For the majority of the first quarter of 2023, it seemed as if the economy was largely immune to the cumulative Fed restrictive actions. Heavily financed items, such as homes and cars, experienced decreases in value, but jobs market strength seemed unshakable and inflation metrics were generally uncooperative with the Fed’s wishes. It went so far that there were renewed questions about whether the Fed would have to employ 50 basis point hikes to catch up with what could be runaway inflation. The January CPI report showed that inflation was persisting at an annual rate of 6.4%, a long way from the Fed’s current stated goal of 2%. What punctuated the strength of the economy in the first quarter was the January jobs report that unemployment dropped to 3.4%, the lowest number in 53 years. Euphoric market commentators were calling for a goldilocks scenario, where there was not job pain, or economic challenges, but inflation would be controlled. It was truly a magical time.
The economic strength from January, which was mostly reported in February, led to steadily higher trending yields throughout February and into the start of March. Although concerns about corporate profits have been undulating underneath the stock market sentiment since late fall and the housing market froth was expected to blow off a bit due to higher mortgage rates, it was more esoteric yet significant parts of the economy that made risk appetites diminish. The day of reconning for office-focused commercial real estate may be upon us, compliments of the rise in remote work. According to a Bloomberg article published on March 1st, one real estate brokerage firm estimates that roughly 330 million square feet of office space will be vacant by the end of the decade. Recently, a landlord for one of PIMCO’s office complexes defaulted on $1.7 billion of mortgage notes. The significance of the move is it may represent a “breaking of the dam” and other defaults are likely to follow. Over the next two years, $150 billion of similar debt for non-bank lenders will mature and even if properties are performing, the cost of financing has risen materially. More than 20% of U.S. office supply is vacant or available for sub-lease and according to the Green Street Index, office values are down 20% from March of 2020 through January of 2023. The room for more office space pain is significant and it may have a chilling effect on both the access and availability of credit, as well as on overall risk appetite in the financial markets.
"Although a Global Systemically Important Bank failed, it is the domestic bank failures that may have the greatest impact on the domestic economy."
The semi-surprise for the quarter was the rapid failure of a few significant banks. In Q1 of 2023, we saw a globally significant financial institution need to be acquired by a rival (Credit Suisse being acquired by UBS, with a significant backstop from the Suisse government), along with the 2nd and 3rd largest bank failures in U.S. history. It was the culmination of the consequences of tight central bank policy with capital access headwinds and the age-old enemy of the banking system: significant unexpected liquidity needs (or a “run on the bank”). Although a Global Systemically Important Bank failed, it is the domestic bank failures that may have the greatest impact on the domestic economy. The failure of Silicon Valley Bank (SVB) and Signature Bank may have done more to pull down inflation pressures than all the Fed’s expected future actions. Portfolio market value losses for some community banks were already starting to offer the prospects of reducing the ability of some to fund loans. That, in turn, would diminish the ability for some small businesses to fund growth plans. That is important because in the disappointing jobs report released at the start of April, nearly 70% of the private sector jobs were gained from small employers. Cool off the access to capital for this group of job creators, and you may reverse the course of the recently “unstoppable” job market. The recent banking system panic was very likely localized, but it has exposed an emerging risk to the financial system. It has the potential to introduce financial institution stresses that may cause regulators to choose between new levels of either stealth or overt support for the banking system, or it may put limits on depositors’ access to their money. In addition to risks posed by depositor concentration issues, as well as an average exposure to uninsured deposits, the new challenge highlighted by the SVB implosion is that the run on the bank was effectively an event that took fewer than 48 hours to implode SVB. Online banking has introduced a “speed of money” risk to banks and regulators. Using social media, influential investors can introduce fear into the hearts of their affiliated group, and in a handful of minutes they can collectively move billions of dollars out of a financial institution. If the goal of the modern financial system is to have safe and sound financial institutions, a solution to the “speed of money” risk will need to be creatively addressed and most likely subjectively administered (meaning a hands-on and nimble regulatory approach).
