring to individual bonds) is that I know exactly what your return will be on the investment.  Even if an individual bond loses value at some point, so long as the issuer doesn’t default, it will recover and pay out par at the end of the term (maturity date). 


The prospects for bonds have improved so vastly that the forward return assumptions for a 60/40 portfolio (60% stocks, 40% bonds) have risen by 50%, from +4.4% per year to +6.7%.  [chart 3 above]

We just don’t feel that the risk-reward is all that attractive for taking on equity risk.  Besides inflation and tight monetary policy, a banking crisis has added to investor anxieties.  While I do not see a repeat of 2008 by any means (not even close), it does argue for caution.


Right now, I still anticipate a recession starting sometime in 2023 (likely late summer).  However, we won’t know it actually started until early 2024 when the National Bureau of Economic Research backdates the start.  Expect to see consumer activity really start to curtail as investors draw down their Covid savings and start to see job losses with the unemployment rate rising modestly. 


The Federal Reserve will pause raising interest rates very soon which will be highly beneficial for bond investors.  On average (reference chart 4 above), there is less than six months from the last Fed rate hike to the first rate cut.  I believe this time will be half that average due to the quickening pace of business cycles and fast-falling inflation coupled with slowing economic growth.


Again, this environment is a once-in-a-generation opportunity produced by the Covid outbreak and the overwhelming liquidity response.  The Fed is trying to undo that response with higher interest rates.  And that will be reversed once inflation is kicked – which we think will occur later in 2023.


When interest rates fall, the prices of our bonds will rise and the opportunity to buy investment grade bonds at 6%+ yields will be gone.  We continue to buy these bonds every day and replace open-end bond mutual fund positions.  The return for bonds following a Fed pause (the time between the last hike and first cut) is typically strong. [2]


As we progress throughout 2023, we think there will be more volatility (as an aside, anytime someone says to expect ‘volatility’ it is code for the market to drop).


We continue to believe our clients are far better positioned in individual bonds than in any other risk asset available to us.  The goal is always to take the least amount of risk possible while still achieving our return objective of 5.0%.  We will never take on excessive risk just to add incrementally to returns.


Investors should buckle up and expect to see a bumpy ride.  The S&P is up over 16% from the October 2022 lows but I think we could go all the way back down to those levels, and perhaps lower in the coming months. 


Portfolios remain highly defensive as we await better opportunities to add risk.


A Quick Note on the US dollar

I have fielded a noteworthy number of questions about the US dollar “crashing” and no longer being the global reserve currency.  Given high inflation and waning global US dominance, there have been many concerns about the greenback.  We have also seen headlines from Brazil, India, China, and Russia seeking to create a competing global reserve currency and calling for de-dollarization, particularly in oil and commodity trading.


While this seems to pop up every so often, the collapse of the US dollar is not likely to occurr in my view.  For one, there just is no currency in a position to take over that role.  The euro would be the only potential currency and it just isn’t as stable and liquid as the dollar – and would have a long way to go in order to become it.


China is not anywhere near having a deep enough financial marketplace where the renminbi would be a credible currency.  Additionally, no currency that is NOT free-floating (market derived value) and is pegged to another currency, the dollar, could become the global reserve currency. 


The US dollar still accounts for the vast majority of global reserves (assets held by global central banks in foreign currencies).  The US dollar accounts for over 60% of these reserves where the next largest, the euro is barely at 20%.  China is at 2.7%.
Global trade is still largely conducted in dollars, including oil and commodities.
The U.S. dollar is backed by deep, liquid and regulated financial markets.
As always, we value the trust you place in us and if you have any questions, please do not hesitate to contact us.




Mark J. Asaro, CFA

Noble Wealth Management


[1] LPL Financial

[2] Source:  Bloomberg, Edward Jones