As we wrapped up a turbulent first quarter of 2023, Director of Investments Daniel Dusina led this live webinar and answered questions on the housing market, recent banking crisis, and how recession fears induced a shift on the interest rate outlook. Watch our Quarterly Edge webinar here:
Daniel Dusina: Thanks again for joining, everybody. For those of you that I have not met, my name is Daniel Dusina. I'm the Director of Investments here at Blue Chip Partners. I am looking forward to providing you all with what we believe are meaningful point of conversation for the upcoming second quarter here of 2023.
I will walk through three themes, as I generally do in our quarterly outlooks, but here are some housekeeping items before we get going here. Do feel free to file in any questions that you have intermittently using the chat function or the question function in the application that you're joining through. I'll do my best to address all the questions that flow in at the end, so don't be afraid, it's just me today, not joined by any other colleagues.
We are hopefully going to make this interactive. I'll look to address any questions at the end. Final note, before we get started. For most timely insight, action-oriented insight or any updates from our firm, do be sure to follow along on the Blue Chip Partners blog through our website and follow us on LinkedIn for more up-to-date content.
With that being said, I’ll begin. When I look forward to putting forth three themes for any given quarter, what I would say is the quarterly themes from the previous quarter are generally still pertinent, so that's very much the case today. If you'll recall what we conversed about going into this year, it really was a conversation around the attractiveness of fixed income, the need for quality in fixed income allocations, and ultimately the case for potential valuation expansion in the equity markets throughout 2023.
These three themes very much hold true. We saw some of them come to fruition for the first quarter of 2023, but given the developments that we saw throughout the course of the year-to-date period, there have been additional layers added to our outlook. Those are the elements that we'll look to address today.
First and foremost, we're going to have a conversation around the economy, more specifically inflation: what's been driving it, where we see it heading from a trajectory perspective, and one major theme that could hold the key to inflation going forward.
Second, we're going to discuss the banking sector, so not necessarily the causes and casualties of all the turmoil we saw in the month of March, but instead, a potential knock-on effect that we think is very meaningful and complimentary to the monetary tightening that we've seen from the Federal Reserve over the last 12 months.
Finally, we'll talk a little bit about the Federal Reserve's interest rate trajectory, but more specifically, at least from a historical perspective, what this period has meant for financial market performance. With that, I'm going to dive in. Just a reminder, do insert questions as they come about. We'll address them at the end.
At the onset of 2023, we talked about what the primary considerations were for us at Blue Chip Partners. Inflation was very much one of those. Right now, any conversation around cost increases in the domestic economy really centers around the consumer price index or CPI.
We have seen some progress on CPI moving downwards over the last 12 months, given 5% of interest rate hikes from the Federal Reserve. But even with those 5% worth of rate hikes, CPI, before this morning's print, was annualizing over the last three months, still north of 4%, which is well above the 2% to 2.5% target that the Federal Reserve has.
What in particular has been driving this? It's not the used cars or the supply chain disruption or the energy market that we saw through parts of last year in 2021. Instead, it's actually very much driven by the shelter component of CPI. That in particular is the housing market. It's made up of owner's equivalent rent, which is essentially the price that someone that owns a home would have to pay to rent something of equivalent value and actual rents.
When we look at the shelter component of CPI over the last three months, it's annualizing close to 10% price change, and so with the fact that it maintains a very large weight in the consumer price index, almost a third, just north of a third, actually, the total contribution of the housing market to inflation over the last three months was almost three quarters, just over 70%.
Clearly the path forward for inflation is very much dependent on the path forward for shelter. When we think about what this could look like over the next three months and even really for the rest of the year, we have some observations. I would say that the shelter component of CPI moving lower really depends on a few different things.
The first observation that we have is that we do have a large amount of housing supply that's coming to the market. After record levels, really just a building boom in residential construction in the post pandemic period in both single-family homes and multi-family homes, you have this record level of supply finally starting to come into the market, and that certainly could have an impact on prices.
