VWG Wealth Management 2023 1st Quarter Review

By VWG Wealth Management on April 6, 2023

Executive Summary

• The Federal Reserve’s first interest rate increase in this tightening cycle was a year ago on March 16.  Although this has been the most aggressive tightening cycle since 1980, the Fed is not done.
• Despite a large body of research that monetary policy actions have “long and variable lags,” respected expert views on the future course of the U.S. economy fluctuated wildly during the quarter, from ‘hard landing’ to ‘soft landing’ to ‘no landing’ and back.
• Starting from December’s extreme investor pessimism and heavy tax-loss selling, stock and bond markets rallied at the onset of the 1^st quarter.  By February, continuing inflation, economic and corporate earnings concerns began to weigh on these gains.
• Investors and savers were severely shaken with the collapse of Silicon Valley Bank and Signature Bank in early March.  Depositors withdrew close to $50 billion in deposit outflows between the two banks in a few short days.
• After climbing above 5% for the first time since 2007, the yield of the 2-year U.S. Treasury note plunged almost 1% in response to the banking concerns.  The Federal Reserve quickly launched a program to backstop depository institutions and to quell contagion fears.
• For the quarter the S&P 500 Index gained 7.4%.  Smaller U.S. stocks trailed with the Russell 2000 Index increasing 2.7%.  International stocks domiciled in developed markets were the best equity sector, rising 8.9% (MSCI EAFE Index).
• VWG believes that the U.S. financial system is sound, and our economy is diverse and resilient.  However, the path to ‘normalcy’ will not be smooth, and in the process some excesses and unsound business practices will be unveiled.  Long-term investors should be patient and should continue to hold balanced portfolio allocations.  Periodic volatility and negative headline news should be expected.
• For investors, safety and protection always come first.  VWG Wealth Management intentionally uses Fidelity Investments as the primary custodian for our clients’ liquid assets.  Fidelity is not a bank and does not use fully paid client assets as collateral for making loans.  All Fidelity brokerage accounts are covered by the SIPC protection and additional “excess of SIPC” coverage. 

Struggling for Perspective on Monetary Policy

Maintaining perspective on the tumultuous set of global events and change over the past three years is exceedingly difficult.  Drilling down to the U.S. economy, it is challenging to comprehend the staggering amount fiscal and monetary stimulus applied in 2020-2021, the depth of effects of the stimulus, and the magnitude of efforts being taken to reverse them. Within a narrower view, the bond and stock markets are grappling to view inflation and monetary policy in a realistic timeframe.  Headline case in point – it was only one year ago, on March 16, 2022, that the Federal Reserve made their first 0.25% Fed Funds rate increase off a record low of 0.25%.  Six more 0.25% increases over the rest of 2022 were projected, producing a consensus year end projected rate of 1.90%.  Along with interest rate increases, the Federal Reserve said they would begin significantly reducing the size of their balance sheet.  Fast forward to today and monetary conditions have drastically changed.  The Fed made 0.25% rate increases in February and March, bringing the Fed Funds rate to 5.00%, astounding in comparison to projections made a year ago.  The monetary base (one way to look at market liquidity), as measured by total reserves, was massively reduced in 2022 after exploding in 2020 and 2021.

Chart courtesy of Federal Reserve, U.S. Bureau of Labor Statistics, Hoisington Asset Management 12/22

Despite the Fed’s persistent restrictive stance and guidance, and despite measures of inflation and the economy that appeared to be coming off the boil, asset markets took abrupt twists and turns in the first quarter. Views of respected experts on the future course of the economy frequently fluctuated between “hard landing,” to “soft landing,” to “no landing” in what Aberdeen Standard’s James Athey termed “narrative table tennis.” 

Such confusion and impatience by markets and respected experts is a bit surprising.  It is widely accepted that there are “long and variable lags” for monetary policy actions to impact the broader economy.  Per the Federal Reserve Bank of Atlanta, “a large body of research tells us it can take 18 months to two years or more for tighter monetary policy to materially affect inflation.”  Hoisington Asset Management’s Lacy Hunt predicted in 2022 that it would take up to a year for the rate of decrease in the monetary base to be “sufficient to neutralize the money mountain of 2020/21,” and only if the Fed continued its plan.

