Political turmoil, economic volatility, and geopolitical unrest are just a few themes to describe what took place during the third quarter of 2024.  The theme of the market has been resiliency.  The financial markets oscillated between optimism for a soft landing and fears of a recession as inflation data has continued to trend lower while some recent weakness has emerged in employment data. After declining 8.5% from mid-July to August, the S&P 500 received a boost and ended the third quarter at an all-time high, post the Federal Reserve cutting interest rates by 50 basis points to a range of 4.75% – 5.00%, the first interest rate cut since 2020.

During the quarter, equity market performance was led by the Dow Jones Industrial Average’s return of 8.7%, followed by the S&P 500’s 5.9% and the tech-heavy Nasdaq Composites’ gain of 2.8%. Smaller companies outperformed both mid-sized and large-sized companies during the quarter. Utilities and Real Estate led the market with returns of 19.4% and 17.2%, respectively helping the Russell 1000 value index rise 9.4%, outperforming the Russell 1000 growth index’s climb of 3 .2%. Ten out of the eleven sectors in the S&P 500 posted positive returns during the third quarter. Energy was the only sector that experienced a negative return, losing -2.3%.

The performance of bonds significantly improved during the quarter with the U.S. 10-year Treasury yield falling from 4.4% to 3.8%, resulting in a return of 8.0% and U.S. Corporate bonds returned 5.2%. The US dollar declined 4.8% while gold gained 11.5%. West Texas Intermediate (WTI) crude continued to fall, declining -16.4% during the quarter and was down almost -25% for the year until rebounding shortly after the end of the quarter on the news of Iran’s missile attack on Israel.

The head economist of Apollo Investments, Torsten Siok, recently compared current economic conditions to “Goldilocks,” not too hot, and not too cold. Interest rates have been coming down, easing financial conditions. The rate of inflation has declined to nearly 2% annually and Costco recently noted that “as inflation has dissipated, our members have started to spend more on non­food items, which is really encouraging in our mind.” Recent data for debit card spending suggests consumer spending has been accelerating and weekly data for retail sales remains solid. The Atlanta Fed’s GDP estimate for the third quarter stands at 3.1 %, suggesting growth remains strong. Jobless claims and continuing claims have been in decline for several weeks and the US economy added 254,000 jobs in September versus a consensus expectation of 150,000 jobs. The unemployment rate recently fell from 4.2% to 4.1 % and wage growth was +3.8% in September, well above pre-pandemic trend levels. In addition, default rates and weekly bankruptcy filings have been trending down and the profit margins for S&P 500 companies are near all-time highs.

While the bulk of the economic data and news has been positive, there have been some indications of economic weakness. Consumers have continued to spend but retail sales reports suggest an increase in the prioritization of essentials over discretionary spending. Higher credit card delinquency rates suggest that many lower-income Americans are stretched. The CEO of Ally, an auto finance provider, stated that inflation and softening employment have weakened their customers’ ability to pay back loans as auto delinquencies have been increasing.  The annual U.S. budget deficit currently approximates $1.8 trillion, and our national debt recently topped $35 trillion in September. The annual interest expense on this debt has surpassed $1 trillion annually, an amount larger than the nation’s defense budget. Major geopolitical risks loom around the world with wars in the Middle East and Eastern Europe, as well as increased tensions between an economically moribund China & Taiwan. In addition, the closeness of the 2024 U.S. Presidential, Senate and House of Representatives elections pose meaningful political uncertainty.

On balance, the financial markets have been sending a strong signal that the Federal Reserve will successfully pull off a soft landing and the probability of a recession is declining.  Some consumers may be stretched, but as long as employment remains strong, spending should remain resilient and the Fed has gone on record saying that it will support the economy if a slowdown occurs, particularly in the labor markets. The current supply of political and economic concerns often feel excessive but as a leading indicator, the financial markets have been pricing in an optimistic future.

Mackenzie Edwards – October 2024

IMPORTANT DISCLAIMER: Inlet Private Wealth®, LLC (“Inlet Private Wealth®” or the “Firm”) is a SEC registered investment adviser with its principal place of business in Jupiter, Florida. Unless otherwise noted, all data has been obtained via Bloomberg®. Inlet Private Wealth and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which Inlet Private Wealth maintains clients. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. The data contained in this report was gathered from what we believe to be reliable sources, but we cannot guarantee its accuracy. For information about Inlet Private Wealth’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the 3EC’s Investment Adviser Public Disclosure website (www.advi:serinfo.:seo.gov).

