Managing money is a hard business. Especially at times when financial market environments seem like they are keen on setting some new statistic every few weeks amidst a plethora of never-ending volatility. In the early hours of Saturday morning, I sat and reflected on how Delos Capital Advisors (DCA), in four short years, has endured the repo frenzy late 2019, COVID collapse in 2020, one of the fastest rate hikes in history during 2022, and now the failure of the 16th largest bank in the United States. But while these events usher uncomfortable feelings, we have worked relentlessly to understand the market history and hone our investment strategy to weather these turbulent times. As we’ve said time and time again, patience is key when navigating these types of market environments.
And while I hate to be the bearer of not-so-great news, we, unfortunately, are at the phase of the business cycle where credit risks come to the forefront as the economy digests the lagged effects of rising market rates (long-term interest rates) and Fed rates (monetary policy). Most won’t admit or agree that this economic cycle has been textbook with a few shades of grey.
We are closely monitoring financial and economic conditions during this volatile time. We are standing steadfast to steward our clients just as we’ve done every time in the past. Game On.
Given the time since our last Coffee with Andrew, we have broken out key points in each section for new readers and for those needing a refresher.
DCA Bear Market Call – GAME ON
As most of our clients know, we became increasingly concerned about financial market stress in November of 2021, which prompted a rebalance out of growth-oriented equities into defensive-oriented equities in Q1 2022. At the time, it was not a popular call/trade as many shouted to "Buy the Dip". Additionally, during 2022 we held the highest cash weighting in firm history as we felt fixed income allocations would not buffer equity volatility as it has in previous cycles. This was all based on our analysis that the Fed was behind the curve and that labor issues would drive inflation higher, not supply bottlenecks. Q4 2022 we began allocating to Treasury Bills as they finally began providing a positive return differential. For those that have succumbed to recency bias, I will kindly remind that positive return differentials were not present until September 2022 as it takes time for Fed hikes to filter through the system. Any buyer of Treasury Bills in September and October suffered great opportunity costs as the Fed continuously raised rates throughout 2022. And for Certificate of Deposit proponents, I point to the banking crisis that is occurring as I type.
In 2023, our analysis indicated that the Bear Market Rally had run its course and therefore we began reducing all remaining cyclical investments (industrials, materials, financials, energy) late February and March in anticipation for credit risk to rear its ugly face. The DCA overweight to cash equivalents, counter-cyclical: defensive equities, and negative beta trades has helped buffer the negative returns in February and March on a relative basis.
Understanding the Current Volatility
As most of you are aware, the financial markets began exhibiting increased volatility in February as inflation came hotter than expected which stemmed from an overheated labor market. This caused the market to reprice the expectation of a Fed cut by end of year to Fed hikes. This interest rate volatility spike led to the equity volatility just as it did in 2022. The outcome was that the yield on 2-year Treasury Notes reached a cyclical high of 5.07% on March 8th thus prompting depositors to move their cash from low interest checking and savings to Treasury Bills given the return differential. This is known as Cash Sorting. Fast forward a week, and we are presented with the failure of Silicon Valley Bank as cash/deposit withdrawals caused liquidity concerns.
Bank Issue Today is Not 2008
It is important to make the clarification that the recent bank crisis is NOT due to bad loans but due to liquidity issues stemming from the ability of individuals to access Treasury Bills that offered rates of return above and beyond deposit rates. As deposits are withdrawn, banks must generate cash and usually do so by liquidating assets on their balance sheet. These assets are typically in the form of short to long duration fixed income. Given the inverse relationship between fixed income and interest rates, these fixed income assets are held on the books at a loss given the Feds aggressive tightening mandate. Therefore, any forced selling of these fixed income assets at a loss to cover deposit withdrawals lowers the equity capital of the bank. The bank is then forced to raise additional capital to shore up liquidity. The failure with Silicon Valley Bank was that they were unable to raise additional capital thus leading to their demise. This event has spurred a behavioral concern that other banks may face similar fate but given the recent announcement from the Treasury Department, we believe there will be backstop for banks that hold Treasuries and MBS assets to cover the losses in case of depositor withdrawals. With that being said, this is not a bailout NOR bullish.
Don’t Get Whipsawed With any corrective price action, there will always be the cohorts that either scream "Buy the Dip" or pontificate about the possibility of institutional buying of a depressed asset. This was the mantra post-COVID 2020. They are probably right… for a trade. But we humbly submit that we aren’t buying that narrative. First and foremost, as mentioned previously, we have only begun to feel the lagged effects of tighter policy via market rates and Fed rates. The pace of the Fed tightening was so quick that banks have not had time to rejigger their balance sheet in response. Hence Silicon Valley Bank. Add to the mix the lagged effects of high inflation that hamper consumer demand. Redbook sales (a form of monitoring retail sales) has continued to collapse and sits at pre-covid lows. Here is the rub- assuming banks are able to maintain their liquidity via whatever form of intervention, they will now be less willing to lend capital in an effort to maintain their liquidity ratios. This comes at a time when bank lending standards are almost as tight as they were during the Great Financial Crisis. A lack of access to capital is a harbinger for a deflationary hard landing. And based on our analysis, the last area an investor wants to hold equity exposures is cyclical based investments, financials included.
The Gameplan
2022 marked the great valuation reset in the wake of an aggressive Fed tightening regime. 2023 will be the year of credit risk as companies' profit margins come under attack amidst falling revenue and high cost of capital. This is the normal sequence of all business cycles, and one DCA is prepared for. As mentioned, DCA has eliminated all remaining cyclical exposures in lieu of cash equivalents, counter-cyclical: defensive equities, and negative beta trades. We anticipate increasing our fixed income allocation as we get further line of sight on Fed hike intentions. We believe the Fed is walking a tight rope as inflation still remains well above their target. While we anticipate a quasi-pivot by the Fed during the March 22nd FOMC meeting, we are mindful that any pivot won’t alter the course of the impending credit risk lurking in the market, and any future hikes only entrench a deeper credit crisis.
Conclusion
As we’ve entered the final leg of this bear market, we are mindful that extreme volatility ensues in the last leg of the cycle. We are monitoring credit risks diligently and following our process to maintain capital preservation for our clients. Our expectation is for the market to shift focus from the Federal Reserve to economic conditions, which still remain in negative growth territory. We monitor leading economic housing data for clear signal in an upward inflection.
Please do not hesitate to contact me with any questions or comments.
Best,
Andrew H. Smith
Chief Investment Strategist
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