April 2023 Observations from OCIO Mark Corcoran
Where We Were
Between 2019-2021, the value of the S&P 500 rose +100% (despite the COVID recession) while the U.S. Aggregate Bond index gained +15%. Having exhausted all of the oxygen in the room, however, 2022 became the textbook definition of “reversion to the mean.” Capital markets needed, and received, a return to “normal” growth rates and expectations, unfortunately coinciding with high inflation caused by monetary expansion of yesteryear. It was a hard transition. It was tough love. Equity and fixed income markets alike took most of the year to adjust to this new reality. In 2022, the All-Country World Index (ACWI) fell by -18%, with the non-US contingent of that index declining by -16%. Developed foreign markets dropped -14%; emerging markets fell -21%. The S&P 500 index was off -18%; the Russell 1000 fell -19%. The Nasdaq Composite fell -33%. Within U.S. style segments, Growth fell -30% while Value declined -5%. For market cap styles, mid cap fell -13% and small cap dropped by -21%. In the bond arena, the U.S. Aggregate lost -13%, reflecting the declines of its three main components: intermediate Treasuries -13%, Agencies -12%, and Corporates off -18%. Munis fell -7%; High yield -11%; intermediate TIPS -12%; short TIPS -3%. Gold rose 3%.
Where We Are
Despite bank sector hysteria, the S&P 500 has put in another “higher low” and is close to gaining all ground lost between February and mid-March. The S&P 500 has risen +6% since March 12, from 3855 to 4109. The Financial sector is up 4% in the same time period; the bank index is up 5%, though still off -20% since March 7. Most folks have probably not paid attention to the rest of the market, especially Growth stocks. The Info Tech sector (XLK) gained 11% in March and is up 22% YTD. The Communications Sector (XLC) is up 9% and 21% respectively. By now, a few Chicken Littles aside, most institutional professionals have accepted the gross dereliction of duty at SVB and other small banks as outliers, and not painted ALL banks and financials with the same brush. At this point, given the zero-sum outcome of deposit flows, we believe higher confidence in the larger banks continues to gain ground. Meanwhile, small/mid cap are also suffering from the “flight to quality” trend, and bond prices have been rallying across the board.
YTD, the SPX is up 8%. Value is up 5% (Financials equal approx. 20% of the Value index), Growth is up 10%, Mid Cap is up 4%, Small Cap 3%, Emerging Markets are up 4%, and Developed Foreign Markets have gained 9%. The 10-year Treasury and the U.S. Aggregate are both up from their 52-week lows, they are at 4% and 3% YTD. The 20+ year Treasury index is up 7%. Short Treasuries (2yr) are up 2%. Munis are up 3%, High Yield is up 4%, Short and Intermediate TIPS are up 2% and 4%. Within the 11 economic sectors, leaders are Info Technology, Communication Services, and Consumer Cyclicals, up 22%, 21% and 16%. Laggards include Financials -6%, Health Care -4% and Energy -4%. The S&P 500 held up at 3850 and has since rallied above its 50- and 200-day moving averages. The next technical resistance test is 4180, the February 2 short cycle high.
S&P 500 earnings expectations. Current Q2 2023 estimates reflect EPS of $53.99. On 1/1/23, that estimate was $56.34 (-4%). For 2023, the current EPS estimate is $220, off from $228 (-4%) since the beginning of the year, but still up from 2022’s $216 (+2%). The 2024 estimate has compressed from $252 to $247 (-2%), with implied year-over-year growth of +15%.
Where We’re Headed
Market activity suggests more folks are seeing a “half full” outlook. Economic growth may still be forecast at <1% this year and corporate earnings are decelerating, but employment remains incredibly strong and inflation continues to tick down gradually as hoped. And while bank issues did not keep the Fed at bay last month, the bull case is building in a dovish Fed reversal this year, while layoffs bring unemployment up slowly and tough year/year comps for many CPI inputs portend less pressure on the Fed to push policy rates up beyond the 5.25% level. Ask yourself how you think the stock and bond markets might react to the combination of lower inflation, a more forgiving Fed, bond indexes still off -15% from their highs, and stocks which already priced in a recession last year (-25% from 2021 highs through October), and are still off -15% from those highs?
No matter what, tighter bank regulations are on their way. In the end, this episode will likely be viewed as a net positive to the health and confidence of the banking industry. Given updates so far and a full Fed review being produced in May, we believe a couple of themes are in play:
Larger banks and money market funds are winning deposits from smaller banks. The 25 biggest U.S. banks gained $120 billion in deposits in the days after SVB collapsed, according to Federal Reserve data. All the U.S. banks below that level lost $108 billion over the same period. More than $220 billion has flowed into money market funds over the past two weeks, according to data from Refinitiv Lipper. This is data as of March 30, as sourced by Factset and the WSJ. Perhaps many folks are not aware that SIPC insures $500k of securities and $250k of uninvested cash, so without further federal government backstopping their insurance coverages are similar. It has been posited that some of the upward move in technology stocks is from capital moving into companies which have better balance sheets than Uncle Sam.
Leverage necessary for banks to operate will not change; it is an ever-present risk. Most folks may not understand that banks are required to hold capital equal to a fraction of loans. That is not new, and it should also not be news to professional financial advisors. When there's not a run on deposits, banks win or lose based on loan spreads and their other business lines, but crisis isn't part of the discussion. This fundamental bank operating principle has been ever with us and will remain.
Most of us were not really aware of the mismanagement risk within the minds of bank leadership. We understood that there are two buckets normally filled up from excess deposits: investments with marked-to-market values, and those designated as hold-to-maturity. SVB revealed that it was in fact possible, however unadvisable, for bank managers to allocate too much and chase yield in the HTM bucket, then sell out of that bucket to shore up a failed equity capital raise and falling deposits. Regardless of how different SVB’s deposit base was and is from money center and other leading banks, when the dust settles, we all expect to see regulatory reform in this arena. Some best guesses as it relates to security holdings include a) not allowing an HTM bucket whatsoever, meaning all investments will be marked-to-market every 90 days; b) restricting HTM to a smaller percentage of total investments; c) all maturities of bonds/bills held equal to less than 12 months, with the majority six months or less; d) further restriction on allowable securities. Higher capital ratios are also decidedly in the cards. Hopefully coming reforms will again afford investors the confidence in banks acting like systemically vital concerns.