Market Commentary:
Summary of our views is as follows:
The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. The full impacts will show up with a lag.
The distribution of potential outcomes in many markets is wide, and much wider than it has been in decades. We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate the equity and the rate markets today.
While inflation is clearly declining, we doubt it returns to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed. It is quite uncertain what the Fed’s response will be if inflation only declines to 4% and remains there.
From 1968-82 the equity market experienced multiple violent rallies and subsequent selloffs, and 70% of purchasing power was lost to inflation. We could see a mini period that is similar -> rangebound choppy markets and steady erosion of purchasing power.
The mark-to-market of private assets into 2023 could be an additional drag. Many will show losses, which may result in less ongoing demand, and possibly a desire to pair back exposure. This all brings elevated risk to public and private equities.
The risk of a credit crunch in the second half of 2023 is real. Investors are no longer willing to accept zero interest from bank deposits and have been reallocating capital into money market funds or other short duration investments. Regional banks have historically been a major provider of CRE, C&I and personal loans. Regional bank business uncertainty could result in tighter lending standards or even an unwillingness to extend credit.
Active management has the potential to generate superior performance than passive long positions in the most widely followed US equity indices or mega-cap stocks. The market’s new leaders are most likely not the leaders of years past.
Demand for downside protection in the US equity markets remains anemic. Put option skew remains low, while market liquidity has been on a general downtrend. Don’t under-estimate the potential for either a grind lower or a gap lower in equity indices at some point in 2023.
Concerns of a Credit Crunch:
March has historically been a month that has brought turmoil and March 2023 didn’t disappoint. The fed’s large and rapid rate rise finally broke something – Regional banking. Silicon Valley Bank was invested in longer duration liquid Treasuries & mortgage-backed securities and they allocated them to their “held to maturity account” where they can’t hedge interest rate risk. As depositors pulled money out, the bank had to start selling their Government securities, realizing large losses. The situation spiraled down quickly, as SVB was an institution that focused mostly on clients with accounts far above the FDIC limit, and that money left quickly at the first sign of trouble.
The bank run led to SVB filing for bankruptcy protection. Subsequent ripple effects included Signature Bank being closed by regulators, First Republic Bank aggressively trying to navigate out of harms way and even Credit Suisse (certainly not a Regional bank) being forced to get taken over by UBS.
Concerns over systemic banking risk led to one of the fiercest reversals of Fed policy expectations and short maturity interest rates of the past three decades. The US Treasury 2-year yield plunged more than 100 bps in a week and a half – a larger change than in the 1987 stock market crash. This was a 12 standard deviation event. In the days following, the 2-year yield gained or lost at least 30 basis points for a record 7 days in a row. The implied probability of a 50 bps Fed rate hike went to a 78% probability on March 8th to a 0% probability on March 13th. The MOVE Index (VIX for bond markets) exploded higher and reach levels only seen in the 2008 financial crisis.
While SVB may have made some bad decisions on the investments they made (longer maturity Treasuries & Mortgage bonds that contained significant risk to interest rates going higher), along with where they allocated them (held to maturity accounts), the bigger risk in our opinion is what is slowly transpiring now.
We have repeatedly discussed that the Fed will probably hike rates until something breaks. The business of regional banks supporting small and medium sized businesses with lending and banking services could be the item that breaks.
Jim Bianco said it very eloquently last week – what we are experiencing now is not a bank “run” but a bank “walk.” Deposits at many regional banks are steadily leaving and going into money market funds.
How big are the regional banks? According to Bloomberg, there was as much as $7 Trillion in regional banks before the recent exodus. That is more than at JP Morgan and Bank of America combined. Regional banks have made many or in some cases most of the commercial real estate loans, personal loans, C&I loans to the markets that they operate in. According to Bianco Research, the majority of the workforce is employed by companies of less than 100 employees. These companies have specialized and local needs, and these companies are best served by the 4,000 small and regional banks.
The decline in deposits at all banks started long before the SVB crisis in March. This is of no surprise as it is relatively simple to transfer funds from a bank deposit earning zero interest to a money market mutual fund. But the combination of regional bank stresses & loss of confidence, along with short duration interest rates exceeding 4% accelerated the flows (see charts below). As of the end of March, there is now $5.25 trillion in money market funds – an all-time high.
As deposits leave, bank profitability declines, which leads to sentiment declines. We expect deposit outflows to continue – not purely from a lack of confidence but simply as it is a smart economic decision. A 4.5% yield on a $100,000 account is $4500 in annual interest. Compare that to zero in a bank deposit. Banks are trying to figure out what to do. And an inverted yield curve makes the situation even more difficult.
