BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
Contagion Cogitation
"People generally see what they look for, and hear what they listen for."
- Harper Lee
Bank equities have recently experienced their largest selloffs of the past twenty-five years. Contagion fears stemming from the uncertainty have helped to erase the S&P 500’s year-to-date gains. For many of us, the echoes of the Global Financial Crisis were ringing with the potential for widespread and unexpectedly quick value destruction. Thinking about the worst potential outcomes is a prudent exercise in the context of thorough investment management.
The general story here is that several banks, in particular Silicon Valley Bank (SVB), grew deposits and assets at a rapid rate between 2015 and 2021 as the technology bull market grew. They had to invest all their deposits somewhere and, unfortunately, that somewhere was in “risk-free” assets with historically low yields. Now that interest rates have gone up almost 500 basis points, those bonds are down in price. At the same time, there have been no IPOs or exits for their concentrated client profile (primarily founders and VCs), and the cash burn rates at these businesses have necessitated the ongoing withdrawal of funds. Therefore, SVB had money going out faster than it had been coming in and the bank had an asset portfolio with big losses.
This appears to be an isolated matter unique to SVB's business model, asset mix, and funding structure. The amazing detail is that the primary securities at the heart of this crisis are Treasuries and Agency MBS (pools of securitized residential mortgage loans that are issued and guaranteed by US government agencies), which are widely considered two of the safest assets on the planet. The culprit is poor timing on the purchases and ineffectively managing the interest rate risk. That said, uncertainty and lack of confidence in the system led to an “ask questions later” reaction to an already jittery investor base.
Fortunately, fears that more banks would follow led the Federal Reserve over the weekend to create an entity to provide relaxed terms and cheap access to capital to prevent other banks from following suit. They are directly aiming to prevent contagion. We believe that the Federal Reserve acting quickly and guaranteeing deposits for these banks and others should be enough to prevent the worst outcomes from materializing. If contagion fears abate, we should see prices recover. In the weeks and months to come, we will see how the broader market may be affected, but at this time we are comfortable saying contagion is not our base case.
In times like these, it is important to have an investment process in place that removes emotion from the equation. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a balanced (neutral) position while our longer-term view is positive.
For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated that while growth is slowing, the downturn is more cyclical rather than secular. We do not forecast a break to our longstanding “growth normalization” view.
We do believe volatility will stay elevated, but ultimately, another year of economic and earnings growth should be enough to offset the monetary tightening in place and its fallout (the current banking crisis) and support an eventual grind higher in equities. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.
The Fundamental Perspective
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Earnings takeaways over the past several weeks have reinforced our belief that, while the growth backdrop remains challenging, there are offsets. Headwinds like dollar strength and input cost pressure are slowly abating and are balanced by consumer spending resiliency and improving supply chain commentary. Our weekly series for forward revenues, earnings, and margins are well off their peak, but remain far from recessionary. We have championed a “braking but not breaking” view in regard to corporate profitability. Importantly, while the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look reasonable. On balance, we expect corporate results to match expectations and provide some stalwart defense against any profit-recession narrative.
Valuations are near long-term averages. The pace of the expansion in corporate profits has far exceeded stock prices over the past couple of years, so multiples are now providing a compelling opportunity for long-term investors, but prospects are not universally favorable. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree. We see opportunities in both groups.
The credit backdrop will be important to monitor as growth concerns persist. The banking issues only reinforce this key fundamental input. One of the defining criteria between pronounced or shallow recessions has been the behavior of the credit markets. Both investment-grade and high-yield spreads vs. Treasuries are somewhat elevated but remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.
The Macro Perspective
The macro discussion must start with a view of the global economy. Incoming economic data continues to support our slowing but not recessionary growth narrative (e.g., unemployment is at a fifty-year low). After two consecutive negative quarters to start 2022, GDP growth accelerated back to positive territory to close out the year. Real-time estimates forecast for the first quarter of this year remain positive. Recent macro worries have centered on the mix of higher inflation combined with slowing growth and tighter financial conditions (e.g., restrictive monetary policy). While these certainly have our attention, we continue to expect the inflation scare will subside. Cooling input prices and easing supply chain pressures amid softening demand and tighter policy suggest inflation momentum has peaked.
Interest rates will be the fulcrum by which investors express their economic growth, inflation, and thus Fed policy views. Yield curves have inverted as the front end of the curve has moved higher with the prospects of further rate hikes. Curve inversion should be respected, as they have a very strong track record in signaling recession over the past 40+ years. What they cannot predict accurately is the timing of the recession nor its depth and magnitude. As mentioned, one of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? It is going to be tricky, but at this point we believe they can.
Macro themes will remain important, no doubt, but we anticipate markets to sharpen their focus on specific security characteristics as the year progresses (e.g., company fundamentals, asset class relative strength, etc.). Security selection, identification of investable themes, and traditional bottom-up analysis will play an expanding role and help portfolios ride out the lingering macro-induced market gyrations.
The Technical Perspective
The technical backdrop has weakened tactically but remains structurally intact. We believe the market is in better shape relative to last autumn, but we are mindful of the building stress (e.g., many indices have recently fallen below their 200-day moving average, the Volatility Index, or VIX, recently hit a four-month high, etc.). Despite price weakness, internal momentum and breadth metrics haven't collapsed (e.g., advance-decline lines are still holding well above October lows). Leadership has had a pro-growth bias over the past few months and we are watching to see if that changes with the recent bout of volatility.
We expect the market to broaden and leadership to continue to adjust as we move through 2023. One interesting technical dynamic of late is that the broader the index is (e.g., Russell 1000 over the S&P 500), the better the news vs. new lows data has trended. Also, equally weighted indices have been outperforming their market-cap-weighted brethren. Both developments point to a broader participation rate. Healthier markets tend to have strong participation rates, so we are encouraged by the improvement here. We are also encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. We expect lower correlations will continue with macro-healing later in 2023, an environment we welcome.
Investor sentiment has improved but on average tilts bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, Consumer Sentiment, etc.) point to a skeptical investor base with the number of “bears” still elevated. Tactical positioning data (e.g., put-call ratios, cash balances, fund flows, etc.) are still leaning defensive and will act as a catalyst should the macro backdrop improve. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower).
Concluding Thoughts
We continue to see markets in 2023 gradually shifting towards more bottom-up (micro) influence, particularly those centered on growth prospects. We have championed an active approach of investing with secular winners while simultaneously allocating capital toward assets that will benefit most in recovery. We do believe the frequency by which investors can actively tilt portfolios towards those pockets of opportunity or away from risk will become more pronounced as growth slows.
Volatility should stay elevated given the macro uncertainties and unresolved banking stress. Systemic risks that could result in prolonged recessionary or bear market conditions exist but are not overwhelming given the accompanying growth backdrop. Again, we see the contagion risk stemming from the bank failures as low. Our forecast for a maturing but sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.
Our investment philosophy is based on a dual mandate of growing and protecting client assets. We are staying active, using any volatility to harvest losses while opportunistically deploying capital where appropriate. Our cash weightings remain residual in nature and are focusing on strategy positioning vs. our respective benchmarks to control risk. Of course, should the backdrop destabilize, we will take a more defensive stance.
Should you have any questions or comments, please contact BakerAvenue. We are happy to share our thoughts in greater detail, and we welcome the opportunity to speak with you.
Disclosure: Past performance is not indicative of future performance.