3rd Quarter, 2023
Non-bank leverage is a potential threat to global financial stability.
THE MARKETS
The third quarter began with a continuation of the money flows into technology that included a broadening demand for Artificial Intelligence (AI) stocks and expectations that global inflation had been collared, thus paving the way for a round of rate cuts from monetary authorities.
This scenario started to wane in early August and further weakened after the Federal Reserve’s annual global summit at Jackson Hole, where the message of “higher for longer” resonated on a global basis. Although the Federal Reserve put rate increases on hold in September, other central banks have continued to push rates higher, with Norway being the latest going to 4.25% with the expectation of 4.50% by year-end. Many European central banks started from a negative rate environment just two years ago and have now surpassed levels not seen in 16 years. While the lagged effect of higher rates has varying outcomes due to country-specific factors, in total, rates are entering the restrictive phase of the economic cycle in which recessionary forces come into play.
Earlier in the year, equity markets mispriced the likely negative aspects of restrictive policy and allowed valuations and leverage to move in a risk-on cadence. The current reality check in the stock market may continue until positive economic fundamentals become verifiable.
The US dollar has seen some reversal of the last 12 months’ downtrend, which was most aggressive in late 2022. Over the past 8 weeks, roughly half of the decline has been recovered.
The outflows of bank deposits into money market funds that began with the Silicon Valley Bank insolvency continue, leading to renewed pressure on banks to maintain competitiveness by increasing deposit rates in line with Treasury Bills and money market fund rates. The good news is that older consumers are reaping a windfall in their savings balances, which can be used to support consumer spending. The bad news is that excess duration has punished the market value of longer-dated bonds held by investors who reached for yield.
The new question is what market risks are arising from quickly increasing short-term rates and the rush to money market funds? With the need to invest billions of dollars of money market inflows into a supply-constrained market, dislocations and compromises on quality may be made. Additionally, as the yield curve flattens in the wake of sharp increases in the Fed Funds Rate, the federal government will be forced to roll over existing debt and fund new spending at significantly higher rates, further pressuring the fiscal situation in the US.
We expect markets to continue their fixation with the broad range of economic outcomes that might result from restrictive monetary policy: soft-landing, hard-landing, or no landing with stagflation? This debate sets the stage for bouts of higher volatility, with harsh punishment for companies whose results or forward guidance fall short of expectations.
Despite increasing interest rates, corporate debt issuance has not ground to a halt. In fact, spreads between Treasuries and corporates have narrowed, implying little concern for cyclical credit risk. Continued upward pressure on global interest rates remains a strong headwind to both stock and bond prices.
THE ECONOMY
Restrictive global interest rate policies are beginning to constrain economic growth in most of the G20 nations. Forecasts for the United States call for real 2023 growth of 2.2% and 0.8% in 2024. Factors affecting the projected slowdown are particularly important for the consumer. These factors include the rising cost of borrowing, which has an impact on both housing costs and consumer debt levels, deceleration of wage growth, and dwindling savings that were accumulated during the pandemic.
Labor market resilience continues to beguile monetary policy makers in general. The post-COVID labor force has been broadly reshaped. In sectors like health care, large numbers of career workers have withdrawn from the labor force, creating significant gaps in the recruitment of professionals. Replacements come at much higher costs, with the shortage of qualified pharmacists being a case in point. The trends towards deglobalization and the reversion to domestic supply chains have added to skill-set deficits. The domestic energy industry, which suffered significant price erosion during COVID, cannot meet the current demand for skilled workers. Service industries, like food services, have a large employment gap that is becoming chronic. Overall, the labor pool appears to be unable to meet the demands of changing population demographics. Higher salaries appear insufficient to satisfy the demand.
There is no monetary playbook for the Federal Reserve to use in trying to solve the labor conundrum in the shadow of the lagging fallout from the current restrictive monetary policy and the overriding commitment to reduce inflation to 2%. Officials have turned to adopting the “dot plot” as they seek to navigate the challenges of the global economic minefield.
