Market Commentary - April 2023

Monthly Update

While the S&P 500 rallied in April for a 2^nd straight month by 1.5%, it masked underlying weakness as the strong performance of big cap tech names like Microsoft and Meta Platforms offset softness elsewhere[1]. The equal weight S&P 500, which does what the name says, equally weights all the holdings, was little changed, up .2% and the small cap Russell 2000 was lower by 1.9%[2]. The NASDAQ was unchanged in the month. Contributing to the mixed signals was a confluence of very important things that took place during the month of April and into the early days of May. We saw another bank failure, First Republic, that eventually merged with JP Morgan. That was followed in the first few days of May with one other regional bank having announced they are seeking strategic alternatives because of the collapse in confidence and the collapse in their equity value. We were also flooded with earnings that while better than estimated, as they typically are in earnings season, are still expected to be down year over year for the second straight quarter. Finally, on May 3^rd the Federal Reserve raised interest rates by another 25 basis points taking the fed funds rate to a range of 5-5.25%[3].

I’ll talk more about the Fed’s action but as expectations have been priced in the fed funds futures market that the Fed is likely done raising short term interest rates, the 2 yr. yield, after falling by 79 basis points in March to 4.03%, held that level by April month end[4]. The 10 yr. yield also saw little change after falling sharply in March. Corporate debt was mixed as higher quality bonds traded better than lower quality ones.

International stock markets continue to outpace US indices. The Euro STOXX 600 index was higher by 1.9% in April and by 10% year to date[5]. The French CAC 40 is the particular standout in Europe, higher by 13% year to date as of this writing, led by consumer product companies[6]. The Nikkei rallied by 2.9% in the month and is up almost 12% year to date[7]. Optimism with the China reopening though cooled as it’s been more isolated to leisure, hospitality, and travel. The Hang Seng was weaker by 2.5%[8].

The Banks

The US economy relies on the banking sector for about 20% of total lending according to the Federal Reserve with the capital markets and non-bank private lending making up most of the balance. That is in stark contrast to Europe where the figure is around 80% according to the ECB. However, in the United States, small and medium sized businesses are highly reliant on small and medium sized regional banks for funding.

To highlight the importance of these smaller banks, according to Fed data, small and medium sized banks have a 38% market share of all outstanding bank loans. Their market share is 28% for commercial and industrial loans, 37% for residential real estate loans, 67% for commercial real estate loans, 27% for credit cards, 15% for auto loans, and 48% for other consumer loans. Thus, with many banks more focused now on firming up their balance sheets and trying to retain deposits that are leaving for Treasury money market funds and other venues like CD’s, there will most likely be a slowdown in the extension of bank credit. Even before the failure of Silicon Valley Bank, bank lending standards were the tightest since 2009, not including Covid, as seen in the Fed’s January Senior Loan Officer survey which by the time you read this, a new updated version will have been released. Austan Goolsbee, President of the Federal Reserve Bank of Chicago, estimated that the banking crisis we’re currently seeing is the equivalent of the Fed raising interest rates by 25-75 basis points[9].

Many banks have a tough trade off as they need to raise the deposit rates they pay on savings and checking accounts to stem the outflows but that will inevitably crimp their net interest margins. The other challenge the banks face is we are potentially in the midst of a credit cycle downward where delinquencies start to creep higher. Commercial real estate (CRE) is the most front and center credit worry right now.

There are two challenges being faced in CRE right now, one is office properties and the other is capital structure. We all know the issues that office landlords face due to the work from home trend where Tuesday, Wednesday and Thursday is the new normal with the ‘in the office’ workweek. There is some distinction here though as high-quality Class A buildings are doing much better in terms of occupancy than Class B and Class C office space. Also, cities like NY, Chicago and San Francisco are seeing lower occupancy rates relative to sunbelt states like Austin, Atlanta, Charlotte, and Tampa to name a few.