Since the 3rd quarter of 2022, we have been suggesting that the Fed would be restrictive until something breaks. We have also said that the response would likely be technical in nature or slightly obfuscated. The banking turbulence resulted in both. First it was said that the banking system depositor assets would be protected and that depositors in systemically important banks would be made whole. In truth, during the panic, the next bank to go down would have been deemed to have been important, as would the one after that, until the panic subsided. Treasury Secretary Yellen walked back the implied guaranty of deposits, possibly to reduce the moral hazard that the implied guaranty might perpetuate. The on-again, off-again implied guaranty of deposits likely achieved its goal. On the technical side of things, the Fed rolled out its Bank Term Funding Program (BTFP), where banks could get an advance for up to a year on eligible collateral based on the par value (face value) of the securities. The fact that the advance is based on the face value rather than the market value, greatly helps banks because much of their portfolios have market value losses, since the Fed has allowed inflation to hit historically high levels and has subsequently had to raise short rates to the highest level in nearly 15 years. As we said last quarter, this is a mission-focused Fed. They want to bring inflation down toward their long-term target of 2%. The market believes that the Fed will need to cut the Fed Funds Rate by 50 basis points this year. The nimble actions of the Fed, and the supporting cast of characters, have shown that the first response to future uncooperative corners of the market will be targeted, rather than pivoting their restrictive policy and using more blunt instruments. The piece of the equation that might make them change course would be if the Fed finally breaks the consumer. In an economy that is 70% a service-driven consumer economy, the real burden of inflation reduction likely falls on the shoulders of individuals. We don’t expect the ever-optimistic consumer to capitulate soon.
10-Year Treasury yields got as high as 4.07% in the first quarter and ended up at 3.47%. 10-Year AAA-quality municipal bonds saw yields as high as 2.65% and ended the quarter at roughly 2.25%. Through the end of the first quarter, the most broadly watched taxable bond indexes experienced returns of 2.4% to 3%, while many municipal indexes saw returns of 1.5% to 3%.
Observations and Outlook – Consumer or Credit, We Think Credit
In past editions of Insights, we have discussed the challenges facing the U.S. dollar to retain the global reserve currency status. We have said that subsequent emergencies would likely need larger amounts of stimulus and debt to have the same effect. Changing global trading blocks were addressed, as we move from the two previous “poles” of trade policy to “poles” of a changing mix of participants. The disinflationary impact of advancing technology has been mentioned, with the added backdrop of a decrease in the value of human capital. All these dynamics seem very much at play in the global landscape, and they may be particularly impactful for the U.S. The emerging changes that could make for unknown consequences involve protectionism, tax policy, collectivist versus individualist interpretations on the value of social contracts between the generations and segments of the population, as well as military conflict (and the potential for the type of warfare not broadly experienced in human history).
"Clearly consumers don’t expect a near-term Fed victory against inflation."
It is tough to know if institutions will pull away from risk first or if a crack in the strength of the consumer will cause the aversion to risk. Our best guess is that increased borrowing costs, along with manufacturing inefficiencies caused by the reversal of the current makeup of the global supply chain, and a profitability recession, will lead institutions to diminish risk appetites. Ever the optimist, U.S. consumers are slow to desire changes to their buying habits. Although the consumer may be the key to getting inflation expectations down on a sustained and less traumatic basis, we don’t think they will grab the most headlines in 2023. According to the New York Fed Consumer Credit Panel/Equifax, in late February, consumer credit card balances surpassed the pre-pandemic high, with balances totaling $986 million, less than we would have expected, as compared to the total credit limit of roughly $4.5 trillion. In the Great Financial Crisis, extended credit card limits shrunk nearly 40% between 2008 and 2009. The ability for the consumer to continue their current buying habits may be quickly reversed if credit lines are rapidly restricted. Inflation is taking a toll on consumers, who are once again achieving anemic savings rates and building credit card balances. Interestingly, credit card delinquencies are historically low, but appear to be rising at a noticeable rate in 2023. Another sign of impending difficulty for consumers is the pace at which they are falling behind on their auto payments. At the end of 2022, the percentage of subprime auto borrowers who were behind on payments (being at least 60 days late) hit 5.67%. At the peak of the great recession, in January of 2009, the number hit a maximum of 5.04%.