The Conference Board now predicts that output “will buckle from headwinds in the first Quarter of 2024, leading to a shallow recession”. The University of Michigan consumer sentiment index has begun to soften from the near-term high in July and should be watched carefully for the September and October data as energy prices and higher consumer interest rates have yet to kick in.
We are in a new era in which there are no valid historical analogs, so surprises are more likely to be dour rather than optimistic until we have conclusive evidence that the inflation genie is back in the bottle.
INVESTMENT STRATEGY
Asset allocation, which is always critical to long-term investment success, is particularly important in the current environment of elevated inflation and heightened economic uncertainty. We are focused on ensuring that each client has liquidity to comfortably meet cash needs while preserving and enhancing purchasing power for the future. The right balance of equities and fixed income is specific to each client, and difficult markets present a good opportunity to review and affirm (or revise) that target.
We have maintained short duration fixed income portfolios of high-quality bonds for quite some time. As such, clients are positioned to take advantage of the higher rate environment by reinvesting proceeds from maturities as they occur. With yields now more appropriately pricing the likelihood of “higher for longer,” we are opportunistically using bonds of slightly longer maturities. While we are lengthening maturities modestly, our stance remains short duration, and we would not compromise quality in pursuit of yield.
Bonds provide stability, diversification, and predictability of cash flows. Equities, however, serve as an excellent inflation hedge over long periods of time, producing attractive real returns through various investment climates. Our investment approach emphasizes companies with durable business models generating healthy cash flows, which can in turn be used to reward shareholders with a growing stream of dividends. Balance sheet strength, which is always important, is doubly so in this higher cost of capital environment. Equity returns this year have been concentrated in a small number of mega-cap companies, and we are using this division of haves and have nots to add to positions of high-quality companies at attractive prices.
RISKS THAT ARE ARISING
Whenever a major financial event morphs into a calamity, subsequent market moves tend to foster new risks, which at the beginning are largely misunderstood or ignored until the gathering mass reaches a size that attracts scrutiny. The fallout from the Silicon Valley Bank insolvency is no exception. Nor is the fallout from the higher-for-longer global inflation purge.
There are several new risks that have reached the scrutiny phase, and each has the potential to generate serious headwinds for an economy that is seeking to find a new interest rate neutrality and build a stable runway for the next business cycle. In a majority of changing business cycles, the exacerbation of risk stems from one or more financial market excesses or miscalculations.
The stampede into money market funds following the Silicon Valley Bank collapse has caused an unprecedented shift of liquidity from bank deposits to non-bank funds. Money market funds have been under pressure to put the inflows to work at competitive short-term rates. According to the Bank for International Settlements (BIS), a growing proportion of the inflows have been directed to US dollar commercial paper issued by overseas entities, implying that domestic inflows exceed the supply of quality US commercial paper. This begs the question of recourse by a US fund against a foreign entity.
The BIS has recently called attention to the growing financial stability risk created by hedge funds using highly leveraged strategies built around US Treasury bonds and derivatives around Treasury futures. To have a profitable trade utilizing such a strategy, significant leverage is required (50x – 70x). While the exact amount committed to this strategy is unknown, the latest BIS estimate is $900 billion. A misstep could lead to volatility in the Treasury market, invoking the Fed to the come to the rescue. Sound familiar?
Recently, the Financial Stability Board (an international body that monitors and makes recommendations about the global financial system) launched an inquiry into the lack of visibility in non-bank leverage, stating that its continued growth has the potential to threaten global financial stability. There is no visibility on total exposure and leveraged lenders have little knowledge of who the other lenders and players are. This can become very risky when a hedge fund field becomes crowded. The Board will be setting up an agenda to tackle other areas of non-bank risk and proposing reporting and establishment of uniform margin requirements related to risk. We support such oversight.
The forgoing all point out that notwithstanding the positive effect of monetary tightening in reducing leverage risk across areas of open market visibility, financial leverage continues to expand in risky enclaves of financial engineering which lack transparency. We reiterate our emphasis on high-quality fixed income and equity investments.