The LTWM Insider- Market and Economic Commentary Q1 2023
Executive Summary
Stocks and bonds were positive in the first quarter of 2023. Not enough to offset losses for the previous year and reach a new record high (last set on January 5th, 2022), but well above the lows of October 2022. There is plenty of economic data to support either the bull or bear view for the rest of the year. The bull argument is supported by the very strong jobs market and when jobs are plentiful, U.S. consumer spending is strong. The Fed is applying a heavy brake to the economy by raising short term rates 4.75% over the past year and selling bonds to increase long term interest rates. The bear argument is the inevitable conclusion that the current path of rate hikes will lead to recession in the fight to bring inflation back down to 2%. Stocks tend to climb a wall of worry and the past two quarters resulted in positive stock returns.
We have stated for several quarters, it is not about the Fed, it is all about inflation. Now, inflation is on a downward trajectory; and the supply chains appear to be functioning normally again. The consumer price index (CPI) peaked at a 9.1% annual rate in June of 2022 and has declined each month to its current level of a 6% annual rate. We remain cautiously optimistic on the strength of the American consumer to make it through this period of higher but declining inflation and believe corporate earnings will remain strong enough to avoid large layoffs. What keeps us up at night is a potential credit event, which we did have this past quarter, and so far, is contained.
The failure of Silicon Valley Bank and Signature Bank brought down the entire regional bank sector (the KRE regional bank sector ETF was down 35% during the quarter) and caused the Fed to offer new lending programs to make sure all banks had sufficient liquidity to meet customer withdrawal requests. The sector remains down, since regional banks have many headwinds this year, but once the systemic risk potential dissipates, bank stocks should recover.
We would like to remind everyone that you don’t own the highs and you don’t own the lows, you own the long-term performance of your portfolio. The best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are here to support your continued success and would be happy to answer any questions or concerns.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 1st Quarter 2023 Index Returns
All equity and fixed income asset classes were positive in the first quarter. For the broad U.S. Stock Market, the first quarter return of 7.18% was well above the average quarterly return of 2.2% since January 2001. International Developed Stocks returned 8.02%, also well ahead of the long-term average quarterly return of 1.5%. Emerging Market Stocks returned 3.96%, above the average quarterly return of 2.5%. Global Real Estate Stocks returned 1.37%, above the asset class’s average quarterly return of 2.2%. The global supply chains are functioning well, and it does appear the peak in inflation is behind us, but Q1 positive returns were not enough to offset losses in the past year. The Federal Reserve reduced its rate hike from 50 bps to 25 bps at its last meeting, in response to lower inflation readings, but the probability of recession this year is still high. Here is a look at broad asset class returns over the past year and longer time periods (annualized):
For the full year, International Developed stocks led all broad categories by declining the least, down -2.74%, while U.S. stocks were down -8.58%, Emerging Markets stocks were down -10.7% and Global Real Estate stocks were down -20.29%. The U.S. Bond Market lost -4.78% and Global Bonds were down -3.27% for the past year, sizeable losses for bonds. Over the past five years, U.S. stocks were up 10.45% annually, while International Developed stocks were up 3.8% annually, Emerging Market stocks were down -0.91% annually, and Global Real Estate stocks were up 2.41% annually. The U.S. Bond Market was up 0.91% for the past five years, while Global Bonds were up 0.9%. Over the past 10 years, the U.S. stock market (up 11.73% annually) is well ahead of International Developed (up 4.91% annually) and Emerging Market (EM) stocks, which are up only 2.0% annually over the past 10 years.
Taking a closer look within U.S. stocks during the first quarter, we experienced the reverse of fourth quarter 2022’s significant outperformance of value stocks, with Large Growth leading, up 14.37% compared to Large Value leading last quarter, up 12.42%. Large Value stocks were only up 1.01% for the first quarter. The reason for the strong reversal was the failure of Silicon Valley Bank, which led to a deep pullback in the regional banking index (KRE was down 35% in March) bringing down small cap value stocks from the leading asset class to the bottom during Q1:
The current sell-off in regional bank stocks remains near lows for the year and likely won’t recover until investors believe the crisis is contained. So far, there is no evidence of a systemic banking concern. We believe the vast majority of bank stocks will recover in the near future and we will see the small value stock asset class recover as well. The high volatility and uncertain future weigh on small cap stocks, since large cap stocks are considered more defensive during challenging economic times.