Review of the Markets

After a disastrous 2022, most sectors of the U.S. bond market stabilized in the first quarter.  The notable exception was the 2yr. U.S. Treasury note, whose yield climbed above 5.00% for the first time since 2007, reflecting continuing inflation fears and expectations for further Fed rate increases.  This sharply reversed with the 2^nd and 3^rd largest U.S. bank failures in history.  Silicon Valley Bank (SVB) failed to raise additional capital, suffered an estimated $42 billion in depositor withdrawals in a day, and received requests for almost $100 billion in transfers the following day before the FDIC closed the bank.  Fears over the security of depositor balances in banks across the country quickly spread.  Both SVB and Signature Bank were placed into receivership by the Federal Deposit Insurance Corporation (FDIC). Their depositors did not lose access to their funds and will bear no losses.  The Federal Reserve quickly launched a new Bank Term Funding Program to backstop depository institutions and to quell contagion fears.

Katie Martin, markets editor of the Financial Times, commented, “the market reaction in Treasuries was nothing short of apocalyptic.  Two-year Treasury notes, the most sensitive instrument in the debt market to the outlook for interest rates, rocketed higher in price.”  The three-day drop in yield of almost 1% was its largest since 1987.

Chart courtesy of Financial Times 3/23

The collapse of SVB, Signature Bank and Silvergate Capital, fanned investor fears of a recessionary “hard landing” which might be exacerbated if U.S. regional banks struggled.  Bond markets responded through the end of the quarter.  The yield of the 10-year U.S. Treasury note slid to 3.49%.  The Bloomberg U.S. Bond Aggregate gained 3.2%. The S&P Municipal bond Index increased 2.5%.  Even high yield bonds gained in the quarter despite fears of increasing stresses on corporate balance sheets. From a backdrop of heavy tax-loss selling and negative investor sentiment, stocks globally rose for the quarter.  The S&P 500 Index rose a solid 10.5% before backing off amid renewed recession fears and signs of slowing corporate earnings.  For the quarter it returned 7.4%.  Large international stocks domiciled in developed markets followed suit.  The MSCI EAFE Index gained 8.9% in the quarter.  U.S. small cap stocks and emerging markets stocks lagged.  The Russell 2000 Index was up 2.7%.

In response to forthcoming congressional U.S. debt ceiling debate, and the SVB banking collapse, gold gained in the quarter. The NYMEX Gold continuous futures contract rose 8.5%.  Reflecting an unseasonably warm winter and concerns for decreased demand,  the NYMEX West Texas Intermediate Crude Oil continuous futures contract declined 6.0%.

Lessons for Individual Investors from the SVB Collapse

By now most readers have consumed media accounts on the demise of Silicon Valley Bank.  We will not take time here to delve into the intricacies of banking mechanics and regulations.  Nor will we revisit other periods in history when sharp rate rises lead to failures of weak institutions and structures.  We do not believe that SVB is emblematic of systemic risk in the U.S banking system.  We do believe this episode provides some key lessons for individual investors, and it helps convey some of VWG’s core investment tenants.

Diversification is Essential

Concentration – having large exposure to a single strategy, sector, or security – can result in spectacular gains when it is successful, and in terrible losses when it fails.  Silicon Valley Bank (SVB) had an extremely homogenous depositor base, highly concentrated with institutions and early-stage/ venture capital businesses, with reportedly 87.9% of its total deposits being larger than the $250,000 FDIC insurance threshold.  It had a very low reliance on stickier retail clients.  Our clients, and most individuals, build long-term investment portfolios to fulfill the most important goals in their lives – to fund retirement, education, family legacy, and charitable interests.  Risk management is critical in achieving these goals, and diversification is the essential cornerstone.  As Nobel Prize laureate Harry Markowitz reportedly said, “diversification is the only free lunch” in investing.

