As Konvergent has grown, we’ve recognized the need to bring more firepower and more expertise to the table for our clients. We’ve been on a search to find who’s the right research group to partner with to help us improve, better manage, optimize the work that we are doing and bring their expertise to the table. That search lead us to Aptus Capital Advisors.
David Wagner, an equity analyst and portfolio manager, and John Luke Tyner, fixed income and portfolio manager, at Aptus Capital Advisors joined Homer Smith to take a look at the market as a whole; reviewing where we’ve been so far this year, where we’re headed, and some of the key themes and analysis to go along the way.
We always talk about long volatility as an asset class or volatility as an asset class, and it’s always hard simply to describe exactly what that is due to its many variables. Looking at last year, as the Fed raised interest rates to try to cool record inflation, we saw a lot of volatility in bond prices and as well as the stock market. For the first time in many years, we saw both bond prices and stock prices have correlation and decline together. We expected more of the same coming into this year, but that’s not been the case so far this year, at least through the first quarter.
Last year can be considered one of the worst years for a traditional 60/40 portfolio since 1929. Bonds were no insulation to equities during that volatile period. We’re not saying we’re going to have another year like we had last year but that we need to continue to look at this market differently. We need to play defense to have some type of offense moving forward.
From a lot of the research we’ve done is that it takes about 18 months for a Fed rate hiking cycle to really work its way through the system which means we’re still three plus months away from really seeing some of the major effects.
In early March we started to see some of those effects with the banking crisis and the collapse of a couple of major US banks with the most recent being First Republic. When looking at the banking sector, banks faced a rapid rise in interest rates. A lot of them just simply followed what the Fed told them, that inflation was transitory and that rates weren’t going to have to rise drastically, and so, what did they do? They took in a bunch of deposits and then they bought a bunch of long-term bonds to lock in a spread. As interest rate policy changed and bond prices fell, banks had to realize the massive losses in their balance sheet to make depositors whole. Looking ahead, there’s still really two main parts to this issue.
Number one is the safety of the banking system, which needs to be instilled by Janet Yellen and the Chairman to solidify the safety of banks. The other side is an uphill battle because of where Treasury bills are and money markets rates are. Nowadays, with online banking everyone can look at their phone and move around their deposits quickly. Why wouldn’t you move your cash from near 0% interest rates at your current bank to money market fund at 5%, especially if your deposits are over the FDIC limit.
This banking crisis is very different than the two previous banking crises that we had. Looking back to the financial crisis of 2007-2008 or to the savings and loan crisis of the 1980s, they were due primarily to credit issues, while this is collateral damage due to a rapid rise in interest rates causing balance sheet risk and deposit flight. Yet in the face of this banking crisis, the market continues to march higher to start the year because investors are convinced the Fed has no choice but to pivot now. Meaning, they can’t afford to continue to raise rates and further extend this issue of deposit flight due to higher money market rates.
The Fed is in a difficult position on how they will ultimately navigate this, they have what we see as a three-pronged mandate on inflation, employment, and financial stability. Unemployment is still very low, and inflation is still high, seemingly sticky in key areas. When you look at financial stability, the Fed has been very quick to act and try to isolate the banking crisis through their different lending facilities, which have worked in easing the markets. Given their ability to ease part of the crisis and the numbers we see on inflation and employment we don’t see the Fed being able to pivot at any point soon. At this point there is little chance of us seeing rate cuts as soon as July which is what the market is pricing in.
Looking past inflation, we hear a lot about the corporate debt space and the need for corporations to refinance their debt that could potentially be a landmine. We’ve seen a number of borrowers the last several years really extend their debt profile, which helped them weather this storm. Another key issue is on some floating rate bank loans that reprice in lockstep with Fed policy. Those needing to refinance at substantially higher rates could lead to some trouble in the floating rate and low rated fixed income markets which play a big role in economic growth.
The other potential wild card is the debt ceiling. Right now, 50% of the US debt expires in the next three years and it has an average interest rate below the current two-year treasury rate. In other words, if we’re going to have rates continue to stay higher for longer, the debt load the government has to pay from an interest expense perspective is going to be exorbitantly high.
One thing we always focus on is that we’re not trying to predict the future, rather we focus on always being prepared for whatever might come next. True diversification is not just a mix of stocks and bonds and private equity and real estate, but it’s making sure you have defensive asset classes that provide liquidity and protection when offensive assets are struggling. We hope you have enjoyed our Introduction to Aptus capital advisors by taking a deeper look into our investment research and current events. We look forward to continuing to provide this for you going forward.
Integrated Partners and Konvergent wealth partners are separate entities from Aptus Capital Advisors