The opening quarter is in the books and not even the PTSD from the ’08-’09 GFC of a new banking crisis could stand in the way of solid gains in all asset prices to kick off 2023.  The S&P 500 rallied +7%, the Nasdaq Composite ripped nearly +17%, gold gained +8%, the MSCI All-Cap World Index (ex-US) appreciated +7%, and Emerging Markets increased +4%.  The bond market got in on the party as well with the 10-year part of the Treasury curve gaining +3.5% while the long-end surged by more than +7% and investment grade corporate credit registered a solid +4% showing.  Positive, but lagging were the Dow Jones Industrial Average and the Russell 2000 which returned +0.4% and +2.34%, respectively.

The Q1 2023 scorecard highlights the notion that it’s never just ‘one thing’ that drives the complexity and dynamism of capital markets.  Afterall, the Fed continued its tightening path (albeit at a moderating pace), economic growth remained resilient (while still slowing), and inflation remained elevated (while still declining).  The two major variables with the biggest shifts in support of risk assets in Q1: 1)sentiment/positioning – investors entered 2023 with sentiment readings in the doldrums and positioning significantly underinvested, where a simple reversion to the mean would be a positive development, and 2)liquidity – credit tightening via bank lending and monetary tightening via continued QT were mounting pressure points coming into and during most of Q1.  However, the regional banking turmoil in the first week of March caused the Fed to create an emergency lending program (BTFP) which caused a nearly $350 billion spike in the Fed’s balance sheet over the final three weeks of March.  In true Pavlovian nature, market participants took the bone and ran with it as if its QE reincarnated – I have my doubts that this is anything more than a temporary stopgap, but for now the market is acting as though it’s not.  As for bank lending, its only going to get tighter following the events over the past three weeks, so this liquidity tailwind will become a liquidity headwind in the following quarters.     

As for the rally in the equity market, it isn’t nearly as strong (broad) as the S&P 500 and Nasdaq would lead you to believe.  This has been a very narrow rally with seven mega cap Tech/Discretionary/Communication Services companies accounting for 90% of the gain in the S&P 500 year-to-date.  The below breadth chart from Hi Mount Research shows the decay that is going on under the surface of the equity market.  This year started out with 33 consecutive days of NYSE + Nasdaq new highs > new lows and finished the quarter with 19 consecutive days of new lows > new highs.  That’s a deterioration in internals worth paying attention to. 

Investors seem too excited about the prospect that the Fed either hikes rates for the last time at its early May FOMC meeting, or that we have already gone past the peak of this aggressive tightening cycle.  This notion of a Fed pause/pivot has played a meaningful role in the rotation ongoing within the equity market causing a significant divergence between value and growth stocks.  For instance, the Russell 1000 growth index is up 14% in Q1 vs. the Russell 1000 value index being flat on the year – this is the widest gap between these two groups since Q1 of 2020. 

I do think investors cheering on the possibility of ‘bad news is good news’ on the expectation that it brings about Fed rate cuts should “be careful what you wish for”.  The long and variable lags inherent in monetary policy works both ways, and for Fed policy to have a chance of offsetting oncoming economic weakness they would need to be cutting today to impact activity 6 – 12 months down the road.  However, they are still considering hikes at the next two Fed meetings and yet our read of incoming economic data over the next 3 – 6 months sets up to be the worst we’ve seen since Covid and before that the GFC.  We got a taste of that this morning with the release of the March ISM manufacturing PMI falling to the lowest level since May 2020 at 46.3 versus 47.4 in February.  This was the fifth consecutive month of a sub-50 contractionary print.  New orders slipped to 44.3 (7th consecutive month of contraction and nine out of the last ten months) and employment fell to 46.9 (2nd consecutive month of contraction) – see charts below compliments of Hedgeye.

Bottomline, the goods economy is in recession territory, the services economy is slowing, and both household consumption and capital investment are slowing organically.  All of this is occurring in front of a discrete tightening in credit that is set to intensify following the banking problems percolating in the past month. 