If we extend our analysis of U.S. stocks over longer time periods, the strong quarter for Large Growth stocks was not enough to catch Large Value stocks over the past year, which are down the least, -5.91%. Small Value stocks lead over the past three years, up 21.01% and then Large Growth is the top asset class over the past 5 and 10 years. The trend of value outperformance took a hit with the regional bank crisis but is still strong and likely to continue for some time. The valuations of growth stocks have increased during the first quarter. It is worth noting that Market wide results for the past 10 years are very strong, up 11.73% annually.
The U.S. business cycle continues to slow by many measures, and the majority opinion is still that the Federal Reserve will land the economy in recession at some point this year or next with its heavy-handed demand destruction tools to fight inflation. However, the American consumer has weathered the inflation storm so far and continues to spend. We still believe it is difficult to see a heavy recession with the job market so strong. The average wage earner is doing well; and jobs are still plentiful. The U.S. job market remains very tight; and until it breaks down, we are not likely to experience a recession in the near term.
It is difficult, if not impossible task for the Fed to fight supply side inflation by using demand side destruction tools, which is all they have. The Fed has successfully slowed the housing market and used car sales have declined substantially from their peak, due to higher interest rates. The supply chain has recovered for the most part and prices for most goods at the grocery store have declined. U.S. inflation is expected to be down in the coming months, which could allow the Fed to pause rate hikes for a substantial period. A lengthy pause by the Fed will allow stocks to continue to climb higher. Any systemic credit event in the banking system or the Federal debt ceiling political impasse could send stocks down to new lows.
Across the pond, for the second quarter in a row, International Developed Stocks were up in local currency, and up more in US dollars, since the dollar depreciated against most foreign currencies. The Euro went from $1.07 to its current value of $1.09. It is still down from $1.18 just over one year ago. The currency effect served as a small tailwind to international stock returns during the quarter. The value premium (value-growth) was negative, along with the size premium, similar to U.S. stocks during the first quarter, and likely a result of the regional banking crisis. Our investment funds are priced in U.S. dollars (unhedged) and benefit from a weakening dollar:
Over longer time periods, the value premium (value-growth) is positive over the past 1 year and now 3-year period, but still negative for 5 and 10 years. The size factor premium (small cap-large cap) is negative in the past quarter, 1-year, 3-year and 5-year periods but it is still positive over the past 10 years.
Shifting the commentary to fixed income, bond market returns around the world were positive during the first quarter, due to lower inflation expectations, higher overall yields, and the regional banking crisis. One more interest rate increase is expected at the next Fed meeting in May and the Fed’s QT (quantitative tightening) program is expected to continue for many years. The yield on the 5-year Treasury note decreased by 39 basis points, ending the quarter at a yield of 3.6%. The yield on the 10-year Treasury note decreased by 40 basis points, ending the quarter at a yield of 3.48%. And the 30-year Treasury bond yield decreased by 30 bps to 3.67%. Here is the U.S. yield curve, and you can see how yields fell all along the curve, except the very short end so now the highest yield on the curve is at a maturity of 3 months and the yield curve is inverted from 6 months to 10 years and flat from 10 to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):
As a reminder, during the fourth quarter 2022, the LTWM Investment Committee decided to sell its temporary investment in money market funds and move back into our original fixed income holding DFIHX, the DFA One Year Fixed Income Portfolio, which has more flexibility to invest in the highest yields around one year of maturity. We believed the risk of one-year yields increasing from Q4 levels was low and we were correct. During the first quarter, we sold our entire position in the variable rate bond ETF, USFR and moved back into DFGBX, the DFA Five Year Global Bond Portfolio, which has a higher duration and more potential for return. So far, both decisions are working well. DFIHX had a better first quarter return than the money market and DFGBX had a higher return than USFR.
