March 16, 2023
Market Conditions We are seeing unprecedented moves in fixed income driven by the collapse in a few regional banks. The US Two year note has dropped from above 5% to below 4% in less than a week! The MOVE index, which is the volatility of fixed income, is at levels not seen since the 2008 Financial Crisis and materially higher than the volatility of the equity market as represented by the VIX index. In response to the regional bank failures, the government has stepped in to backstop previously uninsured deposits of over $250k ONLY at these institutions. Balances over $250k at any other financial institution are still uninsured! *See www.FDIC.gov for more details regarding FDIC insurance coverage.
Thoughts The market is conditioned to believe interest rate cuts will support financial assets, I suspect the market will be quicker to adopt this approach and buy financial assets in expectation that they will rise due to Federal Reserve support. Credit conditions in the economy are likely getting tighter. When lenders become concerned about risk, they generally become more cautious. Companies that have large cash needs might find that it is more difficult and/or more expensive to obtain. All else equal, long duration asset prices have more uncertainty today compared to a week ago. After all, if we do not know where short-dated US government yields will be (expectations of interest rates are very volatile), it is hard to forecast the correct price to pay for future cash flows of corporate bonds and equities. Thus far, the decline in the main equity indices have been subdued relative to the changes in interest rate volatility.
Potential Outcomes
Equity market price change has remained relatively small compared to interest rates changes because the market anticipates this banking situation will be contained and that interest rate volatility will calm down and not much will change in the near term. Stock indices expected to remain unchanged.
Equity market is anticipating that the expected Fed rate cuts will support company share prices. Stock indices expected to move higher over the year.
Because of market conditioning to buy on expected Federal Reserve interest rate cuts, investors are acquiring shares, but they are not accurately accounting for the increase in risk associated with increased uncertainty. Stock indices should move lower over the year.
“My job is to protect the purchasing power of wealth over time depending upon cash needs and risk tolerance. Therefore, portfolio changes are made to reflect the changes to circumstances (both your own and the market). I do not try and “time the market” because my opinions can be as wrong as anyone. My only advantage is in recognizing risks and opportunities and comparing that reality to the market’s perception and bias. When I perceive there is a deviation, that generally provides opportunity.”
- Joe Cardello
Changes to the Portfolio
Reduced exposure to higher risk fixed income.
Increased exposure to US Government fixed income.
Increased cash and treasury bills.
Reduced exposure to our highest volatility equities (mining).
Increased exposure to precious metals.
Decreased risk to both tech and biotech companies.
Opportunities
“The Shopping List”
Energy: We have been waiting patiently for lower prices as the economic slowdown begins, but the underlying thesis remains a tight energy market for years to come as the ESG transition takes longer than expected.
Utilities: As previously discussed, we view this sector as a higher probability expression of the transition into green energy which also provides a defensive equity market exposure.
Broad based: Companies domestically and international with: (1) high levels of free cash flow, (2) reasonable price to cash flow, (3) high returns on capital, and (4) growing businesses that are not subject to lots of competition.
Risks Numerous new risks have come to the forefront given the recent bank failures, but that does not make me “negative” or “bearish”. I continue to focus on the opportunities that should arise. In the meantime, we have allocated a large amount of fixed income in all our portfolios that currently provide attractive levels of return. If the S&P 500 were to move higher over the course of this year and stay high, there is a risk of underperformance compared to the overall index, but we view this as a risk worth taking at this juncture.
Because I must protect cash against erosion of purchasing power and higher asset prices, I must be careful when the portfolio becomes too defensive. I don’t feel like the risk is imminent, but it seems to me that many portfolios are already positioned defensively like ours. Hence, I will start strategizing about the next cycle now!
Joe
Joseph Cardello, Principal
August Wealth Advisors, LLC
51 Riverside Avenue, First Floor
Westport, CT 06880
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