You saw building in the single-family space peak out in the middle of 2022. We may have seen a peak in the multi-family space very late last year. The reason that this is important is because when you look at the broader employment in the economy, when things are really good and employment is robust, and hiring is rampant, people are willing to pay for workers. That's inflationary. If all of a sudden you get the employment pictures start to roll over slightly or in a larger way, that can be deflationary. Usually you see construction employment start to roll over before broader employment in the domestic economy and with construction employment, a large part of that is residential construction.
As we see a potential peak in residential housing construction, that would mean greater construction unemployment, and thus greater unemployment throughout the domestic economy. The Federal Reserve's target is 4.5%, rather, their estimation for the end of the year is 4.5%. We're not even close to that right now. In order to get to that number, I think you'd have to see some rolling over of construction employment. To get a rolling over in construction employment, you'd have to see a peak in residential home building, which we very well may have seen late last year.
The only other element I will note about the shelter component of CPI: about two thirds of the shelter component is that owner's equivalent rent. The additional third is actual rents that are paid. The important thing to note about this rent component though, is that the official government data puts a lot more weight on rent renewals, which really only happen once a year because most rental agreements are for 12-month periods. They don't put as much weight into new rents, those that are signed every single day. Thus, it can operate with a bit of a lag, which is why you've seen the shelter component be so persistently high. It was very much persistently high today in today's CPI print, and it very well could be for the next few months before it starts to roll off, but we do see the pressure starting to abate. At least there's some early indications of that.
Now we all know that the Federal Reserve has been aiming at tamping down inflation and has done so through monetary tightening. 12 months and 500 basis points of interest rates later, there certainly has been an impact on the financial system and the broader economy through that monetary tightening.
What we see as an ongoing kind of conundrum in a knock-on effect from what happened in the banking environment in the month of March, is essentially an alternative form of monetary tightening. At the end of the day, this could be very complimentary to what the Federal Reserve has been trying to do for the last 12 months, and that's by way of tighter lending standards.
I think right now you're getting an increasing likelihood of an uptick in regulation. Higher balance sheet stringency, especially on those banks that weren't as closely watched before this crisis. With those things, you likely will get an uptick in lending standards, and this matters because the domestic economy is essentially fueled by credit and loans.
We see a slowdown in activity, there is going to be that domino effect for consumer spending, for business spending, for hiring across the board. Especially if those that have been most active in lending to small and mid-size businesses, aka regional banks, are forced to start to tighten up their belts. All in, this lower availability and tighter credit conditions could have a stark impact on economic growth.
It's also important to call out the fact that even before the crisis kind of reared its head in March, banks were starting to tighten lending standards well before that. In the fourth quarter of 2022, you can see this in the first chart on the right-hand side of the screen, 40% of loan officers reported that they were tightening lending standards in the fourth quarter of 2022. That's shown in both the blue and the brown lines in that top chart. We haven't seen figures this high outside of the pandemic period since 2009. Certainly, this is a dramatic increase. It's starting to bubble up and it could start to be a little bit more prominent as we look through the next couple of months.
Another reason why this is prominent is because banks are now facing this dual pronged problem. It's both on the asset and the liability side of their books. On the liability side, for banks, that's deposits, the money that you or I would give to a bank for safe keeping. They take those liabilities and they make spread income off of them. They take the money, loan it out, and ultimately can collect income payments on those. If individuals are either A, not feeling safe with those deposits and start to pull them, or B, start to pull them because greater income opportunities are available, that means there's less opportunity for banks to loan out some of those dollars. Thus, given they need liquidity to meet any deposits, they will likely be tightening lending standards.