Notice below, the highest first quarter bond return is for the US Government Bond Index Long, up 6.16%, but the index is still down -15.94% for the past year. The best 1-year return was the U.S. 3-Month Treasury Bill Index, up 2.5%, followed by the BofA 1-Year US Treasury Note Index, up 1.02%. Here are the fixed income period returns:
During the first quarter, the U.S. fixed income markets functioned well and benefited from the drop in yields because of the regional banking crisis, which will likely limit the desire of the Fed board to raise rates. The Fed introduced multiple lending facilities to help regional banks and a systemic credit event has been avoided. The Fed balance sheet increased from $8.3 trillion to $8.7 trillion with the new programs. The Fed will continue its $8.7 trillion balance sheet reduction (selling bonds) at a rate of $95 billion per month or $1.1 trillion annually. This action will keep rates at the long end of the yield curve higher than if the Fed wasn’t selling so many bonds. Most importantly, a healthier supply chain has reduced food price inflation and it may be just a matter of time until inflation as gauged by the Core PCE index, the Fed’s preferred inflation measure, moves toward the 2% target.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.
CONCLUSION
It is still all about inflation. The entrenched inflation outlook is looking less entrenched, reducing the probability of a hard landing, which sent stocks up during the 4th quarter last year and the first quarter this year. The labor market remains strong, consumers continue to spend, and so far, major companies are not responding to the slowdown by letting go of workers.
Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being. Please contact us with any questions or concerns. We are here to help you succeed.
And here is a timely piece from our friends at Dimensional Fund Advisors:
When Headlines Worry You, Bank on Investment Principles
On Friday, March 10, regulators took control of Silicon Valley Bank as a run on the bank unfolded. Two days later, regulators took control of a second lender, Signature Bank. With increasing anxiety, many investors are eyeing their portfolios for exposure to these and other regional banks.
Rather than rummaging through your portfolio looking for trouble when headlines make you anxious, turn instead to your investment plan. Hopefully, your plan is designed with your long-term goals in mind and is based on principles that you can stick with, given your personal risk tolerances. While every investor’s plan is a bit different, ignoring headlines and focusing on the following time-tested principles may help you avoid making shortsighted missteps.
1. Uncertainty Is Unavoidable
Remember that uncertainty is nothing new and investing comes with risks. Consider the events of the last three years alone: a global pandemic, the Russian invasion of Ukraine, spiking inflation, and ongoing recession fears. In other words, it may have seemed as if there were plenty of reasons to panic. Despite these concerns, for the three years ending February 28, 2023, the Russell 3000 Index (a broad market-capitalization-weighted index of public US companies) returned an annualized 11.79%, slightly outpacing its average annualized returns of 11.65% since inception in January 1979. The past three years certainly make a case for weathering short-term ups and downs and sticking with your plan.
2. Market Timing Is Futile
Inevitably, when events turn bleak and headlines warn of worse to come, some investors’ thoughts turn to market timing. The idea of using short-term strategies to avoid near-term pain without missing out on long-term gains is seductive, but research repeatedly demonstrates that timing strategies are not effective. The impact of miscalculating your timing strategy can far outweigh the perceived benefits.
3. “Diversification Is Your Buddy”
Nobel laureate Merton Miller famously used to say, “Diversification is your buddy.” Thanks to financial innovations over the last century in the form of mutual funds, and later ETFs, most investors can access broadly diversified investment strategies at very low costs. While not all risks—including a systemic risk such as an economic recession—can be diversified away (see Principle 1 above), diversification is still an incredibly effective tool for reducing many risks investors face.
In particular, diversification can reduce the potential pain caused by the poor performance of a single company, industry, or country.1 As of February 28, Silicon Valley Bank (SIVB) represented just 0.04% of the Russell 3000, while regional banks represented approximately 1.70%.2 For investors with globally diversified portfolios, exposure to SIVB and other US-based regional banks likely was significantly smaller. If buddying up with diversification is part of your investment plan, headline moments can help drive home the long-term benefits of your approach
When the unexpected happens, many investors feel like they should be doing something with their portfolios. Often, headlines and pundits stoke these sentiments with predictions of more doom and gloom. For the long-term investor, however, planning for what can happen is far more powerful than trying to predict what will happen.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2022, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2022, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2022 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2022 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.