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).

The surge of a new COVID variant, a global supply chain struggling to keep up with demand, inflation on the rise, a major debt crisis in China, and the looming threat of another government shutdown here in the US made the third quarter anything but ordinary. Despite all this uncertainty, the US equity markets did their best to hang in there. For the quarter, the S&P500 was essentially flat with a -0.29% return and the Dow Jones was down -2.28%.

Global supply chain update: Still broken. The queue of container ships waiting to enter neighboring ports of Los Angeles and Long Beach hit an all-time high of 65 vessels in the past couple weeks, and they’ll wait an average of 8.7 days to deliver their cargo. The average transit time from China to the US is now 71 days, compared to 40 days in 2019. This matters because these California ports are the busiest in the US, and they accept more than a quarter of all American imports. Nike and Costco are two victims of these supply chain issues who have recently cut their revenue forecasts for the year. Nike also said that 80% of its shoe factories in Vietnam are currently closed. Be prepared to hear this more and more during the upcoming earnings season. Of all the goods caught up in these bottlenecks, semiconductors and other chips used in electronics may be the most in demand. The global chip shortage will cost the auto industry $210 billion in revenue, according to consulting firm AlixPartners. Automakers are estimated to lose 7.7 million units of production this year because of the chip shortage.

As a result of these bottlenecks and the Federal Reserve’s purchase program of $120 billion of bonds every month, inflation has kicked in and is on the rise. In fact, Dollar Tree (a store that sells a majority of their items for only one dollar) announced that they will be boosting their prices above $1 as their costs continue to rise. To avoid being accused of false advertising, they may soon have to change their name to the “Dollar Tree Plus.” As of August, the U.S. Consumer Price Index, the most widely used measure of inflation, read a 5.3% increase in prices compared to August of 2020. While the Federal Reserve has signaled that they believe this inflation is only “transitory,” these lingering bottlenecks threaten to limit supply and keep inflation elevated. The economic experts at Strategas suggest inflation will likely not be sticky at 5%, but it remains an open question as to whether price changes will remain closer to 3% in years to come. The Federal Reserve has given us more transparency about when they will begin slowing down their bond purchases and, in response, treasury yields are back on the rise. Rising yields don’t necessarily spell doom for stocks. They actually appear to be signaling that a more “normal” economy, one that doesn’t require unprecedented government stimulus, is arriving.

In China, a company called Evergrande promised to deliver apartments to some 1.5 million buyers, who are still waiting for their keys. Some of them have started protesting. They want Evergrande (oxymoron?), the world’s most indebted property developer, to resume construction of the apartments they were promised, or give back their money. On September 23rd, Evergrande seemed to have missed their deadline on interest payments of $83.5 million to offshore bondholders, according to sources quoted in several media reports. The group is now entering a 30-day grace period during which it can still make good with its creditors, but fears have increased about the company’s capacity to manage its $305 billion total debt load. It remains to be seen if and how Chinese authorities will react- whether they will allow Evergrande to collapse, facilitate a restructuring, or bail out the battered group. If that wasn’t already enough Chinese drama for you, President Xi has also been cracking down on industries as he tries to center the country around the ideal of “common prosperity.” During the last three months he has 1) stopped Didi, the Uber of China, from signing up new customers 2) announced plans to break up Alipay, China’s largest digital payments platform 3) expanded a ban on crypto-related transactions 4) limited the amount of time young children can play videogames 5) banned “effeminate” men from appearing on TV and 6) blocked tutoring companies from taking profits.

Although, the media loves to bombard us with negative news, it’s important to remember that there are still positive events happening in the world. The oldest living World War II veteran, Lawrence Brooks, just celebrated his 112th birthday in September. Commercial space flight is officially a reality. In July, Richard Branson and Jeff Bezos separately blasted off into space in their own respective rockets before safely landing back down to Earth. The percent of people in the U.S. who have received at least one dose of a Covid-19 vaccine is now over 65%. Drugmaker Merck just released a study that its antiviral pill, molnupiravir, slashed the risk of hospitalization or death in subjects with mild to moderate Covid-19 by 50%. If approved by the FDA, this treatment could be a huge help to keep hospitals from being overwhelmed. After growing at an annual rate of +6.7% in the second quarter of 2021, forecasters from the Federal Reserve of Philadelphia expect U.S. GDP to grow 6.1% in 2021 and 4.4% in 2022. The net worth of U.S. households rose to a record $141.7 trillion as of June 30th, up 19.6% from a year ago. Of the $5.85 trillion increase in net worth, stocks accounted for $3.5 trillion, and real estate appreciation was responsible for $1.2 trillion. Personal savings in the US is also up more than $700 billion compared to the 10-year average before the pandemic, per Strategas.

With all that’s going on in the world, the fourth quarter promises to be another volatile one. Though volatility may create short term worries, it also typically creates long-term buying opportunities. We will stay tuned.

Mackenzie C. Edwards                                                      September 30, 2021

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. 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).