In the minds of individuals, the current sources of pressure won’t be letting up anytime soon. In early April, respondents to a New York Fed survey expected prices to rise by a half a percentage point to an annual gain of 4.75%. They expect gas prices to rise by 4.6% and food prices will be 5.9% higher. Clearly consumers don’t expect a near-term Fed victory against inflation. The Fed survey also brought to light that consumers see their access to credit diminishing. Perhaps it is for cause, 10.9% of respondents expected they would miss a minimum payment over the next year. Finally, the job environment is presenting a more mixed picture. Although unemployment has dropped to 3.5%, the Labor Department’s Job Openings and Labor Turnover Survey (JOLTS) showed that job vacancies at U.S. employers dropped in February to the lowest level since May of 2021 (available jobs were 9.9 million versus 10.6 million a month earlier). The ratio of job openings per job seeker fell from 1.9 to 1.67. Pre-pandemic, that ratio was roughly 1.2 and we think the ratio falls below 1.0 as the Fed’s inflation fighting work comes to a conclusion. Inside the recent jobs numbers, it may be noteworthy that the new jobs were nearly equally split between services and goods-producing firms, and roughly the same number of jobs lost in the financial activities and professional services sectors were in line with the 98,000 workers gained in the leisure and hospitality sector. We seem to be continuing the trend of replacing higher-wage jobs with lower-wage opportunities. The consumer is showing signs of stress, but our forecast is for a gradual grind lower in terms of the psyche of the economy.
"The debt ceiling will likely come to a head at the end of the second quarter or the start of the third quarter."
Before we address the largest and most disorderly source of a change in the Fed’s path, we will touch on some self-inflicted wildcard developments that will have unknown effects. Worse yet, some of them may be multiplicative if they were to occur simultaneously or sequentially at an inopportune time. The debt ceiling will likely come to a head at the end of the second quarter or the start of the third quarter. Both major political parties have become polarized to a degree and the risk of a centrist compromise seems more remote than past congresses. The game of “chicken” with the country’s credibility, future financial health, and global standing is both predictable and unacceptable. Massive deficit spending (beyond what was needed to combat Covid) to burdensome levels of national debt (along with underfunded entitlements that make the debt look like child’s play) call into question the viability of the U.S. dollar as the world’s primary reserve currency. To make matters worse, the linkage of the U.S. dollar to energy, the lifeblood of many global economies, has been eroded as oil transactions are now being conducted in other currencies. Erosion of the relationship between the U.S. and Saudi Arabia could expedite the weakening of the U.S. dollar as fewer U.S. dollars will be required for this dominant segment of global trade. A valid question is what happens to all the U.S. dollars if they are no longer needed for oil transactions? Recent weaponization of the SWIFT international payments system (to freeze Russia’s ability to participate in trade and international transactions as punishment for the invasion of Ukraine), may have accelerated the move away from using globalized systems so they are less able to be influenced by world governing bodies and trading blocs against which they compete. For countries against which the U.S. and “the west” compete, using the dominant world reserve currency and a global payment system recently changed from being an annoyance to an exposure to economic warfare. Diminished growth in U.S. energy production has likely elevated OPEC’s influence. It is tough to know if the impetus for the two recent production cuts is increased profitability, projection of dominance, collaboration with global carbon-based fuel reduction goals, or several alternatives. The recent hike seems like it will hit the U.S. as more of an inflationary “tax” in that it will cost consumers more for petroleum-based needs, but it may not offer the broad economic benefits we might see if we were larger producers of energy.
