Client Letter 1Q 2023
Another quarter down and yet more volatility and uncertainty. Markets tend to be forward-looking and anticipatory of things to come. This largely comes from FOMO – fear of missing out. No one wants to miss the boat when the market turns higher. So investors attempt to predict and make bets based on these predictions.
During the first quarter, the Fed continued to raise interest rates, raising them twice but only by one-quarter of a point in February and again in March. This left the Fed funds rate in the range of 4.75% - 5.00% at the end of March. Despite these interest rate hikes, the yields on Treasury bonds actually fell for the quarter as investors seemed to be anticipating rate cuts from the Federal Reserve and sooner rather than later. Frankly, I expect one more interest rate hike in early-May by another 0.25% leaving the Fed funds rate at 5% - 5.25%, which is where Fed Chair Jay Powell has indicated he thinks rates should be at a minimum to curb inflation. Let’s look at what investors are seeing and how this has played out in the markets.
At the start of the year, the inflation rate as measured by the CPI or Consumer Price Index had fallen steadily since peaking at just over 9% in June to 6% in February. There seemed to be two narratives that gave investors hope. One was that inflation was falling rapidly and would be under control soon. This would cause the Fed to start cutting interest rates. The other narrative was that the Fed, by continuing to raise interest rates, would cause a recession and would need to cut interest rates in response. In both cases, the idea of falling interest rates plays a key role.
We saw this anticipation of rate cuts being played out across both stock and bond markets. In the bond market, interest rates on Treasury notes and bonds fell during the quarter, dropping by 7% - 9% during the quarter. At the start of the year, the interest rate on 2-year Treasury notes, for example, were around 4.41% but ended the quarter at just over 4% even. The interest rate on 30-year bonds fell from just under 4% in December to 3.69% at the end of March. We can tell a lot about market psychology from the interest rates we see on bonds with different maturities and how these bond yields (interest rate) change over time. By the end of the quarter, the bond market was anticipating the Fed would cut interest rates by the end of the year.
This tumble in interest rates was accompanied by a rally in the stock market, especially among “growth” stocks. The key reason for this is that when interest rates are low, companies that have low debt and higher cash flows see their stock prices become more valuable. We saw this play out as the S&P 500 Index rallied 7.46% for the quarter while the tech-heavy NASDAQ 100 Index gained a whopping 16.77% for the quarter. Volatility in the stock market was relatively muted until mid-March when we suddenly encountered a banking crisis. Actually, that should be banking “crisis”. There was really only one bank in crisis that did lead to a second bank that failed but the idea that we have systemic problem is ludicrous. I will come back to this in a bit.
Where do we stand in this current environment? I have been adamant that I believe what Fed Chair Jay Powell has been saying all along. We are going to see at least one more rate hike and then likely a pause to give the markets a chance to catch up to their policies. Barring some major exogenous event, I do not see the Fed cutting interest rates this year. I believe we won’t see interest rate cuts until at least the end of the first quarter of next year. I don’t see inflation falling to the 2% target very quickly, especially given the issues in the labor market. In a nutshell, the Federal Reserve is extremely worried about this current inflationary environment being a repeat of the late-1970’s era inflation. That was a time when we had wage and price spirals going. Wages for workers would go up, which caused companies to have to raise prices, which caused a new demand for higher wages which led to higher prices and the circle seemed endless. What broke that cycle was when the Fed under then chair Paul Volker dramatically raised interest rates (anyone remember 15% CD’s and 18% mortgages?) which ultimately stopped this cycle and brought inflation back down to a more normal 3% - 4% range. The current Fed is laser-focused on this very scenario. My fear is that they are misinterpreting the situation. This labor market is not like the one in the 1970’s for many reasons. The biggest reason is that that labor market had a larger supply of people to tap into than we do now. Everyone that entered the work force at that point is either retired or retiring and we just do not have enough people to replace them. This lack of supply of workers will keep wages high but I believe businesses will be limited in how much they can raise prices when most of their consumers are retired and on fixed incomes.
Since the likelihood is that interest rates are going to stay higher for longer, this means the stock market is likely overvaluing stocks. I think we will see stock prices fall but I do not see a significant meltdown. I have been saying for the past year that we are in a broad range on the S&P 500 Index between 3,600 and 4,100 and that still seems to be accurate. At the end of the quarter, the index stood just over the 4,100 level which lines up with my thesis. So far. I don’t get too excited when the market hits that 4,000 – 4,100 level and I don’t panic if we fall to the 3,700 – 3,800 level.
