For those of you who would prefer to listen:
The Market ran into a brick wall this week. That wall came in the form of 4% on the 10-Year Treasury yield. Upon impact, stocks and bonds went in opposite directions and fast. Stocks fell sharply. Bonds rallied. That is quite different from last year, when both declined together. It was pretty rare.
The fast pace of rising interest rates made the Bond Market attractive for the first time in years. It’s also choked off the oxygen from the Stock Market. Treasuries have returned to their safe haven status again. Ditto for Gold.
The Stock Market accelerated its fall as news brewed that Silicon Valley Bank was facing insolvency issues. It is ground zero for venture capital and Tech, not to mention crypto; Areas that got stretched. The bank apparently lost $1.8 Billion as it rushed to sell-off its low-interest bonds, purchased when the 10-Year Treasury was below 2%.
The inverted yield-curve has wreaked havoc for lenders that borrow short-term and lend long. The math doesn’t work. Silicon Valley Bank needed a big assist. It didn’t get it. California regulators shut it down. It’s the biggest bank failure since the Financial Crisis. It’s no small deal. Bank stocks got beat up big time this week in response. Given our underweight positioning in financials, we didn’t feel much pain.
We might not be in a recession. But there’s not much growth out there. That’s particularly clear as Silicon Valley continues its headcount cutting. Outside of Tech, most industries are avoiding layoffs. That was evident in the February Job Report, released Friday. 311K jobs were created last month. That was well ahead of the Street’s 215K estimate. The service sector still can’t find enough help. The unemployment rate ticked up to 3.6%. It’s still near fifty-year lows. The Labor Market continues to run hot, which has set a higher floor for inflation. It has perplexed the Fed for months.
Fed Chair Powell was on Capitol Hill this week. It was the annual grilling session for Congress. Senators and House members from both parties tend to push their agendas and show off how much they really don’t understand the Economy. It rarely disappoints.
Of course, the Fed is complicit in the runaway inflation, having kept rates at zero despite the recovery. Powell took the heat in stride and set the tone for more rate hikes, meaning interest rates will be higher for longer.
These higher rates are having a cooling effect on the Economy, precisely what they’re designed to do. But it doesn’t show up everywhere. Weakening manufacturing data reflect both companies and consumers pulling back from big-ticket item purchases. That part of the Economy is slowing. But travel and entertainment continue to be white-hot. Americans still have the itch to go out and about after the extended period of sheltering in place. That trend is showing little sign of slowing.
I was in Arizona for meetings with Schwab this week. My flight was packed with seemingly eager travelers doing business, hitting the golf course and catching some baseball at spring training. Hotels are still jammed and Spring Break is just around the corner. This is precisely the economic contradiction that keeps puzzling the Fed. The aggressive rate hikes haven’t taken down inflation to the desired level and the unemployment rate is still parked near 5-decade lows.
Housing is a key component for America’s Economy. People feel richer when their home prices are going up. They tend to spend more. Of course, the reverse is true too. We saw that in 2022.
Housing picked up at the start of the year. Falling rates and seller incentives greased the wheels. It has since slowed. Rates have reversed higher again, reaching those peak levels from last year. Mortgage applications fell to a 3-decade low the last week of February. Higher interest rates were the cause. For perspective, a 1% increase in interest rates from 6% has the effect of a 10% increase in the price. US home prices fell year-over-year for first time since 2012. It’s pretty clear, a 7% mortgage buys a lot less house.
The timing is tough as we have entered the busiest season for home sales. 40% of annual transactions take place from March to July. The school year is an obvious driver there. Importantly, there are many industries and high-paying jobs tied to housing across the country. The slowdown is felt nationwide.
Earnings Season has come to a close. Revenues in Q4 2022 increased 5.8%. But earnings declined 4.6%. Importantly, profit margins contracted by 10%. Inflation accounted for all of the revenue growth as higher prices offset lower unit sales. This marks the first time earnings have declined since Covid. That trend is expected to continue. Estimates have already been cut for 2023. They might still be too high.
Back to the Market: The Fed made a quick turn to a more Hawkish attitude this week. It was an abrupt shift in message from the February meeting, which suggested back then the pace of rate hikes was slowing. Inflation is proving to be sticky. A half-point hike is a possibility at the March meeting, something that was not priced in just days ago. But things changed again with the Silicon Valley Bank failure.
The big question now is how much more can the financial system take with these rate hikes as growth continues to slow. The Fed is choking off the money supply to combat inflation. But that has clearly caused the stress in the system, which has triggered the Stock Market decline. More Market turbulence returned.
The Fed meets in 2 weeks. The Fed Chair made it clear the next moves will be data dependent. The data has been sending mixed signals. But the inverted yield-curve has clearly and consistently signaled danger ahead. That had our attention from day one. The fear all along was the aggressive Fed would break something. This week, Silicon Valley Bank broke.
We remain as defensive as we’ve been. It was nice to see the green to start the year for stocks. It’s proving to be short-lived. Bear Market rallies mess with investor minds. They suck people back in. We didn’t get sucked in. We’ve been buying bonds after shaving stock exposure.
We outlined the course for more price volatility in our 2023 Outlook piece and event. It’s playing out and our playbook for defense, which we aggressively deployed last year, is strategically in place. Here is a link to the newsletter as well as our video for reference. Anticipation and preparation are so critical to investing. And as you know, it’s all about execution.
We have rotated substantially into the Bond Market, taking advantage of that 5% yield at the front end of the curve. Treasuries are considered the risk-free asset. It’s looking and feeling really good there. Treasuries rallied this week.
We are long-term investors who are equipped to deal with shorter-term pressures. That’s precisely what we are doing. We anticipate this choppy price action to continue a bit longer. So hang on tight.
Have a nice weekend. We’ll be back, dark and early on Monday.
Mike
