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Trade Memo – 2nd Quarter 2023 April 3, 2023 Spring has sprung! Well, I am sure that many of you have noticed the interesting happenings in the banking sector over the past few weeks. You may be asking…. What on earth happened to Silicon Valley Bank (SVB)? While researching this for myself, I came across the March 16, 2023 Market Snapshot by Liz Ann Sonders, Schwab’s Chief Investment Strategist. She discusses what led up to the deterioration of SVB in plain English. I am quoting Liz Ann because she gets right to the point: • “The pandemic and the commensurate epic monetary and fiscal policy response to the pandemic ledto a surge in money supply, a surge in liquidity, tech startups, venture capital, of course, were keybeneficiaries of that. And in turn, that led to a massive surge in deposits at SVB. That was a favoredbank of that world, particularly from startups, tech and biotech startups, as well as the venturecapital world. Now, in order to boost yields on those deposits, SVB loaded up on longer-term government bonds without hedging the interest rate risk. Oops. • Now given in addition the 2018 rollback of some Dodd-Frank regulations, including upping the sizeof banks in terms of their size that were subject to stress tests from $50 billion to $250 billion. As a result of that rollback, SVB was not subject to stress tests, including in the event of a sharp spike ininterest rates. Double oops.”1 I would encourage you to watch this 10-minute video because it goes beyond SVB and is very helpful in understanding the current banking turmoil. Click here to view her video or click here to read her transcript which is attached to this memo. So, what happened in the markets? February was quite the eye-opener for investors who had been riding a wave of optimism in anticipation of low inflation. Market sentiments shifted as data showed signs that consumer spending, jobs numbers, and interest rates could be headed higher than expected - signaling an adjustment to key economic relationships may soon be underway.
The Federal Reserve had a clear message for investors - more still needs to be done. Global yields climbed, dragging down values of bonds across the board; however, international stocks with value bias showed some signs of strength due to lower energy prices which has bolstered consumer and business morale as well as improved European energy security. As the economic landscape remains uncertain, we prioritize investing strategies that can weather potential market turbulence. That’s why our core philosophy is centered around making high-quality investments and diversifying them to meet long-term goals with protection against additional volatility or inflation. What are we doing today: Our firm typically rebalances your retirement accounts quarterly, unless we have unusual market conditions. If you have non-retirement accounts, we rebalance up at least twice a year, depending on your tax situation. Here are the key takeaways from this quarters rebalancing: Our focus? Reduce risk and increase quality. • Seek to enhance the overall quality and resilience of the portfolio, cutting net exposure to stocks and credit amidst unusually elevated uncertainty. • Continuing to rotate out of names with the most embedded active risk and selling out of US small caps and momentum-oriented stocks. • Tilting into growth and out of value names, adding to US technology stocks and growth-factor international developed market stocks. • Maintaining an overweight to duration, consolidating the fixed income sleeve to align exposures closer to the benchmark. Why are we making these changes? The recent events involving two major US regional banks have highlighted the alarming consequences of rapid financial tightening, potentially forcing the Federal Reserve to reassess its newly enacted hawkish policies. This could be a crucial step toward mitigating economic risk across America and promoting stability in our markets. The cracks appearing in the regional banking sector may have greater potential to derail an economic recovery than even a gradual rise of Fed target rates. As evidenced by Haver Analytics, BlackRock and the Federal Reserve Board data as of 2/28/2023 these banks still account for almost half of American business and consumer lending but now face higher costs resulting from deposit leakage that require more
collateralization on top. This could result in reduced loan availability leading to financial tightening with potentially severe consequences across all sectors. The current state of the banking sector has upset expectations for further Fed rate hikes and has sent ripples through global financial markets. Recent earnings, economic data, and now loan availability could signal a cloudy outlook ahead - potentially even recessionary pressures if these developments are not addressed swiftly - significantly increasing downside risks to stocks within portfolios. As we analyze the current banking-lending landscape, it is evident that financial conditions pose a substantial risk to economic stability. To combat this, our team has opted for an overtly defensive portfolio approach while decreasing stock exposure and volatility sensitivity. We are emphasizing long-duration investments which could potentially provide outperformance if market stress increases. What we know today: Growth 4Q22 real GDP showed the economy grew by a 2.7% annualized rate and 0.9% for the calendar year, even with the economy contracting for two consecutive quarters in the first half. While the overall print looked solid, the underlying details still point to a weakening economy. More than half of the GDP gain came from an increase in inventory accumulation (a trend that will inevitably be reversed), real consumer spending was softer than expected and residential investment plunged further. Looking ahead, boosts in real personal income, pent-up demand for autos and a very tight labor market should keep growth afloat, but very modest, in the year ahead. Profits The 4Q22 earnings season highlighted the challenges that higher rates and input costs, combined with lower consumer spending and a strong dollar, impose on all companies. However, it also revealed important distinctions among companies in weathering these headwinds. 4Q22 EPS declined by 11.4% y/y and 0.2% q/q. In total, 62% of companies beat earnings expectations, while 55% beat revenue expectations. Management commentary across sectors highlighted that higher input costs and a stronger dollar negatively impacted results. Notably, margin contraction was the largest detractor in earnings while revenue grew modestly.
