First Quarter Client Newsletter
Clients and Friends of Mader Shannon,
The relationship between calendar years and markets is a funny thing. A seemingly inconsequential space between December and January can make a monumental difference in how markets behave.
At the end of 2021, the world was riding high on stimulus and a raging bull market. Flip the calendar forward one month, and boom, markets were on their way to one of history’s broadest and deepest declines.
As 2022 ended, anxiety built. Would 2023 be more of the same, or would the tenor flip 180 degrees just as it had the year before? The mood has remained frenetic in many ways. Uncertainty and angst are easy to find in the media and general conversation. But there seems to be a tinge of optimism.
Markets still have a long journey ahead to recapture their 2021 highs. Relative to markets, our strategies need a fractional gain to return to rarefied air; we are grateful for that.
Please let us know if you have any questions about our positioning or strategy. There seems to be more than ever to discuss, and we’re available.
- Kyle and the Portfolio Management Team
A Bankable Recession?
Another quarter has passed in the post-pandemic era, and we’re still waiting for history’s most widely anticipated recession. We tempted fate at the end of last year by dismissing the numerous indicators flashing imminent recession warnings. Coincident indicators that worked in previous cycles have done a terrible job predicting this disjointed business environment. Let’s recap the whipsaw-inducing economic narratives in the first quarter of 2023.
The first few weeks of the year brought more signs of falling inflation and subdued, but still expanding, economic growth. Was this an indication that a so-called ‘soft economic landing’ was in the works? Had the Federal Reserve succeeded in its fight against inflation? Markets sure thought so – the bear market lows established in October ’22 were quickly fading in the rearview mirror.
February’s data brought news of reaccelerating job creation in the US, surging retail sales, and resurgent inflation. The month of the ‘no economic landing’ narrative had begun. The sudden jolt of accelerating economic growth caught economists off guard dramatically, again.
John Kenneth Galbraith once said, “The only function of economic forecasting is to make astrology look respectable.” Boy, the pandemic has made that quip painfully true. Economists tend to get too optimistic and then too pessimistic in a cyclical way. Unfortunately, market participants tend to fall into the same trap, except we tend to call it fear/greed – the shift back to fear was violent.
By the second week of March, all the market gains for the year had been lost. The Federal Reserve forcefully reaffirmed its intention to continue its inflation fight; interest rates took note and burst higher once more. The pessimistic ‘growth leads to inflation, inflation leads to higher rates, and higher rates are bad’ narrative of 2022 was back.
Enter the failure of Silicon Valley Bank, Signature Bank, and Credit Suisse. Each company had a unique fatal flaw. Though, none of the catalysts for failure were particularly novel in the banking business. Still, the sudden collapse of multibillion-dollar institutions sent shockwaves through markets and the narratives that describe them.
When you hear about banking problems, the first analog that comes to mind is likely the Great Financial Crisis (GFC). Luckily, financial system stress thus far in 2023 bears no resemblance to the GFC. Here’s a review of some popular financial stress indicators. Some are elevated, and some are calm. But none are near 2008 levels.
The measures above represent interbank stress, credit risk, and volatility. Those were the arenas that defined the Great Financial Crisis. There was widespread mistrust in how assets were priced and, worse, in the viability of counterparties. Systemic was the word of that era.
Lucky for the system, regulators learned a few lessons in ‘08 that would come in handy in 2023 – act fast and be forceful. On the weekend SVB failed, the Federal Reserve opened a term financing facility for banks, and the FDIC guaranteed all deposits. Systemic needn’t be a word to describe this predicament just yet.
Although, there are other issues at hand that aren’t dominoes cascading toward systemic failure. Management teams at banks are just like every other management team – they’re trying to grapple with an uncertain environment. When things get increasingly uncertain, firms take less risk. And less risk for a bank typically means less lending/credit creation.
Don’t forget, financial crises are nearly undefeated foes of economic growth. The vertical lines representing financial crises almost always land at the end of an economic expansion (pink shading).
The Fed Funds rate can be used as a proxy for economic expansion/contraction; when rates are rising, economic growth is increasing, a crisis occurs, and rates are cut to soften the blow of the resulting recession.
Aggregated banking data tends to be released in monthly or quarterly increments. Since the bank failures occurred in mid-March, any data available now is, at best, only partially reflective of the post-failure reality. Best to think of them as a ‘pre-SVB’ world.