You can already see some of this taking shape in that bottom chart on the right-hand side of the screen. Commercial bank deposits are shown in the bar in blue, money market fund assets are shown in the bar in brown. As you can see, these money market fund assets have exploded upwards, even more so at the onset of the banking crisis that we saw in March because individuals are looking to obtain a greater yield, which money market funds are providing relative to simple bank deposits. This dual pronged problem for banks could become a greater issue and again, could have an impact on lending standards and ultimately economic growth.
The bottom line here is just a tougher environment for businesses that are looking to expand, whether it's via new equipment, research and development or new hiring and employees. It's also more difficult for consumers, whether it's a mortgage or a line of credit. Ultimately if you're tamping down, demand a little bit, tamping down, spending a little bit. This is conducive to the Fed's efforts, right, wrong, or indifferent.
Given both of those two themes, we've already called out that the Federal Reserve has raised rates at a historic clip. We're 5% higher on a Fed funds rate than we were just 12 months ago. The fact of the matter is we're nearing the end of this federal reserve tightening cycle. When we came into 2023, opinions were very much split in terms of the trajectory of interest rates domestically from the Federal Reserve, but thanks to some pretty robust economic data through the month of January, we got a really strong jobs report, a really kind of mixed inflation print, really strong retail sales number.
That essentially led individuals and experts and economists in the US to expect an additional three to four interest rate hikes from the Federal Reserve, and you saw the terminal rate, essentially the high rate of this tightening cycle, resting at around 5.7% in September of this year. That was the expectation in February and March of this year, right before the banking crisis. Well, that banking crisis and all the turmoil that happened and the potential knock-on effects completely flipped the existing narrative on its head. So much so, that the market is now expecting significant rate cuts beginning as soon as the next meeting.
You can see a pretty dramatic reversal in terms of interest rate expectations. You've seen it reflected in the bond market, as longer duration bonds have significantly outperformed since May 8th. They were outperforming before that, but there was a very big inflection that happened thereafter. While I would say we don't necessarily buy into the fact that the market's pricing in significant rate cuts beginning almost imminently, we do think that the setup based on the data that's been flowing in is getting ripe for the Federal Reserve to take a pause.
Most likely we'll see the Federal Reserve hike again at their meeting in May. After that, depending on how things develop, and we'll get a lot of information through this next earning season, that starts really on Friday. We do think that the Fed will take a pause. We still don't have a visibility into the full economic impact of all the tightening that's happened over the last 12 months from an interest rate perspective, and then you layer on the stuff that's happened from the banking environment and the knock-on effects there.
We think the Fed will be more comfortable taking a pause and maintaining the interest rate level where they're at, and assessing what the impact of everything has been. This is important because when you look at historic periods in which the Federal Reserve has paused their interest rate increases, so essentially the end of a tightening cycle, the environment has been fairly good for stocks and bonds on a forward-looking basis as it pertains to returns.
From the bond side of the equation, in the six tightening cycles that we've seen between 1984 and 2023, all six of those periods on a forward six-month, one-year, two-year, three-year basis exhibited positive returns in the bond market as represented by the US Aggregate Index. From the stock market perspective, you're seeing average returns in the table, on the bottom of the screen.
I would say that four out of the six tightening cycles, if you invested when the Federal Reserve paused, the outcome was tremendously positive. The two periods in which it was negative was right at the onset of the .com bubble, and then in the middle of a financial crisis. The average numbers stack up incredibly strongly, and I would say not an assumption on our end that you're going to necessarily see a massive V-shaped recovery right off the bat when the Fed pauses. The fact of the matter is that once the Fed pauses and inflation's been coming down, you have more clarity as an equity market participant as to what you're buying into.
If you looked at the market this time last year, there were so many unseen and uncertain headwinds. What is ultimately going to be the terminal rate of interest rates? What is going to be the rate of inflation that we should be comfortable with going forward? Both of those things have a pretty dramatic impact on corporate earnings.