Risks • Banking sector turmoil could result in tighter lending standards, posing a drag on economic growth. • An overly aggressive Fed could push the economy into recession. • Markets may remain depressed and volatile until investors receive clarity on the pathway for inflation and the Fed. Jobs The February Jobs report highlighted solid gains in payroll employment, but other details were softer than expected. Nonfarm payroll employment rose by 311K, well above consensus estimates of 223K, however, gains for the prior two months were revised down by 34K and the unemployment rate rose above consensus to 3.6%. Average hourly earnings were also below consensus, rising by 0.2% m/m and 4.6% y/y. Overall, the report suggests that the labor market is starting to feel the pressure of tighter policy and provided little evidence that a tight labor market will disrupt the downtrend in consumer inflation. Inflation The February CPI report saw headline CPI rise by 0.4% m/m and 6.0% y/y, respectively, marking an eight consecutive monthly decline for the year-over-year measure, while core CPI rose by 0.5% m/m and 5.5% y/y, respectively. Shelter inflation remained strong, although continues to reflect lagged rent inflation. That said, other measures of services saw disinflation, suggesting a deceleration in Powell's favorite PCE measure of core services excluding housing. While not falling as fast as the Fed would like, inflation is gradually falling and continued moderation in wage growth increases our confidence that year-over-year headline CPI will fall to 4% or lower by June of this year.2 Key principals to keep in mind:
• Diversification supports portfolios through market downturns. If you had invested in the equity market at its October 2007 peak, it would have taken you until March 2012 to recover your initial investment. However, if you had invested in a 60/40 stock /bond portfolio instead, your portfolio would have recovered in October 2010 – a year and a half earlier. Diversification captures returns on the upside and protects on the downside to deliver better risk-adjusted returns. • Volatility is normal – While we cannot control the market’s volatility, we can control how we react to it what we own in our portfolios. Remain focused on your long-, and short-term goals. If you feel that these have changed, please let me know. We can make changes based on your new information. • It’s about time in the markets… Being invested in the equity market for any one calendar year since 1950 could have yielded a 47% return or a -39% return. However, over longer time horizons the range of outcomes is compressed significantly and overwhelmingly skews positive, particularly if diversified with bond exposure. A 50/50 diversified stock/bond portfolio did not experience a period of negative returns over the rolling 5, 10, or 20-year calendar periods since 1950. • …not timing the markets. Investors are often tempted get out when markets get choppy. However, if an investor were to miss the 10 best days in the market rather than staying fully invested, they would have cut their return in half from 9.5% to 5.3% annualized over the last 20 years. What is the chance of missing the 10 best days? Seven of the 10 best days occurred within two weeks of the 10 worst days, often immediately following the worst days. Exiting on a bad day means potentially missing the rebound. • Stay invested when you feel the worst – Sentiment is not a great guide for investor behavior. Looking at the peaks and troughs of consumer sentiment since 1970, average one-year equity returns
following peaks in consumer sentiment were 4.1%, but average returns following the bottoms in sentiment were 24.9%. One more crucial point: through multiple wars, recessions, pandemics, and crises, the S&P 500 has never failed to regain a prior peak— and then surpass it. The best strategy during volatile times is to maintain composure and stick to your investment plan. How we can help: It's true that the future can be a mystery at times, but making sense of past events gives us confidence for what lies ahead. We know it may feel difficult right now, yet we want to assure you – our support is here whenever needed! We understand that navigating markets and financial uncertainty can be daunting. That's why we limit the number of families with whom we work—so that our team has ample opportunity to provide personalized attention and support. Together, let’s talk through any questions or worries you may have! As always, please feel free to reach out to us if you would like to talk to us about your personal situation. Warmest regards, Kelly L. Olczak, CFP® Managing Partner, Private Wealth Manager Office – (585) 623-5982 eMail – kelly@lynnleighco.com Article Sources 1 Market Snapshot – March 2023, Liz Ann Sonders, Managing Director, Chief Investment Strategist – Charles Schwab 2 JP Morgan – Economic Update – Week of March 27, 2023 This information is provided by LynnLeigh & Co. for general information and educational purposes based upon publicly available information from sources believed to be reliable – LynnLeigh & Co. advisors cannot assure the accuracy or completeness of these materials. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice. Past performance is not a guarantee of future returns. Investing involves risk including loss of principal. No strategy assures success or protects against loss. Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.