We are certainly for clean energy pursuits, especially if nuclear fusion meets your definition of clean energy, but as we have said in the past, the burden of the change falls on the shoulders of those who can least afford the cost. The average cost of a compact combustion engine car is $26,000, while the average cost of an electric vehicle is $64,000. Forcing lower income people to buy an electric vehicle, even with a $7,500 tax credit, seems somewhat cruel, even if you get there by taking away their choice by ending the supply of combustion engine cars. With all the pressures facing low-income people, it feels like we are corralling some of our neighbors into inescapable cages, with bars of debt, labor and voting cooperation, all born out of desperation. Corporations and higher-income people won’t likely be unscathed. Just a year after the congress appropriated $80 billion to rebuild the IRS over the next decade, the Biden administration, though Treasury Secretary Yellen announced a request for an additional $14 billion to provide “steady-state operational funding” that will “allow taxpayers the best service possible.” It seems a gold-plated cage, or collection basket, is being built. Is it right to think that it is being built to capture the taxes desired to continue the level of spending and allow for the wishes of the many to be carried by a relative few? According to a 2021 Treasury report, the $80 billion would allow for the hiring of approximately 87,000 IRS employees over the next decade. The expectation from the Congressional Budget Office is that the investment will generate $200 billion in additional tax revenue over the decade, but it will come at the cost of companies having to field IRS inquiries and spending more money on accountants and tax advisors, rather than inventing products, giving raises and bonuses, focusing on customers, and several productive pursuits. Did anyone bother to quantify the cost of audit and inquiry activities when calculating the windfall profits that this might “net?” Most people would like to see tax evaders pay the appropriate amount. This seems like a job for machine learning/artificial intelligence, rather than an army of additional people. The time to build the systems, hire people, and promote the digital U.S. dollar to capture increased levels of tax revenues is ahead of the move toward a higher tax regime.
The area that we think has the greatest chance of abruptly changing the trajectory of the economy is a biproduct of declining corporate profits and increased borrowing costs. The recent banking crisis has interest rate risk in the forefront of the market’s mind. Interest rate risk is the risk of market value losses as interest rates rise. The more interest rate risk you assume, the greater the loss for a given increase in interest rates. What the market may be lulled into believing is that risks in the market away from stocks are settled. Over the next couple of years $150 billion of office-related commercial real estate financing has to be refinanced. Crowding out that space is the $430 billion in loans and bonds that high-yield corporate borrowers must refinance through 2024. Although Bloomberg’s Junk Index has seen borrowing costs move from roughly 10% in the last quarter of 2022 to approximately 8% in the first quarter of 2023, the current levels are nearly twice what they were two years ago, when borrowing costs were roughly 4%. The zombie companies that were not profitable enough to pay debt service with a 4% cost of borrowing will be in difficult shape if they have to pay 8% in the current market. Often in a recession, credit spreads (the incremental yield for a risky bond as compared to a similar maturity Treasury security) will widen as people abandon risk and flee toward safety. If a recession hits the U.S., it would certainly be possible that junk bond yields could hit 12% with ease. In a related development to the impact of rising borrowing costs, U.S. banks will likely see profits come under pressure. As banks were able to pay depositors very little for the use of their funds, awareness of what is available in the marketplace has spread and banks generally must pay materially more to keep deposits from leaving. At the same time, some banks have pulled back on lending. If banks are paying more for deposits and lending less, profits will very likely be under pressure. With companies increasingly more challenged to find sources of financing through the syndicated loan market, the junk bond market, or the banking system, disorder may occur. As we have suggested in the past, if corporate profits experience their own recession, and borrowing costs make matters worse, we expect both mergers and acquisitions activity and defaults to pick up. There are plenty of looming factors to fuel a frozen credit market or materially wider risk spreads. We expect the impact could weigh heavily on the corporate outlook, hiring plans, profitability, the consumer’s confidence, and potentially even Fed policy.
"We think the Fed hopes to be able to mentally grind down economic expectations over time, rather than have to jump in to save the economy."