If we don't have any certainty in those variables, how can you accurately price the stock? Instead of accurately trying to price the stock, a lot of market participants exited the market, which is why you saw such dramatic declines last year. Thinking about it now, the pause environment can be conducive to positive equity return and positive fixed income return. Returns have definitely been stronger when legging into the market ahead of, or at, a Fed pause instead of waiting outright for a Fed cut, which generally happens a few months after the Federal Reserve ends its tightening cycle.
This cycle very well may be a little bit different, as the expectation is for the Fed to kind of hike and hold interest rates higher for longer instead of reverting to cuts imminently after. Either way you slice it, what we outlined in our first quarter outlook was that in a period of high and declining inflation, you don't necessarily get very strong earnings results, but because of that additional clarity that's provided to investors, they're willing to help expand equity multiples. I think that lines up very well with a Fed pause phase, which is essentially what's on the horizon, potentially for the second quarter of 2023.
I think there's a lot to digest there, but certainly as we look at the second quarter, it really is an environment where there are still opportunities abound, those that have been discounted sometimes without reason, quality businesses that are trading in a discount. We're still very optimistic on the bond market. After a 13% decline in the US Ag last year, there are certainly more opportunities in bonds today than at any point that we've seen since the financial crisis, essentially. It remains an area we are still optimistic on, and there are a number of sectors and opportunities within equities that we're constructive on today.
All that being said, I'll take some time to address questions. I don't see any that have filed in quite yet, so maybe I will take a shot at answering one that we frequently hear from some of our clients and folks that we talk to.
It’s related to volatility. Can we expect this volatility in the equity market to persist, or do you see this starting to turn down as we progress through the year? The short answer to that is no. I don't think that you're going to see any dampening in volatility over the course of this year. I think there still will be volatility present. There is potential for us to be in a more range-bound market, over a period of time over the next six months until we really get full clarity on not just the interest rate trajectory and the inflation story, but the earnings picture, the economic picture and aggregate.
Because of what I mentioned in the banking sector and its potential impact on GDP, I think there is some room for further volatility, but what I would say is now is the type of time where cash is king in a couple different ways. Number one, you're getting paid in money market funds, so build a balance and dollar cost average into the equity markets. Number two, high free cash flowing businesses can thrive in this type of environment where there's, I would say, above average lever level of dispersion and stock returns, aka volatility.
Focusing on those types of quality aspects within businesses is going to be really important. It was a winning strategy over the last year and a half. It's been a winning strategy to start this year. I think that's certainly something that we hear and we get asked all the time.
First question that we have from the audience, how do you expect the equity market to react when the Fed actually cuts rates?
I think part of the reason that the Fed has been so cautious on their messaging is because they don't want to unwind everything that they've worked to essentially tamp down, the second that they start to cut interest rates or even pause on interest rate hikes. I think they've been very careful in that regard for a good reason.
What I would say is that I think the market will likely move in advance of any Fed movement. We've seen the market rally that happened in the first quarter. The Nasdaq was up 20%. Some of that was predicated on interest rate movements. Just as the Nasdaq was sold off way more than the S&P or the Dow last year, in a period of rapidly rising interest rates, you have investors that are probably pricing in way too rosy, way too easy of a monetary environment from the Fed, and thus have bid up Nasdaq stocks accordingly, kind of in the exact opposite fashion as we saw last year.
I do think that you'll see some element of equity market optimism, but I think it'll actually happen before the Fed actually makes a move, which in all honesty is what can contribute to volatility because there's no certainty on the Fed's direction. They've taken a hard line in meetings in the past, and so if they do come out a little bit more aggressive than the market's currently pricing, you're going to see stocks, especially those that are a little bit more highly valued, and those that might be considered your high flyers and Nasdaq type names, take a hit after a pretty significant run to start the year.
I think the Fed's going to do its best to avoid that kind of whipsawing in the market, but ultimately, they don't want to undo everything they've done over the last 12 months by stoking a massive equity market rally.
Another question came in from the audience. Given where the Fed is in their hiking cycle, do you think long duration bonds have bottomed?
