“What we learn from history is that people don’t learn from history.”
– Warren Buffett
“It’s tough to make predictions, especially about the future.”
– Yogi Berra
Another winter has passed, and it appears that hope springs eternal. Cliché maybe, but it resonates when related to the recent behavior of markets. Given the magnitude of losses, capital markets were poised to rebound. However, we wouldn’t have predicted that in a quarter that included the second-largest bank failure in US history, markets would continue to cling to the hope of a soft landing.
After the sharpest and swiftest tightening in Federal Reserve monetary policy since the late 1970s, history would suggest investors remain patient as businesses acclimate to higher interest rates. The lagged effect of sharply rising interest rates inevitably leads to cracks, if not outright breaks, in the economy.
With this backdrop, it is not surprising that stresses would appear in the banking sector. The implications for an economy dependent on credit seem profound, yet markets continue to reflect a more sanguine outlook.
While this may be the most forecasted recession I can recall, the economy continues to operate close to full capacity. Inflation pressures have receded from extreme levels but remain elevated. Consumer balance sheets remain healthy (in aggregate), unemployment is historically low, and wage and real personal income growth are positive. At face value, these facts provide a boost to the soft-landing camp supporting rising equity prices and falling interest rates year to date.
Our more cautious stance remains grounded in where we believe the economy is going, not where we may sit today. We anticipated a more challenging economy at this point in the year, although we respect the lagged effect of tightening monetary policy on economic activity. While it would be easy to ascribe the stresses in the banking system to individual banks, our interpretation suggests a more systemic challenge for the broader economy as businesses adjust to the rising cost of capital.
Banks are acting rationally to tighten lending standards given stresses on both the asset and liability sides of their balance sheets. In an environment where leading indicators are broadly weakening, the tightening of available credit by banks increases our conviction in the likelihood of a recession.
Yet, markets are whistling a different tune.
As interest rates have declined to start the year, equity markets have been revalued higher, particularly the higher-growth technology sector. This technology leadership has been particularly narrow with six stocks (Meta, Apple Alphabet, Microsoft, Nvidia, Tesla) contributing more than 100% of the 7.0% return for the S&P 500. While the size and growth of some of these businesses are impressive, we are skeptical that buying a business at 32x aggressive earnings estimates in the hopes that it can sell at 60x earnings three months later (see Nvidia) is an effective long-term investment strategy.
Our challenge is a sense that the market is taking the wrong message from falling interest rates. While falling interest rates are supportive of higher asset prices, falling interest rates associated with weakening economic activity are problematic for stocks. It is this mismatch between earnings growth expectations, which are accelerating, and economic growth, which is decelerating, that gives pause.
Over the course of the last year, we have taken multiple steps to position the portfolio in anticipation of a more challenging economic and earnings environment:
- Lowered our exposure to the financial sector (including banks)
- Reduced our exposure to corporate bonds
- Increased our exposure to Treasuries (both Treasury Bills and Treasury Inflation Protected Securities)
Each of these moves are reflective of our desire to lower the risk profile of portfolios. We do not know what the future may hold but given our assessment of higher interest rates, persistent inflation, and a weakening economy, financial markets are likely to remain volatile.
A quick word on private markets, we continue to look to private markets as a means to enhance the long-term return potential of portfolios while improving overall diversification and risk management. We remain clear, however, that the risks we see in the public markets are equally acute in private markets. We are pursuing a disciplined, patient approach to allocating across private markets with the same focus on risk management.
We thank you for the confidence that you and your family have placed in our firm. Please do not hesitate to reach out to your wealth advisor or a member of the Investment Advisory team with any questions.