Survey data regarding access to credit has been deteriorating for months. The New York Federal Reserve Bank collects one of the more popular datasets, presented below. As of the end of March, “Somewhat Harder or Much Harder” to access credit comprised about 60% of the responses – a new 10-year high.
Small businesses surveyed by the National Federation of Independent Businesses also sounded the alarm during the March survey period. Small and medium-sized businesses are usually the first casualties in a credit crunch, and the trend was not friendly, even pre-SVB.
Credit creation has two components – the demand for loans/debt and the willingness of banks to originate. In our view, the deterioration over the past year has resulted from falling demand. Companies spent the last three years refinancing at low rates with extended maturities. Anybody who needed long-term money should have it already, and anybody who waited too long has been contending with higher-interest rates. Loan demand was already challenged.
Now we must contemplate the willingness of banks to keep the spigot on… and that will take time.
We’ll get earnings and commentary from publicly listed financial institutions over the next week. And some top-tier data in the first week of May. Even without updated data, it’s plain to see that nothing got easier in bank-land over the past month.
Bank failures and a resulting credit crunch are the most concrete catalysts for economic contraction since the pandemic, slow-burning as they may be. Of course, there are plenty of other factors in the recession debate. Let’s review already-in-progress crosscurrents.
Survey data has gotten very recessionary. Remember, PMIs are perceived activity indicators, not readings on the output level. Services remain in expansion territory (>50), while the manufacturing side of the U.S. economy continues to worsen.
In some ways, the survey data is weak in all the right ways. Prices paid and received keep coming down as supply chain issues resolve. That’s good news.
Receding pricing pressures seem to be making their way into the CPI report. Check out the itemized Core CPI chart below. Goods are in outright deflation, and nearly 70% of the index increase is attributable to shelter – which is horribly lagged and methodologically questionable.
Lower inflation is the ticket out of our collective recession obsession. A miraculous return to a pre-covid world appears to be fanciful. It’s increasingly looking like credit conditions will drive the economic and price data from here.
When the inevitable recession does begin, we’ll be sure to keep in mind the level of economic activity just as much as the periodic change. After all, we’ve had nearly two years to prepare for a contraction.
And maybe, like waiting for houseguests, the worst part will be the preparation.
Technical Review
Many practitioners turn to technical analysis when the fundamental outlook becomes uncertain and markets are volatile. Just as there are no atheists in foxholes, everybody is a technician in a bear market. Fortunately, we’re technicians all the time - here’s how we see things shaping up.
Step one is always to zoom out. Here is the S&P 500 over the past 15 years. Two years up and two years sideways has been the trend.
We’re currently in month #16 of sideways trading. A few higher lows help to make the October ‘22 lows look like a convincing bottom. Although stocks are effectively in no man’s land: they need to rally +16% to reach new highs or fall -16% to make new lows. If the S&P 500 is under 4175, the trend still looks fragile.
How do people feel about ‘the market?’ Not great. Significant drawdowns aren’t much fun. But for market declines to end, somebody needs to start buying – and there is no shortage of potential converts. Investor surveys have been extremely pessimistic. More pessimistic even than in the Great Financial Crisis!
Outright positioning is also dismal – large speculators tend to express their pessimism by ‘shorting’ the market. To reverse a ‘short’ position, a speculator must buy stocks to get neutral and then buy more to get ‘long.’ Too many shorts/bears are logs for the fire if you can find an initial spark.
Although, before getting excited about stocks, don’t forget that the equity markets aren’t in charge. Currencies and interest rates are the dog – stocks are the tail. The S&P 500 typically tends to be inversely correlated with the U.S. Dollar, but the relationship has been extreme over the last two years.
Dollar up, stocks down – it has been as simple as that. The same relationship has played out in commodities. Gold works well in periods of stress derived from inflation or systemic doubt.
The Great Inflation of the 1970s and the aftermath of the Financial Crisis of 2008 are the chief examples of inflation and systemic doubt. It’s been a nice place to hide in this ordeal as well.
Technicals are constantly shifting. There’s always a next target, higher or lower, so holding simultaneous, often conflicting views is necessary. When the bear market began last year, we expected it would take years to resolve, and we hate that our outlook remains primarily unchanged. From an optimistic perspective, though, that would mean that we’re more than halfway through this consolidation.
Though, that could all change tomorrow.
