Expect the Unexpected

In our last WJBlog, we discussed the collapse of Silicon Valley Bank (“SVB”) and its investor implications. Fortunately, as of now, the bank failure has not spread to other banks. However, SVB’s failure will likely lead to FDIC limit adjustments and could tighten credit conditions, increasing the chance of a recession.

The first quarter of 2023 saw significant moves in several asset classes, as the following chart shows:

The chart shows three asset classes. The blue line is global stocks; the red line is long-term treasury bonds; the green line is managed futures (trend following) strategies. Note that the red line shows bond prices, so it moves opposite of interest rates.

There were three distinct periods in the quarter:

• Period 1 saw stocks and bonds perform strongly as interest rates fell and investors bought last year’s most beaten-down stocks.
• Period 2 saw interest rates rise and bonds fall and as market participants, encouraged by Jerome Powell (Fed chairman), began to believe we would avoid a recession. Managed futures rose as they were betting on interest rate increases.
• In Period 3, SVB’s failure led to an extreme and unprecedented decline in interest rates and a corresponding increase in bond prices. Stocks initially sold off as concerns about additional bank failures increased. But the selloff was short-lived, and stocks moved back to their yearly highs by the end of the quarter. Managed Futures experienced one of its most rapid reversals as interest rates collapsed.

The net result was a good quarter for stocks, up 6.4%, and bonds, up 3.3%. Long-term treasuries were up 7.5%. Managed Futures struggled during the quarter, down 4.5%. But our other diversifier, reinsurance, had a great quarter, up 8.0%. The two combined (our alternatives portfolio) were flat for the quarter.

What might happen in the remainder of 2023?

Here are a few things we expect to see for the rest of the year:

We expect inflation to continue to decline. The following chart shows inflation through the end of February.

Neither Federal Reserve member forecasts nor market-based inflation estimates expect inflation to return to the 2% Fed target by year end. This means the Fed will likely keep rates high, if they have a choice, to bring inflation down. Unfortunately, this also means increased unemployment and slowing GDP growth.

We think the FED is very close to ending interest rate increases.

The above graph shows the Fed member’s consensus Fed Funds rate (the blue line) and the market-based fed funds rate (the orange line). Both show rates either slightly rising or declining by year’s end. There is obviously a divergence between the two which also needs to be resolved. Rate increases may end at one of the Fed meetings this quarter on May 2-3 or June 13-14.

We will see more financial system cracks exposed. Fed policy operates with a long and variable lag, meaning we are just beginning to feel the full impact of increases last year. So far, we’ve seen issues at UK pension funds, FDIC-insured banks, and in interest rate-sensitive real estate stocks. Will more cracks appear? It seems likely.

Based on this outlook, how are you positioning portfolios?

At the start of the year, we saw two likely scenarios. Both are still in play:

1. We avoid a recession entirely or it is minor in magnitude. Interest rates likely stay about where they are, leading to returns on bonds equivalent to their current yields (6% or so), and stocks muddle through as earnings only decline slightly. A balanced portfolio would experience low single-digit returns, notably better than last year.
2. We experience a significant recession. Stocks fall 20% or more, and the FED is forced to cut rates to stabilize the economy, thereby increasing bond prices. We expect similar returns to the previous scenario as bond gains would offset stock losses.

In both scenarios, bonds deliver better returns than stocks. As a result, we are overweight bonds in all of our portfolios and underweight stocks. We would also expect bonds to outperform alternatives as managed futures continue to bet on rising rates.

Please contact us if you would like to discuss your personal portfolio.