We believe the risk isn’t simply another bank failure. The risk is a steady and severe decline in the willingness to lend to small and medium businesses and consumers. Do regional banks pull back on lending enough to severely hurt the economy?
Uncertainty on deposit outflows and bank profitability = continual tightening of lending standards or simply not lending. Look for a real credit crunch in Q3 or Q4 if these trends continue.
2 Year US Treasury Yield Candle Chart:
Source: TradingView
Source: https://twitter.com/biancoresearch/status/1635407339711787008
MOVE Index Chart:
Source: Bianco Research
Equity Markets – Under the Hood Checkup:
The S&P 500 rose 3.51% for the month of March, however the underlying health of the rally was simply awful. The average stock within the index actually fell about 1% in March. The equal-weighted version of the S&P 500 index, as measured by the RSP ETF, fell for the month. According to Bianco Research, "eight stocks are keeping the YTD gains in the S&P 500 positive, while the other 492 stocks are collectively down on the year."
The following charts illustrate the relative unhealthiness of the equity market performance over the past month:
Here's a chart that provides a historical perspective on the performance trends of S&P 500 stocks versus the index.
Source: https://twitter.com/DeanChristians/status/1642140849613033474?t=4OCv5TshYNYtXZ1Stw428w&s=09
The underlying weakness is similar in the Nasdaq 100 (QQQ). While the price action of the headline QQQ ETF is solid, most of the underlying components are falling apart:
Source: Danny Merkel Newsletter Issue #113
Here is another sobering statistic: The Nasdaq and the Russell 2000 have become inversely correlated. A negative correlation is quite rare, and perhaps is related to the concerns over a credit crunch coming, as large cap tech would seemingly have an easier time sourcing funding than smaller companies.
Source: TradingView.
Adding to the concerns is the XLI/XLP ratio, a proxy for economic growth prospects, has broken down sharply in March. XLI is the Industrials sector and XLP is the Consumer Staples sector.
Source: TradingView.
Monthly Podcast Recommendation:
This month we are recommending 2 podcasts of “Mike’s”
The Meb Faber Show. Morgan Stanley's Mike Wilson Says the Earnings Recession is Worse Than You Think https://www.stitcher.com/show/the-meb-faber-show/episode/morgan-stanleys-mike-wilson-says-the-earnings recession-is-worse-than-you-think-472-300959790
The Derivative. WTF?! Will 0DTE Cause Gammageddon? With Mike Green and Craig Peterson https://www.stitcher.com/show/the-derivative/episode/wtf-will-0dte-cause-gammageddon-with-mike-green and-craig-peterson-300369232
STRATEGY COMMENTARY:
As a reminder, our Sundial Dynamic All-Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets Utilize both active (tactical) and passive (buy and hold) strategies
Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non-correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our systematic tactical equity strategies paired back risk in mid March on the regional bank concerns. This brings us comfort as we really don’t like what we see in market breadth and participation. We continue to believe this is an environment for individual stock picking, and not investing in equity indices, despite the recent moves and also relative outperformance of the indices since the start of the year. Most importantly, should the recent US equity rally turn out to be nothing more than a bear market rally and aggressively reverse, our tactical equity strategies would be expected to decrease remaining exposures quickly and go back to full capital protection mode of 100% cash, which is yielding an attractive 4.5%.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and not in single names. We see little reason to tinker with the positions until the outlook is more clear. We are biased to pair back exposure even more on any strength in small caps and value stocks. We are relatively optimistic on healthcare exposure here and will look to rachet up exposure slightly on weakness. There are simply moves on the margin – trading around exposures, and not widespread asset allocation changes.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects our defensive stance. We continue to utilize mostly alternative yield generating investments and avoid Government and corporate bonds. We continue to modestly increase exposures to our preferred strategies such as litigation finance and reinsurance. Additionally, there have been some new alternative yield generating ETF launches and our due diligence with the sponsors has been positive, so we have started to weave them into portfolios. With so many choices to generate yield, convexity and non correlated returns to equities, there is no reason for any portfolio manager to still be endorsing a 60% equity / 40% bond type portfolio in our opinion. One other nice perk of higher yields in the front end is that some of our strategies are derivative based. These strategies have large amounts of excess cash as they are required to place margin on exchanges, and not the full position notional value. This excess cash was yielding zero a year ago and now all of these strategies are collecting yields on the excess cash, which should augment returns in this environment. Derivatives such as options and futures do not carry additional risk as long as they are sized and utilized appropriately, and the managers we allocate to have decades of experience and very robust risk management.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: March was a poor performance month for trend following strategies in aggregate, mostly due to the aggressive reversal in short rates and Fed rate hike expectations mentioned above. While our trend following investments and managers did experience drawdowns, they were relatively modest. This is one of the reasons
trend following is such a robust long term strategy – it can be painful to participate in at times, as positions are never exited at the top. Our trend following investments did give back some recent gains, and although they are negative for the year, they are still quite positive over the past year or longer. The macro picture remains even more murky now in our view, and we aren’t proponents of trying to predict markets anyway. We believe the macro environment continues to be constructive for “dislocation seeking” trend following strategies. Now more than ever, we seek this uncorrelated stream of returns, particularly as these strategies could capture some very painful trends of lower stocks, higher or lower bond yields, and increased implied and realized volatility if we do go into a recession and/or credit crunch
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: We are actively increasing exposures to these strategies. The cost of tail protection (skew) remains quite low, the potential for a left fat tail is increasing, and we are strong proponents of this exposure in all portfolios. This is another area where we tell anyone who will listen to initiate or add to exposures while the cost of protection is cheap.
