Earlier this year, I published an article titled “Bank Failures, Bond Rallies, Inflation Softening”. In that piece, I covered failures in a handful of banks mostly due to irresponsible management of their bond portfolios and a weak venture capital backdrop (many customers of the bank were VC). The result was essentially a bank run as these customers needed capital, and a panic ensued from lack of such capital that the bank could make available while they sold heavily discounted bonds off their balance sheets to return capital to depositors. Not exactly a recipe for success or risk management.
 
We’ve seen interest rates climb higher and higher throughout the year as the Fed tightened and inflation data lacked a perfect downward slope. We’ve seen massive debt issuances by the Federal Government causing supply gluts in bonds which further helped push rates higher. It’s remarkable to me how the U.S. debt pile and resulting interest expense from that has not been at the top of every politician’s list, and I would venture to say this is my biggest concern fiscally in our country.
 
This week’s CPI report for October indicated a 3.2% year-over-year increase, one tick lower than the 3.3% expected by economists and a whole 0.5% lower than September. While this is very encouraging, it is a result of the economy weakening. As part of my career, I am consistently conducting channel checks with various business owners in different segments of the economy, and the consensus has been clear for many months now – things have slowed considerably and in some businesses, activity is flatlining. More often than not, the things we see in real time take many months to show up in the economic data. By the looks of the latest labor data, I think we are finally starting to see more weakness there which is another significant data point that the Fed uses to determine the course of monetary policy.
 
Given the returns available in fixed income now, I have been on a steady path adding bonds for clients when I can find value. I have also been upgrading credit quality. I think it is prudent to hold higher levels of cash in the money market (roughly 5% yield) now, and prudent to lock in these rates for the future by owning bonds with maturities and durations longer than what we’ve owned in the last several years. As we saw what happened to banks earlier this year, properly managing a bond portfolio is paramount to success. I think we can feel more comfortable locking in these rates for longer.
 
Lastly, in looking at equity returns for the SP500 this year, they look pretty good when you consider 2023 only. However, an important caveat is that essentially 7 stocks in the SP500 have carried practically all the returns. That means that the remaining 493 are down. If you did not own large quantities of these mega cap stocks, you did not participate in upside this year. That strategy doesn’t exactly accomplish reducing risk by diversification.
 
Fed Funds Futures are indicating the early-middle of next year for the Fed to reverse course and reduce rates. I think this will ultimately un-invert the yield curve which historically is a phenomenon that occurs when we are in recession (as Fed has to reduce to stimulate economy). It seems that this is a plausible forecast if the economy continues to weaken, and inflation reduces along with it. If I want to be invested anywhere in equities in that environment, it’s in technology, and I am fond of municipal bonds over Treasurys to diversify balance sheet risk. My approach into the end of this year and into 2024 continues to be cautious, holding higher quality securities and keeping significant cash on the sidelines.