Chart courtesy of JPMorgan Asset Management, Gavekal Research/Macrobond 3/23

Be Cautious of Excessive or Inappropriate use of Leverage

Banks make money by employing leverage.  They take in deposits, and then use these as collateral to make loans and conduct other activities at some multiple of the deposits.  It does not appear that SVB over-levered their balance sheet.  But its demise should serve all investors of the potential risks in using leverage.  When things go wrong leverage can magnify risks and can force untimely forced selling.  VWG approves of select managers and specific strategies that prudently use leverage, on a limited basis, for only certain asset classes, and preferably in closed structures (more on this to follow).  Excepting special situations, including accessing short-term funds or managing year-end tax exposure, most investors should not use leverage (margin) in their long-term portfolio strategies. 

Match Assets with Liabilities

For most individuals this means matching the amount and payoff period of any debt incurred to the length of the life of the asset.  It is appropriate to place a 30-year mortgage on your primary residence.  Taking a 36-month term loan to finance next months’ vacation is not so wise.  It also means matching the duration of assets to when it will be needed for a specific goal.  Funds needed to pay for a daughter’s marriage in two years should be kept in liquid, stable instruments.  Those needed to fund retirement should feature long duration investments, seeking long-term appreciation.  Goal-based planning can help identify specific objectives, segregate pools of assets to fund these, and invest them appropriately.  Unfortunately for SVB, long-term U.S. treasuries invested against their assets (deposits) became mis-matched to their capital structure when depositors withdrew $42 billion.

Be Wary of Investments and Strategies that have Enjoyed Huge Jumps in Assets

In today’s world of tech platform businesses and network effects, it is easy to take growth for granted.  However, generating sustained organizational, client and asset growth is no easy task.  The demands of growing from a mature, larger sized firm are different from those when young and starting out.  Past performance is not a guarantee of future results at scale. Managing hyper-growth (compounding more than 40% per year) presents a much different set of challenges.  Unplanned and unexpected risks can emerge.  The following chart shows SVB’s stratospheric balance sheet growth over the past three years.  The rate and size of this growth contributed to decisions made that ultimately proved fateful when flows quickly reversed.  As Nigol Koulajian, founder of asset management firm Quest Partners recently commented when discussing his firm’s strategy, “speed of the growth in assets should not be that attractive because it creates long-term instability.”

Chart courtesy of JPMorgan Asset Management, Gavekal Research/Macrobond 3/23

Social Connectedness and Transaction Speeds have Changed, Human Behavior has Not

Social networking, and interconnected banking digitization, surely brought the SVB capital structure weakness to the fore at breathtaking speeds which could never have been achieved ten years ago.  Fears quickly spread leading to massive cash movements from banks throughout the U.S., made in only four days. 

The world has changed.  Human behavior has not.  Greed quickly turns to fear.  Shouts of ‘fire,’ whether justified or not, quickly spurs the herd to stampede.  Often the responses to a panic gain a life of their own, creating worse effects than the original irritant.  How can individual investors, in the shadows of massive, seriously-armed market participants, avoid being trampled?

As Morgan Housel has stated, the lesson for individual investors is to “figure out what game you’re playing, then play it and only it.”  Individuals should define their own “game,” their own goals, their own financial plan, their own risk tolerance, and their own investment strategies to achieve these.  Fortunately, most individual’s “game” centers on the long-term.   As such they can minimize the effects of manias and bull rushes.  As Warren Buffett instructs, “the trick in investing is to only swing at pitches that are right in your sweet spot.”

Less Liquid, Closed-end Investments have Attractive Qualities for Appropriate Investors

As we have learned from in the SVB incident, accessible liquidity – combined with a lack of diversification, leverage, an asset/liability mismatch, and a rapid change in sentiment – can have disastrous results.  For appropriate clients, primarily in portfolios created for long-term growth, VWG embraces proven funds and managers that operate with a fixed asset pool, offering periodic or no liquidity over a fixed term.  We lean toward nimble, niche managers and strategies that seek a unique stream of returns that are optimized to run in a relatively constrained fund size.  They can offer many attractive qualities by enhancing diversification, providing participation in illiquid assets including real estate, private businesses, and certain high yield debt.  Closed-end structures allow the manager to focus solely on managing their portfolio, not having to deal with inflows and outflows.  Investors in these funds (often as limited partners) are all treated equally and cannot be adversely affected by the actions of other LPs. 