With respect to capital structure, many real estate loans are coming due this year, irrespective of asset class, and they will most likely reprice at a much higher interest rate than the loan that is expiring. For example, a multi-family building that is 98% occupied and has debt coming due this year, might still be hurt by the sharp rise in interest rates. The end result is that the owner will need to come up with more equity to pay down debt, will need to restructure a new loan with their lenders, or will have to give the keys back to the bank.

Growth and Inflation

The US economy grew by 1.1% in Q1 q/o/q annualized which was below the estimate of 1.9% and coincident with this news we’ve been flooded with corporate earnings[10]. As is typical in earnings season, about 75% of companies that report exceed analyst expectations and this time is no different[11]. That said, expectations are still for a second quarter in a row of declines relative to the same quarter a year ago. Companies are seeing moderating revenue growth and slipping profit margins.

The March consumer price index was reported in April, and it rose 5% y/o/y, down from 6% in February and that is the slowest rate of change since May 2021[12]. The core rate has proven to be more persistent as it was higher by 5.6% y/o/y vs 5.5% in February and 5.6% in January[13]. There is hope though that core inflation should continue to recede in the back half of 2023 as rental price growth slows and that is eventually reflected in the government statistics. The rental component within CPI is showing gains of more than 8% versus last year but surveys from Apartment List and what some public company REITS have said, the trend is more like 4-6% right now on a blended basis of new leases and renewals.

The Federal Reserve and Others

In the face of the collapse of four banks as of this writing and worries about others, the Federal Reserve, after hiking rates in March, did so again on May 3^rd to a range of 5-5.25%. As stated above, if you take Austan Goolsbee’s estimate of a mid-point of a 50-basis point hike equivalent as the result of a likely credit contraction, we’ve seen 100 basis points of tightening AFTER the fall of Silicon Valley Bank. That comes on top of an already aggressive pace of interest rate increases along with quantitative tightening.

I believe the Fed made a mistake in raising rates in May and should have taken a time out instead. From a risk management perspective, they should have waited to see the fallout from the bank failures and its possible impact on credit availability and demand. That said, I believe the Fed is done raising rates and the bond market not only agrees with me but is pricing in rate cuts in the 2^nd half of 2023 and a lot more in 2024.

The European Central Bank, Reserve Bank of Australia, and the Norges Bank in Norway all raised interest rates as well in April, but it does seem like we’re coming to the end of this rate increase cycle. Inflation is still a challenge that central banks are confronted with but we’re reaching a point where the economic impact of all the tightening that has already taken place needs to be considered.

Conclusion

I heard a lot about ‘challenging economic conditions’ when listening to quarterly conference calls from a variety of companies in different industries over the past few weeks. It’s also a challenging investing landscape as well. I don’t expect either to change much in the months to come. The old playbook that worked so well over the past 10 years no longer is applicable. The world of zero rates and massive QE is over for now and a higher interest rate and stickier inflation backdrop is something we need to acclimate to. In this new world, investors should be realistic of the risks of this shift to a new investing regime.

Whatever comes our way though, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor.

Disclaimer

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The market and economic data is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The information in this report has been prepared from data believed to be reliable, but no representation is being made as to its accuracy and completeness.

Nothing in this material should be construed as investment advice offered by Bleakley Financial Group, LLC or Peter Boockvar. This market update is for informational purposes only and is not meant to constitute a recommendation of any particular investment, security, portfolio of securities, transaction or investment strategy. No chart, graph, or other figure provided should be used to determine which securities to buy, sell or hold. No representation is made concerning the appropriateness of any particular investment, security, portfolio of securities, transaction or investment strategy. You should speak with your own financial professional before making any investment decisions.

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[1] Bloomberg

[2] Bloomberg

[3] CNBC

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bloomberg

[8] Bloomberg

[9] Wall Street Journal

[10] Bloomberg

[11] Bloomberg

[12] Bloomberg

[13] Bloomberg