CHARTS & TABLES:
This chart comes from the Fed H8 report. It is current through the latest data, March 8 ... two days before Silicon Valley Bank failed. What has been the largest drawdown of deposits since the financial crisis? The weeks BEFORE the bank failures of the last few weeks.
Source: https://twitter.com/biancoresearch/status/1638271286152675330?s=20
Money market flows overlaid with interest rates showed things changed when rates exceeded 4%. -- The middle panel in the chart below shows total assets in money market mutual funds are now above $5 trillion for the first time. The bottom panel shows cumulative inflows into money market funds since March 2022. As rates went from 0% to 4% between March and November 2022, inflows into money market mutual funds were a paltry $62 billion. This changed when rates crossed above 4% last November. $143 billion flowed into money market funds as rates rose from 4% to 4.5%. Another $80 billion flowed into money market funds in just a few weeks as rates rose above 4.5%. $250 billion flowed in the last two weeks. -- Behavioral changed when rates moved above 4%.
Source: https://twitter.com/biancoresearch/status/1641205963951685638
The gap between money market rates (blue) and deposit rates (orange) is now quite extreme. The spread between the two is the bottom panel (red). It is expected that the bleed of deposits will continue until the rate differential is gone.
Source: https://twitter.com/biancoresearch/status/1641205967302868993
Regional banks, which collectively have about $6.8 trillion in banking assets, no longer understand their deposit base (bank's liability). This will force them to pull back for expanding loans (bank assets), leading to a credit crunch. Restated, the Fed hiked too much, and deposit behavior, super-charged by mobile banking, broke. Now Regional banks have to compete with market rates to hold deposits. This kills profitability, which may explain why the bank stocks cannot rally even as fears of failure subside. Banks may not be cheap, as earnings expectations should be collapsing with net interest margins.
Source: https://twitter.com/biancoresearch/status/1641205968867405826
Source: https://twitter.com/mrzepczynski/status/1635962362468392961
Wild gyrations in early March around fed hike expectations:
Source: https://twitter.com/biancoresearch/status/1635773254664110086
S&P 500 ETF vs the Equal Weighted S&P 500 ETF
Source: https://twitter.com/TheChartReport/status/1640449665756954624?t=VL1MtbUwp4xrhhjuj_mYdg&s=09
Source: https://twitter.com/SuburbanDrone/status/1641964004120641537?t=gv1M52ghSckDMiv_UsQmA&s=09
Source: https://twitter.com/Mayhem4Markets/status/1645030644299210754/photo/1
Source: https://twitter.com/ISABELNET_SA/status/1643916750705111042?s=20
St. Louis Fed Financial Stress Index rises to 1.575 - a level seen only four times during the last 30 years.
Source: https://twitter.com/CheddarFlow/status/1640503970018803712?t=pnd5EiWGIVHcDl8RgtMVEA&s=09
Source: https://twitter.com/PinkPoloShorts/status/1642617364805033990/photo/1
US auto loan delinquencies continue to rise.
Source: https://twitter.com/MikeZaccardi/status/1636379631392796676?t=2t9HzHudsdFKoHmJXIMfnw&s=09
Source: https://twitter.com/SethCL/status/1644686995753402368/photo/1
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