Looking Forward

We believe that the U.S. financial system is sound, and our economy is diverse and resilient.  However, it is not surprising that there are significant ramifications from attempting to reign in the massive stimulus applied in 2020-21, which followed an eleven-year period of global near-zero interest rate policies and very low rates of inflation.  The path to ‘normalcy’ will not be smooth, and in the process some excesses and unsound business practices will be unveiled.

In this environment, and always, security and protection come first.  VWG Wealth Management intentionally has chosen Fidelity Investments as the primary custodian for our clients’ liquid assets.  Fidelity is not a bank, and it is a private company.  It does not use fully-paid client assets as collateral for making loans.  All Fidelity brokerage accounts are covered by the SIPC protection.  Fidelity automatically provides its customers with additional “excess of SIPC” coverage.  Your money market funds, treasury bills,  and securities held in Fidelity Investment accounts are secure.  We have multiple vehicles available to us to achieve extremely competitive short- and longer-term rates.

We continue to believe that the investment environment will be volatile, punctuated by a challenging set of macro conditions and swings in investor sentiment.  The economy is slowing, liquidity has been drastically trimmed, and short-term interest rates are competing with other assets.  Consumer and commercial banks have been tightening lending standards for the past year.  We don’t believe this is the time to be aggressively increasing investment risk at the overall portfolio level.  At the same we are counterintuitively comforted by negative investor sentiment and stock market outflows.  Although the short-term path could be rocky, volatility and uncertainty are providing opportunities for active long-term focused managers and strategies.

Diversified and balanced portfolios are called for.  Investors should allocate and maintain a prudent amount of cash and liquid quality short-term instruments that match their expected near-term needs and risk tolerance.  We will stay in touch and will communicate any significant changes in our views and investment stance.  Please don’t hesitate to convey your questions and concerns to us.  Most importantly, please let us know if you have any significant life changes that affect your financial needs, current cash flows, and your longer-term financial plan.

Regards,

VWG Wealth Management

Suzanne, Ashley, Rashmi, Kay, Brandi, Lynette, Ona, Michelle, Ryan, Ryan, Ryan, Susan, Marnie, Justin, Elana, Patricia, John, Rick and Jeff

Who we are

* All stated index returns are as of 3/31/2023 unless otherwise indicated.

* Index Data and Charts Sourced from FactSet Research, Morningstar, Bloomberg, U.S. Federal Reserve, U.S. Bureau of Labor Statistics, Hoisington Asset Management, J.P. Morgan Asset Management, GaveKal Research/Macrobond

VWG Wealth Management is a team of investment professionals registered with Hightower Securities, LLC, member FINRA and SIPC, and with Hightower Advisors, LLC, a registered investment advisor with the SEC.  Securities are offered through Hightower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

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The information provided has been obtained from sources not associated with Hightower or its associates. All data and other information referenced herein are from sources believed to be reliable, although its accuracy or completeness cannot be guaranteed. Any opinions, news, research, analyses, prices, or other information contained in this report is provided as general market commentary, it does not constitute investment advice. VWG Wealth Management and Hightower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. 

This document was created for informational purposes only; the opinions expressed are solely those of VWG Wealth Management, and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

The2019 Financial Times 300 Top Registered Investment Advisors is an independent listing produced by the Financial Times (June, 2019). The FT 300 is based on data gathered from RIA firms, regulatory disclosures, and the FT’s research. As identified by the FT, the listing reflected each practice’s performance in six primary areas, including assets under management, asset growth, compliance record, years in existence, credentials and accessibility. Neither the RIA firms nor their employees pay a fee to The Financial Times in exchange for inclusion in the FT 300.