Six months ago markets were falling, inflation was rising, the Federal Reserve was hiking interest rates, and it looked as though a recession was right around the corner. Since then, we’ve had a banking crisis and the threat of a U.S. default. Fast forward to today and the stock market has defied gravity with the S&P 500 gaining 16%. While investors’ worst-case scenarios never materialized and the markets rallied, the first half of the year is a reminder that the stock market is not the economy, but a leading indicator of where investors think the economy will go.

The S&P 500 is up over 20% from its October 2022 lows and we’ve technically entered a new bull market, but before breaking out the champagne, investors may want to consider the concentrated and inequitable nature of this performance. According to S&P Global, seven of the S&P 500’s constituents have provided more than 100% of the gains in the index while the remaining 493 companies are essentially flat for the year. Just five of those seven companies represent nearly a quarter of the market cap of the entire index. The largest constituent, Apple, has surpassed the $3 trillion valuation mark, making it worth more than the combined market capitalization of the entire Russell 2000 index.

The extreme concentration and inequality in performance has been driven by investors going “all-in” on the rise of artificial intelligence and the possibility of it bringing a future boom in productivity. In addition, when the U.S. hit its debt ceiling in January followed by the failure of Silicon Valley Bank in March it led to a meaningful liquidity injection into the financial system. According to Strategas, the size of the Fed’s Balance Sheet jumped by $300 billion in March while the Treasury Department’s General Account fell from roughly $580 billion in January to $23 billion by early June. Since the debt ceiling was increased in June, the Treasury has begun replenishing funds in the General Account which should drain liquidity from the financial system.

Though the annual rate has decreased from 5.4% to 4.6%, inflation remains higher than normal. According to a report on the Economic Well-Being of U.S. Households, over 23% of adults reported that their spending had increased but their income had not. Packaged goods company General Mills recently issued a profit warning due to consumers substituting from their branded products into generic alternatives because they are no longer able to stomach (pun intended) the company’s price increases. The U.S. economy is dependent on consumer spending which makes up 70% of its GDP but consumers now need 18% more today to buy the same set of goods as they did in January 2020. Households will keep spending as long as they have jobs and access to credit, but inflation continues to erode their purchasing power.

Cracks in the economy are beginning to show. From the start of the year through May, 286 U.S. companies filed for bankruptcy protection, including Bed Bath & Beyond and Vice Media. According to the Wall Street Journal, that is the highest number during the first five months of a year since 2010. Banks have become more strict with their underwriting and data on the manufacturing sector has been deteriorating for months. Commercial real estate continues to be a major area of concern, especially offices. In the U.S. alone, about $1.4 trillion of commercial real estate loans are due this year and next, according to the Mortgage Bankers Association. Americans continue to say they are concerned with the economy and believe it’s in bad shape; in one poll 83% of Americans think the economy is fair to poor and 72% expect it to get worse.

In spite of this negativity, not all things are bad and the American consumer has remained resilient. Compared to all other G7 countries, the U.S. is growing the fastest and has the lowest rate of inflation. The labor market is still strong, unemployment remains at record lows, and jobless claims decreased in May. People are back to traveling; the number of people flying in the U.S. recently rose above pre-Covid levels according to the Transportation Security Administration. Mortgage rates are undoubtedly high at 7%, but housing starts unexpectedly surged 21.7% in May and new building applications increased, suggesting residential construction is on track to help fuel economic growth.

As amazing as this market rally has been, it can be humbling to take a step back and view it with a wider lens. Most of 2023’s year-to-date gains represent only a partial recovery from 2022’s declines.  We may now technically be in a bull market, but last year’s bear market has not yet gone completely into hibernation.

Mackenzie Edwards – July 2023

IMPORTANT DISCLAIMER:  Inlet Private Wealth^®, LLC (“Inlet Private Wealth^®” or the “Firm”) is a SEC registered investment adviser with its principal place of business in Jupiter, Florida. Unless otherwise noted, all data has been obtained via Bloomberg^®.  Inlet Private Wealth and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which Inlet Private Wealth maintains clients. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. The data contained in this report was gathered from what we believe to be reliable sources, but we cannot guarantee its accuracy. For information about Inlet Private Wealth’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

The financial crisis in 2008 was essentially caused by trillions worth of debt going bad.  In its aftermath, Dodd Frank legislation and the Federal Reserve placed an emphasis on the creditworthiness of the assets banks held and incentivized them to own what regulators considered “very safe,” liquid government securities.  Because regulators considered these securities essentially riskless, they required banks to have relatively nominal levels of regulatory capital when owning them.  However, the legislative emphasis on credit risk and the Fed’s use of risk-weighted capital to judge a bank’s health do not take into consideration the risk of potential investment losses that can result from increases in interest rates.  Treasury securities are only free from credit risk when held to maturity.  As rates rise, even assets that are safe in credit quality will fall in price, resulting in a loss if sold.