I'll kind of provide some context for this question before I dive into it. Interest rates and bond prices have an inverse relationship. Thus, as interest rates go up, bond prices go down. Those that are longer dated in maturity have greater sensitivity to interest rate movements than those that are shorter in maturity.
In a period of rapidly rising interest rates, you're going to see those longer dated long duration bonds have a greater price impact than their shorter-term maturity counterparts. That was kind of a story for all of last year in which long duration bonds took it on the chin, while shorter duration bonds were relatively less impacted.
When you looked into the out years, the argument for short duration over the last six months has really been: look, I'm getting paid 4.5% or 5% in these shorter duration bonds. Why would I ever use anything long duration given the fact that I'm getting paid the same, if not more, and I have less interest rate risk?
The answer to that is because it's not a certainty that you're going to be able to roll over that short duration bond into something when it matures, that's yielding the same amount. If you were going to lock in a one-year treasury today, or a two-year treasury six months ago, you're essentially banking on the fact that you can roll that into something that's distributing a significant or equivalent level of income when that matures.
The benefit of longer duration bonds is that you don't have to worry about the interest rates moving against you and having to roll it into something else. You do have more interest rate risk, but we started nibbling at longer dated bonds in that space in the back half of last year, and more explicitly in November of last year.
We did so in a very quality oriented manner, to emphasize credit quality. I do think that where the Fed's at today in the hiking cycle, there's a reason we started nibbling on longer duration bonds. It wasn't explicitly because we thought that they had bottomed, it was because there wasn't a lot farther for them to potentially go.
Even if we don't catch the bottom precisely, if we look back in two to three years, we had confidence that that would've been a good decision. You've seen how long duration bonds have moved this year and it's been significantly positive. What I would say is you've removed the primary headwinds, aka 500 basis points of interest rate hikes, even if you do get another two interest rate hikes, 50 basis points versus 500 basis points is, I don't want to say chump change cause it's not nothing, but realistically, if you had long duration bonds sell off 20% on 500 basis points, what is 50 basis points. It's a fraction of that, especially when compared to your opportunity costs. Hard to call a bottom for sure, but I would say they've gotten attractive and we've been a proponent of lengthening duration, not going full out overweight in a meaningful way. We've been in that camp since the back half of last year.
Next question. Have you been seeing folks that are greater than 50 years old entering muni funds and muni offers? It seems as if many people missed the opportunity. Still pretty good opportunity but fading.
What I would say is municipal space always has a fantastic value proposition for those folks that do have a significant amount of taxable dollars in play. We essentially have a more or less structural allocation to municipal bonds in our portfolios, and there's a reason for that. The tax equivalent yields that we see in the space today remain very, very good. You're getting in some cases a tax equivalent yield that we haven't really seen across the board in the last 15 years.
It's certainly a very good value proposition, and especially if you think about how they set up in an economic environment like this. In an economic environment like this, on the debt side of the book, you really want to be in place with quality lenders. That includes investment grade corporate bonds, and I would throw municipal bonds in that hat too, because realistically, if you look at any defaults through recessionary periods in the municipal bond space, they're very limited.
Municipal revenue collection, aka the money that's actually servicing the debt payments that you'd be collecting on municipal bonds, it very rarely takes a meaningful hit in economic recessions. When we talk about quality and fixed income, municipal bonds very much fall into that and especially considering the tax equivalent yields today, we're very much a proponent of them.
We have interest in them. We have clients and other individuals across the street, Wall Street that is, that have made the case of the attractiveness of municipal bonds. We continue to like that space.
Well, we're right up against time here everybody. I just wanted to thank you again very much for joining. Shameless plug once more: for all the most up-to-date content, be a frequent participant in our blog on the website, BlueChipPartners.com. And do follow us on LinkedIn because that will be the way to get the most up-to-date info.
Until next time, I'm Daniel Dusina. Thanks again for joining.
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