SFM 1st Quarter Update 2023
Market Synopsis: First Quarter 2023
The first quarter of 2023 saw a bit of a rebound for the investment markets. There was a lot of headline news, some good and some bad, but the markets responded with much less volatility than they did in 2022. Over the last 3 months, we’ve seen the rate of interest rates increasing begin to level off with only a 0.25% Federal Funds overnight lending rate hike. This comes as we continue to see declining inflation expectations. Meanwhile, interest yields on longer-term Treasury bonds actually declined in the quarter, which is a sign that investors believe the Federal Reserve will reverse course and begin to reduce interest rates in the next few years. A big news story was the failure of some large regional banks due to their mismanagement combined with an old-fashioned bank run. Added to that, was the news about Credit Suisse becoming unstable and being forced to be acquired by UBS. While tensions abroad continue, corporate America continued its trend of deglobalization with many more companies announcing plans to increase production and supply chains closer to home. Additionally, various companies made headlines as artificial intelligence began surging into the news as people begin to see what is possible with ChatGPT and other revolutionary new AI technologies. Overall, it has been a good start to the year 2023 and your investment portfolios have benefited from this.
As we mentioned above, the US Federal Open Market Committee (FOMC) slowed the rapid pace of interest rate increases seen over the past year. As we show on the SFM Quarterly Chart in 3 pages, we seem to be near the end of this extremely rapid 4%+ increase in rates in just a year. The question is, where do we go from here? As the SFM Quarterly Chart displays, the market expects interest rates to decline, and this expectation rose in the aftermath of the recent bank failures. What was unprecedented was the speed of these failures as bank depositors withdrew very large amounts of their money all at once. For example, depositors at Silicon Valley Bank withdrew $42 billion in one day on March 9th and were scheduled to have another $100 billion leave the next day when the FDIC stepped in and took over the bank; freezing all assets where they were. This would have represented 81% of all SVB’s total deposits as of the end of 2022 going out the door in two days, a shockingly fast bank run. This was made possible by the speed that the internet can spread info/rumors and because most of their depositors were in the same industry and many were backed by the same partners. So far the banking failures have been limited to two banks, but even so, this was interpreted as a signal to the markets that the FOMC has finally “broken” something by raising interest rates as quickly as they did. However, if inflation remains sticky, interest rates may stay higher for longer as the FOMC is likely to be cautious about lowering rates too quickly too soon.
Another news item that has impacted many technology stocks (including many that you own) is artificial intelligence or AI. The release of ChatGPT, Dall-E, and others has quickly shown the mainstream world how capable this technology has already become. This has people not only dreaming about what is possible but aso trying it out themselves. This year many stocks you own such as Microsoft, Alphabet (Google), Amazon, Meta, Adobe, Salesforce, and ServiceNow have been talking about how they have been working on AI for years and incorporating this technology into their businesses. These innovative AI technologies are a step ahead of anything most people have ever seen and while there are real risks, they have the ability and potential to reshape the world and business as we know it.
As we analyzed the economic landscape to start the year, SFM made several strategic portfolio changes. One example of an investment change we made was to increase your allocation to international stock investments. We have strongly favored US investments over the past 10+ years and this has paid off as the US stock market has vastly outperformed its international counterparts. However, for many reasons, we feel that this dynamic may be shifting in the future. One sign of this is the value of the US Dollar compared to foreign currencies. In 2021 and 2022 (and most of the last 12 years) the dollar soared in value. However, this recently began to reverse and it has been falling in value since September 2022. This decline benefits Americans that are investing in companies overseas because as the value of the home currency for these stocks rises against the dollar, this increases the value of these stocks when converted back to US dollars. Even just a return to a more normal value of the US dollar should help increase the value of our portfolio’s international exposure.
