Market Commentary - 2023 - Q1

‍Key Takeaways:

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• Stocks rebound in Q1, led by technology shares
• Run on regional banks, SVB, Signature Bank, and First Republic fail
• Yield curve steepens
• Inflation slows
• Short-term cash, gold is attractive
• Is the USD losing its reserve currency?
• Commercial real estate could be the next domino to fall
• Earnings growth and consumer spending slow
• Outlook - Cash for short-term, bonds and gold for medium-term, stocks for long-term

Stocks rebound in Q1, led by technology shares

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Run on regional banks, SVB and First Republic fail

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• Fluctuations in interest rates can create unrealized gains/losses for banks as the value of their assets increases or decreases.
• The rapid increase in interest rates has led banks to accumulate unrealized losses in 2022.
• This can create bank solvency issues if banks are forced to realize these losses.

Yield curve steepens

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• The yield curve is deeply inverted due to inflation, Fed policy, and the economic slowdown.
• The Fed intends to keep rates high which could keep pushing up the short end of the curve.
• It is natural for the yield curve to flatten and invert as the Fed fights inflation.

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• Interest rates had been on a declining trend since the 1970s, resulting in a multi-decade bull market for bonds.
• Rates rose over the past year in a way that breaks this long-term historical pattern, but have stabilized more recently.

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• The Fed intends to keep rates high as it responds to high inflation, especially on food and shelter which affects consumers.
• However, the market expects the Fed to lower rates later in 2023.
• This will depend on the path of inflation and the health of the financial sector.

Inflation slows

• CPI is a commonly cited measure of inflation. It uses a basket of goods and services to track price changes for consumers.
• In order to measure the underlying trend in inflation, rather than temporary shocks to food and energy, economists often focus on core CPI.
• Inflation has been cooling but services inflation remains problematic due to shelter costs.

Short-term cash, gold is attractive

• Gold prices often move in the opposite direction of interest rates.
• This is partly because greater central bank stimulus can make gold more valuable as a store of value.
• Recent moves by China, Russia, Brazil, France, and other countries started moving away from USD reserve currency have also contributed to a rise in gold prices.

Is the USD losing its reserve currency?

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• Major global currencies have been extremely volatile over the past few years.
• The dollar strengthened in value over the past year but this trend has reversed a bit as China, Russia, Brazil, France, and other countries started moving away from USD reserve currency.

Commercial real estate could be the next domino to fall

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• Returns on commercial real estate jumped up to their highest levels since prior to the Global Financial Crisis following the pandemic.
• Commercial real estate has declined in recent months following increases in interest rates and the banking crisis.
• Many, including Elon Musk, Warren Buffett, Ray Dalio, Charlie Munger, believe that there is significant risk in CRE as office buildings still have high vacancy rates and CRE loans are often due within 5 years, which can result in numerous defaults over the coming months.

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• Corporate earnings are still growing but at a slower pace as the broad economy decelerates.
• S&P 500 earnings reached historic peaks over the past two years but inflation and consumer worries have slowed its growth.
• In general, higher profitability makes valuations more attractive.

• Retail sales are an important way to measure consumer spending.
• Consumer spending and confidence have declined as prices have risen and the economy has slowed.

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Outlook - Cash for short-term, bonds and gold for medium-term, stocks for long-term

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We believe that the S&P 500 will retest its 2022 low of 3,491 as the economy falls into a mild recession in 2023. A mild recession is our base case, however low growth and inflation is here to stay

When recessions destroy demand, central banks often come to the rescue with lower interest rates and easy monetary policy. This potential recession or market downcycle will likely be the opposite of past recessions as cutting interest rates could cause any declines in inflation to reverse like we saw in the 1970s. Loose policy is not on the way to help support risk assets, in our view.

We believe what worked in the past decade will not work in the next decade as the era of quantitative easing is over. We are calling this our new investment playbook.‍

The Great Moderation, the four-decade period of largely stable activity and inflation, is behind us. The 40 year bull market in bonds, prices rise as yields fall and vice-a-versa, has broken down. Interest rates are once again meaningful.

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Theme 1: Pricing in enough damage, “buy the dip” is dead. Disconnect between the market expectations and Fed.

Theme 2: Bonds finally have a place in portfolios, especially for the aging population. Short-term bonds (less than 2-year maturity) over long-term bonds.

Theme 3: Learning to live with inflation. Gold should have a place in portfolios.

Theme 4: Stocks, long-term. Value over growth. Volatility is normal, get invested and stay invested.

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• This chart shows the performance of the stock market (bars) and the largest intra-year decline (dots) each year.
• The average year sees a stock market drop of -13.5%. However, most years still end in positive territory, averaging 9% gains.
• Volatility is a normal part of investing and investors are often rewarded for staying disciplined through short-term volatility.

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