By Morgan Christen
CFA, CFP, CDFA, CEO and CIO
One of the most incorrectly heard lyrics is courtesy of Elton’s John’s Tiny Dancer. Many car karaoke singers hear “hold me closer, Tony Danza” when the actual lyric is “hold me closer, tiny dancer.”
But I think the most appropriate misheard lyric for the last quarter comes from Bon Jovi. The lyric should be: “it doesn’t make a difference if we make it or not.” What people hear is “It doesn’t make a difference if we’re naked or not.”
Why is this appropriate? Looking back in March, we realize many banks and depositors were indeed naked. Were banks not paying attention to the Fed or their depositors? Were depositors humming a tune of safety, when that was far from the truth?
We often talk about risk, but there are so many factors that could be considered risky. Sitting in a bank that offers almost nothing on your deposit, only to learn your cash hoard is beyond the insured limits… that is a risk.
The risk of loss and the minuscule amount of interest are also risks. Inflation is a risk. Seems to me having large sums of money at a bank is not as warm and fuzzy as one would think.
Are the banking issues over?
Interest rates seem to be leveling, but depositors may continue to bring down their account values to below the insured limit, as many depositors are moving funds to T-bill or money market accounts.
There is also the issue of banks holding commercial loans. With office vacancies and work from home, can the debtholders make do on their payments? That will be playing out, which will keep volatility in the banking sector.
A year has passed since I broke my nose (Police – Message in a Bottle: “A year has passed since I wrote my note.”). With the Fed’s rapid rise in rates, it is not a big surprise banks feel like they have been punched in the nose as they look at the paper losses in their portfolios.
In the bond world, there is a term that mathematically measures a bond’s sensitivity to interest rate changes, that term is duration. Duration shows the inverse relationship between interest rates and bond values.
Rates go up, values go down (and vice versa). If you have a bond with a duration of 10, a one-percent increase in rates translates to a 10% loss in value. As you see on the cumulative change chart below, the Fed moved up more than one percent.
More relevant scenario, duration of 10 with a three percent hike in rates and you have a paper loss of 30%… ouch. Not a big deal if you hold the bond to maturity as you will get 100% of your money back. It is a big deal if you have a run on your bank and they are a forced seller.
After a tough 2022, most sectors of the market posted positive gains in the first quarter. The international developed market beat our domestic market by over a percent.
Domestically, large growth stocks significantly outperformed their value brethren. Not a surprise as we saw growth (technology) stocks take a large hit last year.
Overall, domestic investors favored larger companies.
Interest rates pulled back a bit, allowing bonds to post positive returns in the first quarter.
As I spoke of duration earlier, those with the longer durations performed the best as rates moved down.
One-month T-bills moved up 62 basis points to 4.64% while the 10-year Note decreased 40 basis points to 3.48% and the 30-year Bond decreased 30 basis points to 3.67%.
Inflation seems to be declining, but the Fed may not be completely done with their job. Companies like Truflation take a different approach to calculating inflation. They use over 10 million data points and update in real time, and according to them, inflation is close to 4%. But inflation (and the Feds corrective measures) has left an imprint on the economy.
Credit cards and auto loans have hit consumers’ pocketbooks as they have moved up with the increases in rates. Bankrate reported the average credit card interest rate has reached 20.4%.
The Fed’s ability to bring a soft landing is looking a bit more challenging especially as they are now pumping cash into the banking system. Their “bend don’t break” plan could be pushing parts of the economy to break.
If the landing is a bit harder and we do fall into a recession, that could accomplish their goal of bringing inflation down. However, the bond market is currently pricing in interest rate cuts in the not-too-distant future.
There are risks that we face every day and investing (or doing nothing) are risks. We’ve had a lot of issues over the last three years: the pandemic, the invasion of Ukraine, and the jump in inflation.
A lot of instances to throw in the towel. However, the three years ending February 28, 2023, the Russell 3000 Index (a broad measure of US companies) returned an annualized 11.79%.
We have all weathered the bad markets of 2022 and we will continue to have market volatility. As they say, “life is 10% what happens to you and 90% how you react to it.” Let’s make sure you do not overreact.
With the positive start in stocks and the attractive yields in bonds, we are digging out of last year. Over the long run, I would suggest, investing in markets becomes less risky, while sitting on the side potentially becomes more.
We look forward to speaking with you and we thank you for your continued support.
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