After interest rates fell to zero during the early stages of the Covid pandemic, many banks became accustomed to having a base of deposits that did not pay depositors any interest.  Concurrently, many of these banks invested sizable amounts of the capital provided by these “free” deposits in long-term, “safe” government securities that were yielding around 2%.  To some banks the 2% spread being made from these deposits was viewed as a form of riskless financial alchemy and according to the Fed, U.S. banks bought trillions worth of treasury and agency securities during the past few years.

When inflation reached levels not experienced in over 40 years, the Fed was forced to start aggressively raising interest rates during 2022.  This rapid increase in interest rates caused bond prices to plunge and while this risk is implicit in every bond purchase, accounting and regulatory frameworks can obscure this risk and distort economic reality.  While the intelligence of many bank CEOs is debatable, most were smart enough to counter the potentially negative impact falling bond prices would have on their balance sheets by employing a relatively basic accounting change that also provided the added benefit of keeping billions of unrealized losses on their bond holdings from impacting reported earnings.  This “acceptable” accounting maneuver involves simply declaring an intent to hold bond investments until they mature rather than classifying them as being available for sale.  After making this reclassification, the prices of these bonds become “frozen” regardless of how far in market value they may fall.  The ability to make this accounting change falls well within approved accounting guidelines but has helped enable many banks to report robust levels of capital when the current economic reality of the assets they hold are worth significantly less.

This is the playbook that Silicon Valley Bank (SVB) followed.  SVB bought long-dated Treasury bonds and declared an intention to hold them until maturity.   The unrealized losses of these bonds were initially ignored because they will pay the bank their par value at maturity but the income generated by these bonds went straight to the bank’s income statement, adding to SVB’s reported profitability.   SVB held about $90 billion of its $120 billion bond portfolio as held to maturity investments and did next to nothing to hedge against its exposure to an increase in interest rates.  Almost all of these bonds were rated “risk-free” or “low-risk” from a credit perspective but they were ladened with interest rate risk.  Today’s digital technology makes everything move faster and when withdrawals happen fast, liquidity and solvency (or the lack-there-of) can become synonymous.  After a few tweets by Peter Thiel raising the issue of SVB’s potential lack of liquidity, withdrawals snowballed as depositors instantly moved their funds in mass from SVB to other financial institutions simply via the touch of an app or the click of a mouse.  When SVB’s depositors in mass demanded their funds, the bank had far less in assets based on the current market value of the bonds they owned versus their par value if held to maturity and could not make their depositors whole.  Silicon Valley Bank quickly ran out of capital and was seized by federal regulators and arguably became the first victim of a digital bank run (albeit largely self-imposed).

After reading numerous annual reports of small and regional banks, it’s nearly impossible to predict how broad this problem could become but what’s certain is that many of these banks locked up their capital in bonds and mortgages at what could prove to be well below market rates for a long time.  According to the Fed, these holdings had collective unrealized losses of more than $600 billion at the end of 2022.  To paraphrase Warren Buffett, the tide of low interest rates has gone out and we are starting to learn who has been swimming naked.  As savers continue to seek higher rates of return on their deposits and become more mindful of the FDIC’s $250,000 insurance limit on their deposits, capital has been moving from smaller and regional banks to larger banks that are more heavily regulated, have stronger capital ratios and are too important systemically to be permitted to fail.  Post SVB’s collapse, JP Morgan, Bank of America, Citigroup and Wells Fargo have not been able to open new accounts fast enough.

Throughout history, the United States has seemed to careen from crisis to crisis.  Investors will never run out of things to worry about but over time, the world gets wealthier, new scientific advances improve health and the quality of life while creative people and businesses bring innovations to market that delight us and improve our lives.  In time, this too shall pass.

Ted E. Furniss, CFA – April 2023

IMPORTANT DISCLAIMER:  Inlet Private Wealth^®, LLC (“Inlet Private Wealth^®” or the “Firm”) is a SEC registered investment adviser with its principal place of business in Jupiter, Florida. Unless otherwise noted, all data has been obtained via Bloomberg^®.  Inlet Private Wealth and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which Inlet Private Wealth maintains clients. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. The data contained in this report was gathered from what we believe to be reliable sources, but we cannot guarantee its accuracy. For information about Inlet Private Wealth’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).