The announcement over the weekend by OPEC+ of a surprise oil production cut of more than 1 million barrels a day isn’t going to help consumer pockets that are already being squeezed by inflation and higher interest rates.  Oil prices are up 6% to just over $80/bbl as I type and should these gains be sustained (let alone increase going forward) it only complicates central bank strategies of bringing inflation down towards their targets.  It’s worth pointing out, and while I’m constructive on the energy sector on a longer term basis, I can’t help but think about how weak global demand might be given that these cuts come with OPEC+ producing nearly 2 million barrels a day below its supply target in February.  Sure, these actions likely reestablish a higher floor under the oil price, but demand will come under increasing pressure if/when we’re in the throes of an economic recession.  Any long-term oil bull (like myself) best prepare themselves for some likely rough waters in the near-term before the longer-term opportunity bears fruit.

Let me attempt to try and tie some thoughts together about what’s top of mind.  In a nutshell, our work has us meticulously focused on recession watch at the moment because of the following factors (note, this is not an exhaustive list):

•  M2 is contracting for the first time in the history of the data series.

• The tightening in bank lending was reaching levels that normally foreshadow an economic recession, and this was prior to the recent problems in the banking system which likely will intensify the tightening in lending over the next several quarters.  The current tightening matches the levels seen in 1990, 2001, and 2008 (all recessionary years).

• Leading Economic Indicators (LEI) have declined for 11 consecutive months.

Lastly, common sense.  Perhaps 6 – 12 months from now (depending how this ages) anyone reading this will question my common sense, but I just don’t see how unwinding fourteen years of extremely low interest rates with one of the quickest and most aggressive interest rate hiking cycles on record can unfold without disruption.  Below is a chart of 10-year Treasury yields going back to January 1st, 2000.  The two red bars in this chart distinguish the general range of interest rates from January 2008 through the present with 3.0% representing the ceiling and 1.5% representing the floor.  Yes, there were points where it moved above or below the range for a bit, but for the most part anyone who carried any kind of credit or took out additional credit over this roughly decade-and-a-half period had opportunity after opportunity to lock in some of the lowest interest rates in history.  The fact that rates persisted at these low levels for such an extended period of time naturally causes borrowers, lenders, businesses, investors, and policy makers to assume that interest rates will always remain this low and hence the financial system/economy gradually recalibrates to such an expectation. 

Simple math as well as financial models tells you that when the cost of capital on an asset doubles, the value of that asset falls without a corresponding increase in cash flows.  Reason being is that any asset acquired with the use of credit now requires more of its cash flow to be used to service the higher interest expense on the loan.  This leaves less cash flow for the equity/net worth of the asset.  But Corey, what about all those homeowners or borrowers that locked in those low interest rates over the past fifteen years with a sub 3.5% mortgage or loan?  Great for them, but anyone thinking about buying their house today is looking at mortgage rates double that level.  Now you understand the dilemma where something has to give.  Either values have to come down, rates have to revert back to where they were, or a combination of the two.  This is the adjustment that is underway through the entire system and should interest rates remain at current levels this will take time to work its way through the system.  Just as the prolonged and sustained fall in rates had the effect of increasing values over the past fifteen years it will have the opposite effect going forward (certeris paribus). 

I have my doubts that interest rates will prevail at these elevated levels given the debt backdrop (more on this below), but they could.  Time will be the ultimate arbitrator and I’m open minded to however it evolves, but in the near-term it causes me to lean in the direction of being more cautious and defensive with portfolio positioning.  Consider the fact that even after last year’s 20% decline the forward P/E multiple on the S&P 500 is 18x – above both the long-run norm of 15.6x and average cycle peak of 17x.  Think about that, we’re fifteen months into this bear market and valuations are richer today than what is typical at pre-recession peaks.  To be fair some of this valuation expansion is the result of the earnings recession that has been underway for the last three quarters and a steady diet of EPS estimate cuts, but the cuts and earnings declines to this point have been modest.  I’m not sure yet if that is a good or bad thing, I suspect the latter, but we’ll get a fresh look in two weeks’ time when Q1 earnings season kicks off with the banks. 