The market seems to think that because the Fed was nimble in the past, they will necessarily need to be agile at the current time. We think the Fed hopes to be able to mentally grind down economic expectations over time, rather than have to jump in to save the economy. It would likely mean a more orderly decline in the employment environment, less sharp changes in asset values, and fewer tragic stories. ACG’s expectation is that the Fed will raise the Fed Funds Rate by 25 basis points in May and then pause for an extended time. The market has vacillated wildly this year, in terms of its expectations of the top Fed Funds Rate as well as the expectation of the need to cut the rate. As we enter an uncertain phase, where the last anticipated hike is made and inflationary signals are not uniformly positive or negative, we could see a greater probability that the Fed would surprise the market with an additional hike versus the chance of a cut in 2023. That view is based on the soft-landing scenario where the credit crunch does not occur, and global influences import unexpected waves of inflationary pressures to the U.S. If the access and cost of credit doesn’t get out of hand soon, the probability of a Fed rate cut by the end of the year has a short runway to become a reality. The combination of continued Quantitative Tightening efforts and at least one more rate hike, against the backdrop of a profitability recession may result in challenging times for risky assets, while high-quality bonds should see some appreciation over the next year. Yale University economist Robert Shiller has said “there’s never been another time when the economy was already in an earnings recession and the Fed was still in the midst of a significant tightening campaign” and “ideally, the Fed finished its campaign when companies have something left in the tank.” It feels like zombie companies, weak consumers, and even mismanaged governments have very little in the tank to be resilient through a meaningful economic slowdown. Hope for a soft-ish landing and expect something rougher.
Municipal Market Developments – The Asset Class of the Future?
At the start of this year, our forecast for municipal returns was a range of 4.5% to 5%. We continue to expect that is a good estimate for this year. The main opportunity that we can envision would be a chance to lock in higher yields should a credit crunch become a reality. People tend to sour on risk all at once, as demonstrated recently with the banking issue. Many municipalities are very healthy, the essential purpose projects and facilities that ACG uses as a guide for our strategy are often monopoly assets, and at the end of the day, people are going to pay to have running water, treated sewage, and a population that has the opportunity to be educated. Certainly, there will be corners of the municipal bond market that will grab headlines, but ACG generally steers clear of most muni market bonds that involve the competitive pressures of a marketplace. Areas of the market that are challenged include: toll roads, nursing homes and continuing care facilities, hospitals, and convention centers. In 2022 a BDO study surveyed healthcare executives and 36% said they expected to default on bond or loan covenants. 75% of nursing home executives reported defaulting and 30% of hospitals did. For convention-center-related issues, the 2022 convention attendance was still 30% below the pre-pandemic levels. There will be challenges for some municipal entities in the event of a credit crunch or a meaningful recession, but historically the essential purpose issues see valuation fluctuations, but defaults are exceedingly rare. We expect ACG clients will fare well and if cashflow or portfolio structure allows, adding positions in an environment of fear will only add to the long-term earnings capability of the portfolio.
"In our experience, market extremes often offer the opportunity to adjust the portfolio in a number of ways..."
Over long periods of time, municipal bond yields are often between 85% and 95% of a comparable maturity Treasury yield. The current market environment offers yields that are between 50% and 88% of comparable Treasuries (with the best ratio occurring for longer maturity municipals). Stated plainly, municipal bonds offer a poor value as compared to Treasuries. That relationship moves around frequently. Clients often ask why a person wouldn’t get out of municipal bonds when valuations are rich and get back in when they are cheap. The truth is that when valuations are attractive, there may not be appealing bids on all of the bonds that you own, and when they are cheap, issuers are reluctant to issue bonds (because in their mind they are “paying too much” for financing). In our experience, market extremes often offer the opportunity to adjust the portfolio in a number of ways (more income, more risk, less risk, more call protection, selling “expensive” bonds and going to cash, increasing or decreasing the coupon rates, changing sector exposures, altering credit quality, etc…). Often the opportunities are a gradual change to true up the goals for the portfolio with the client’s preferences, or simply addressing the changes to the portfolio that occur with the passage of time.
The banking crisis impacted the supply side of the muni market, and municipal bond returns were volatile in the first quarter. Municipal bond fund flows have been mixed in 2023. The supply side of the muni market appears to be normalizing and demand is finding its footing, so we anticipate the supply/demand environment to be balanced and neutral for much of the year. As we eluded to earlier, it makes sense that there will be upward pressure on tax rates over the long run. We have the choice to pay for our commitments or not. A reasonable argument can be had about the degree to which future spending is reasonable, what you expect people to do to pull their own weight, and how much society should help those in need, but in all cases, we should pay our debts. Unfortunately, much of the spending in all of U.S. history occurred over the past 20 years and honestly, it doesn’t look like we have much to show for it. Poverty (as a percentage of the population) is roughly where it was 50 years ago, infrastructure needs help, and life expectancy is declining. We are teetering close to the point where Federal debt as a percent of GDP means trade-offs between social spending, productivity-enhancing infrastructure investments, or other beneficial government-coordinated activities (military, education, etc…) and a rising syphoning of resources that will be spent on debt service payments. A natural conclusion is that tax rates will trend higher. According to the Tax Policy Center website, between 1913 and 2022, the average top marginal individual tax rate was 57%. From 1932 through 1981, the top rate exceeded 60%, with an eye-popping stretch from 1951 through 1963 when the top rate exceeded 90%! There is a decent probability that tax rates are heading higher.