The one fly in the ointment that could change the speed at which inflation comes in is the banking “crisis”. Let me clarify what happened here. There was a bank – Silicon Valley Bank – that had been growing tremendously, focusing on tech start-up companies in Silicon Valley in California. The bank’s assets had essentially tripled in size in the past three years, with most of the deposits being corporations rather than individuals. Banks will typically invest their excess funds into reasonably safe investments such as government bonds. This bank, during the pandemic, bought 30-year Treasury bonds which are one of the safest investments around. At the time these were purchased, interest rates were still near zero so these bonds, paying about 3% interest, seemed reasonable. Then, in 2022, the Fed started raising interest rates. A basic principle in finance is that bond prices and interest rates are inversely related. That is, if interest rates go up, the price you can sell a bond you hold will fall. Conversely, if interest rates fall, the price you could sell a bond you hold will increase. With interest rates rising these 30-year Treasury bonds that Silicon Valley Bank held tumbled by as much as 20% in value. These were the worst investments they could have held in a rising interest rate environment. At the same time as their portfolio of bonds was falling, many of their depositors were looking to move their money to other banks offering to pay more interest. This caused a “run” on the bank meaning the bank did not have enough liquidity to pay out all the depositors wanting their money. This happened over a weekend in early March. The Sunday night after Silicon Valley Bank was essentially declared insolvent, I happened to turn on my TV and it was on the business network CNBC at the time. They had a “special report” entitled “BANKING CRISIS IN AMERICA” and I thought “what are they talking about?”. There was one other bank – Signature Bank in New York – that also got caught up in this “crisis”, but in fairness this bank was very involved with cryptocurrency which provided additional risks. Much of this “crisis” is in the fervent minds of the media who need headlines. Because of the failure of Silicon Valley Bank, there are likely to be additional regulations that may limit some lending by these regional banks. The outcome of these new banking regulations will have a similar effect to additional interest rate hikes which may help curb inflation sooner. However, I still do not think we are going to see a 2% inflation rate this year and the Fed has been very clear on their goal.
With all of this as background, how are we positioning clients for this current environment? We made minimal changes this quarter. We are still focusing on “value” versus “growth” as we continue to believe the market is misreading the signals. We have made a very slight modification to our screen, adding a filter for very high free cash flow to find great companies worth investing in for the long term. We remain focused on solid companies that continue to grow sales at a reasonable rate and have strong free cash flows they can use to either reinvest into the company, pay dividends, buy back stock or all the above. We only made two changes of significance during the quarter. We eliminated our holdings in the Invesco DB US Dollar Index Bullish fund (ticker: UUP). This fund took advantage of the U.S. dollar being stronger than other currencies which was a result of the rising interest rates. With that coming to an end and with other countries now raising their interest rates, this fund had run its course, so we sold our entire position.
The other big change we made this quarter was to make a switch in our core balanced mutual fund. Previously we had been using the Janus Henderson Balanced fund (ticker: JABAX) which is a very good fund. However, the only reason we used that one was that our all-time favorite balanced fund, the T. Rowe Price Capital Appreciation fund (ticker: PRWCX) had been closed to new investors. In late February, Capital Appreciation began a limited re-opening and we jumped at the chance to move everyone over from the Janus Henderson fund to the TROW fund. This fund – what we refer to as a 50% - 70% allocation fund, meaning it will be at least 50% invested in stocks and up to 70% invested in stocks with the balance in cash and fixed income – is the best performing fund of its kind over the past 3-, 5-, and 10-year periods. As long as the current manager remains at the helm, this will be our “go to” core fund.
Aside from this core fund, one of our largest investments across client accounts continues to be the Janus Henderson AAA CLO fund (ticker: JAAA). This fund invests in portfolios of senior secured loans with floating interest rates. At present, this fund is yielding about 5.6% but this is expected to climb to around 6% next month when the interest on the loans in the portfolio are adjusted. This started out as a place for us to “park cash” and was one of the few investments that was profitable last year. This fund continues to do well for us, gaining about 1.39% for the first quarter. I have mentioned in the past that as interest rates peaked, we wanted to find places to “lock in” higher yields. However, it does not appear that we can do much better than we can in this fund.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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