Bottomline, while the Q1 rally in almost everything was a welcome relief especially after the beating almost everything took in 2022, it doesn’t change our view that tougher times for both asset prices and the economy lie ahead.  Hence we continue to favor caution with portfolio positioning.  I think patience remains the most important variable in any investors investment process right here, right now.  The last five quarters going back to the start of 2022 have been frustrating for both bulls and bears with each having the upper hand at times in the bull/bear debate.  After a strong start to 2023 the debate favors the bulls, but any argument that we’re in the midst of a new bull market falls flat on its face when you consider that the S&P 500 is at the same level it was in the first week of April 2021.  Two years of violent sideways chop – that’s not a bull market.

I’m going to end this week’s missive with an excerpt from the research team at Tier1Alpha that they published in their daily note last Thursday March 30th as I think it hits on set of factors all astute analysts should be evaluating.      

 In recent decades, the federal government has increasingly played a significant role in the GDP, expanding its reach since the 1980s. One of the great ironies in life is that the Reagan presidency, run on a campaign of fiscal sobriety, kicked off a generational increase in Debt/GDP ratios. Throughout this cycle, interest rates fell to accommodate the higher levels of debt. This pattern has been upended by the inflation fighting quest of the Powell Fed.

Unfortunately, with Debt/GDP approximately 3x higher than under the Volcker Fed, as interest rates climb, this trend runs the risk of accelerating as interest expense climbs rapidly. The Treasury has benefitted from the debt ceiling debate so far as it has restricted issuance of high coupon treasuries, but with the Treasury General Account (the US government's checking account) beginning to run out, the issuance is coming. Remember that decreases in the TGA are liquidity providing (pushing cash out into the system) while increases are liquidity reducing (pulling cash out of general circulation and into Treasuries). The debt ceiling debate is simultaneously raising stress about US policy AND providing liquidity. When resolved, it is likely to have the opposite of the expected impact on US financial conditions.

A similar drain is occurring from the differential between bank deposit rates and money market rates -- a differential completely tied to Fed policy. One must ask whether the system has excessive leverage to withstand higher rates over an extended period.

The current global landscape is approaching a recession, including a looming credit crunch. As monetary policy tightens and defaults emerge, creditors with robust balance sheets and solid business models will be able to weather the ensuing writedowns. In contrast, those with weak balance sheets and shaky fundamentals will struggle. Consequently, we continue to believe we will soon discover the resilience of non-systemic players' balance sheets within both the traditional financial system and the less regulated shadow banking realm.

When referring to 'shaky fundamentals,' we mean the ability to maintain profitability in an environment where interest rates are not at zero. Although rates may not remain near the high 5% mark, they are unlikely to return to zero, primarily because policymakers have become aware of the myriad distortions caused by a zero-rate world. As a result, certain businesses will experience difficulties when easy access to capital is no longer available.

As we enter the earnings season, we believe it's important to challenge the prevailing notion that the consumer landscape is robust. Our featured chart today emphasizes the mounting credit card debt crisis in the United States, which raises concerns about consumer financial well-being. According to a recent study by Bankrate.com, US credit card debt has attained unprecedented levels, eclipsing the emergency savings of numerous households.

The study unveils that 36% of US adults possess more credit card debt than savings. This record-breaking figure, the highest in Bankrate's 12-year history of surveying Americans, represents a substantial surge from 27% and 22% in the years 2021 and 2022, respectively.

These findings arrive in tandem with the New York Federal Reserve's latest Quarterly Report on Household Debt and Credit, which disclosed a 15% year-over-year and 7% quarter-over-quarter increase in credit card balances. The New York Fed reported a $130 billion growth in balances between December 2021 and December 2022, marking the most significant annual upswing observed to date. The report is available here.  

As noted by Daryl Jones of Hedgeye, a substantial number of Americans who benefited from COVID-related student loan forbearance programs are expected to resume payments in the third quarter. This shift will necessitate a considerable adaptation in their spending habits, highlighting the potential financial impact on households nationwide.

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