Last June, I published an update piece to the publication titled “The Reality of Where We Are”. In those pieces was a very cautionary and bearish tone, one that identified a flattening (now inverted) yield curve (when short maturity interest rates are higher than longer maturity rates – almost always a tell-tale sign of recession) and a Federal Reserve that had a lot of catching up to do from way too loose of policy. I also mentioned that we didn’t know exactly what the catalyst would be as a result of the Fed’s change in posture, but we knew something would have to give. The other important item that I cautioned about was the likelihood of a ‘soft landing’, which is something that is highly unlikely from a historical statistical standpoint. We got to a peak stage of denial, in my opinion, among the universe of the investment community when I began to hear the term “no landing” being thrown around. That’s really when I knew nobody had any idea what to do or what to say.

Nevertheless, the first catalyst for Fed rate hikes to counteract inflation has finally shown. Silicon Valley Bank became the second largest bank collapse in US history, and really in epic fashion. The bank poorly managed its own bond investments by taking on far too much duration risk (duration is the measure of volatility for a bond – correlated to the length of time to maturity) during a rate hiking cycle in the face of a stubborn inflationary environment. I think all our clients have heard me warn about how dangerous this can be for fixed income investors who buy bonds for their safety. We saw that come to fruition last year as the 20+ year Treasury (considered a risk-free investment from a default standpoint) collapsed more than 30%, underperforming a lot of the equities markets. Because of this portfolio mismanagement, the bank found itself upside on investments and not able to sustain itself financially which led to an attempt to raise capital, followed by less than assuring commentary by their CEO, followed by a bank run, and then the FDIC came in and seized the bank. The FDIC has backstopped all depositors, leaving shareholders the bag holders of the bank’s mismanagement, as it should.

Fears of contagion rocked the banking sector and soon after Signature Bank showed up as the next victim of an under diversified and over leveraged strategy to VC, tech, crypto (ironically the first assets to fall – the markets can tell us a lot in advance). Most importantly, I am not concerned about large money centers like Bank of America and JP Morgan, and the FDIC I think has made it clear that they’re willing to protect depositors even beyond the 250k limit.

As a result of this, Treasury bonds have rallied in a huge way, attracting risk-off investment and a 2008-esq feeling of investors preferring to own Treasurys than have their money in a bank account. I think the most important feature of this bond rally is the yield curve making a big move towards re-steepening, but we have a long way to go before the curve un-inverts (a bullish signal). I watch the bond market more closely for economic and equity signals than I do the equity markets alone as it has proven to be a reliable indicator if you know what to look for. For clients, I have been a net seller of equities over the last ~16 months and a net buyer of fixed income and preferred stocks, even for our more aggressive clients. Rates have looked attractive enough from a risk/reward perspective to feel confident about this strategy and it appears to be paying off in reducing equity risk for clients and finding return in other places. We continue to hold record amounts of cash and I don’t see that changing until economic data worsens. My thesis is that we will be in for a volatile year in 2023 and perhaps part of 2024 and equity returns may be muted for that period or longer as the economy works off 13 years of stimulus.

On the inflation front, we’ve seen CPI soften to 6% and the PPI report was more encouraging, with prices falling 0.1% as opposed to the expected 0.3% increase. On a 12 month basis, the index increased 4.6%, well below the previous month’s revised 5.7%. While this data, especially PPI, is encouraging, we still have quite a bit of work to do, and I strongly believe that bank lending will tighten up even more with what’s going on and consumer sentiment will fall with this news being the forefront of headlines. I think those two items alone will help the Fed as they will likely feel pressured to take their foot off the gas a little bit when it comes to aggressive hikes in the near term.

As always, I will keep a close eye on things and make portfolio adjustments as needed. With the amount of cash clients are holding in portfolios and the amount of fixed income buying we’ve done, I feel confident that our clients have been properly prepared for further volatility. While I can sit back and say (like most advisors) “it’s time in the market, not timing the market”, I do not feel like I would be doing my job adequately if I was not taking steps to mitigate risk during these times.

Thank you for taking the time to read and please do not hesitate to reach out with any questions.

Mike Lambrechts