"Absent dramatic changes to how municipalities fund projects, municipal bonds could become the dinner party talk of the future."
Absent dramatic changes to how municipalities fund projects, municipal bonds could become the dinner party talk of the future. 50% tax rates may result in taxable equivalent yields that hold up well as compared to the long-run return expectations for large cap stocks. A trend to watch that may portend challenges to the future access to tax-exempt bonds would be a migration out of high-tax states by high-income people and a “need” to nationalize aspects of the challenges facing some states struggling with issues arising from emigration. Detroit took 70 years to lose one million residents between 1950 and 2020, so apparently major municipal failures take decades to occur. California and New York seem to be structurally poised for difficulties as affordability issues and high taxes seem to be exporting residents at an alarming rate. As we socialize the solutions to major problems, nationalizing the response to troubled states feels like a natural extension. If we do it for banks, why not the states?
Strategy and Summary
The path of least resistance seems to involve a “noisy” move toward lower interest rates and softening economic activity. Uncertainty caused by a prolonged Fed pause, faced with whiffs of inflation and a gradual slide toward negative economic data, will cause volatility in both investor sentiment and interest rates. Expect volatility to extend to risk spreads as the Federal Reserve fights inflation with higher short-term rates and a resumption of the Quantitative Tightening activities. The power of the “pause” in policy will be the Fed’s most relied upon tool in 2023. Economic activity will comply with the Fed’s wishes as calls for the Fed to “listen to the market” because they are going to “kill this economy” will go largely unanswered because that’s the whole point, make the market less optimistic. Against the backdrop of spread volatility and declining rates, high-grade corporates, taxable municipal bonds, agency commercial mortgage-backed securities, shorter average-life and tight window Collateralized Mortgage Obligations, and Treasuries and agencies should see strong performance as compared to other sectors.
"Modern Monetary Theory never quite passed the smell test."
Longer-term, although we subscribe to the idea that developed countries are poised for disappointing levels of growth, we have some structural risks that could take us down the path of stagflation. If the hegemony of the U.S. dollar is called into question, our ability to print money to solve economic softness could be a part of our “golden” history. Massive amounts of recent past malinvestment resulted in accelerating consumption and granted us a debt burden that will haunt us for generations to come. A common theme for developed countries is that older populations save more, and they also hold a belief that older workers are less productive, so with the dampened velocity of money and lower corporate return on capital, interest rates will fall as well. Since average and median saving rates for all cohorts is dismal in the U.S., presumably government will need to borrow more money to pay for the needs of aging populations. The crowding out theory of economics would suggest that in the longer term there would be bias toward higher borrowing costs. Intuitively the more an entity borrows, the more it will incrementally cost to borrow. Modern Monetary Theory never quite passed the smell test. At a point free money is a fantasy and the reality of investors caring about both the return on and of their money has got to return both investor and borrower expectations back to a state of sanity.
In taxable portfolios, we continue to encourage a barbell strategy (some exposure short and some long), with an emphasis on quality, and limited optionality/callability. Although the curve inversion has diminished, short rates around the 1-year to the 2-year area are high and we expect the long end will see yields fall in a way that contributes to portfolio returns. Our municipal strategy involves waiting to see if credit fears take longer muni yields higher. Bond portfolio management can feel like being a punter on a professional football team, constant intensity in reading the field with fleeting moments that are make or break to the success of the team. It feels like for the first half of the second quarter of 2023, we will be watching intently from the sidelines.
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