Another example of a strategic portfolio change we made was to increase our bond positions which are paying an attractive income of 4.5% per year or more. Bonds are an area we’ve reduced over the past several years as low interest rates made these bonds less attractive, which in hindsight worked out extremely well as we swapped the proceeds into alternative investments, which have strongly outperformed. However, after the bond market just experienced the largest decline in bond values ever seen in 2022, we feel that bonds are much more attractive than they have been in a long time. Remember, a bond is simply a loan from an investor (you) to a business or the US government. So a bond with a lower interest rate (say 4%/year for 3 years) had a temporary decline in value last year as that same bond purchased for $100 may have fallen in value to $90 (since newly issued bonds were paying close to 5% per year). Still, as long as you hold that bond until maturity (or as we have been doing in your account, buying more of this discounted bond that is $10 below its payoff amount that is now just 2 years away), you will earn the 4%/year income you expected but will now also receive an extra $5/year (for an extra +5.5%/year) as the bond rises back to its $100 payoff amount. This means that this same 4%/year bond has the potential to earn a profit of +9.5%/year for the next 2 years, which should lead to above-average bond performance over the next few years.
Stocks experienced a good recovery to start 2023 with the S&P 500 US index up +7.5% and the technology-heavy NASDAQ index up +17.1% in the first quarter. Technology companies led the way due to the expectations of future interest rate declines (which helps these fast-growing companies more) combined with the excitement around potential artificial intelligence benefits in the future, in addition to the fact that these stocks simply became too oversold in the final quarter of 2022. Some of the best performing individual positions in your portfolio when owned the full quarter included the social media firm Meta +76.1%, the business software company Salesforce +50.7%, Apple +27.1%, Amazon +23.0%, and Microsoft +20.5%. These tech stocks performed poorly in 2022, so some of this gain is a reversion to the mean, however there now is a much more positive outlook for these companies as they have reorganized and laid out a plan to reduce costs to boost profits in the future. Unfortunately, not all the stocks within your portfolio started the year quite as well with Home Depot declining by -5.9% and the paint company Sherwin Williams down -5.0%. Both of these stocks have been impacted by the slowdown in the residential housing market as higher mortgage rates caused a sharp drop in the number of home sales, which led to consumers purchasing less paint and home improvement products than expected, but both companies remain attractively positioned for the future.
Within the bond portion of your portfolio, the prices of bonds rose during the first quarter of 2023 with the Bloomberg Aggregate US Bond Index up +3.0%. Another benefit to rates being higher is that we are now able to earn close to 5% per year with an FDIC-insured brokered CD or US Treasury Bond that is backed by the full faith and credit of the US government. Additionally, higher rates have helped many of the bond positions you own such as the Artisan High Income Fund +4.9% and the PIMCO Income Fund +2.6%, both of which benefited from large income payments and price increases to start the year. Another bond investment we like due to its very low risk and large income is the WisdomTree Floating Rate Treasury ETF, which gained +1.1% in the quarter and has a current annualized yield of 4.8%. This is a basket of extremely short-term US Treasury bonds that make it a safe and attractive alternative to cash and low-risk bonds. Additionally, we’ve begun incorporating Multi-Year Guaranteed Annuities in certain situations as a piece of a fixed-income portfolio to capitalize on the very high fixed rates available. This year we’ve been able to lock in 6% interest rates for 4 years in several accounts where it made sense.
The performance of the overall Alternative Investment category was positive to begin the year. Within the category, the investment performance has varied during these 3 months. The portion of alternatives in “private debt” is off to an impressive start this year as these investments are paying income of over 10% per year. This income is based on floating interest rates, which protects these investments from further interest rate increases. The Blackstone Private Credit Fund gained +3.0% (when owned the entire quarter), the Cliffwater Corporate Lending Fund rose by +2.3%, and the Blackstone Secured Lending Fund earned a profit of around +8.0% to +9.0% before being sold during the quarter (with the proceeds being reinvested in other more attractive private debt investments including the Blackstone Private Credit Fund). All of these funds continue to earn very high incomes while experiencing far lower risk and volatility than other similar-income funds. Meanwhile, private real estate investments struggled for the first 3 months this year. After earning annual profits in the high single digits to +15% per year the previous three years (including strong outperformance in 2022), the impact of rising interest rates hurt private real estate valuations. As a result of higher interest rates, the value of some commercial buildings was slightly reduced. Another major factor affecting these investments is after three years of extremely strong rent growth, the rental income these buildings are receiving has slowed. Over the quarter the Blackstone Real Estate Income Trust earned a profit of +0.5%, Bluerock Total Income+ Real Estate Fund declined by -4.2%, and Starwood Real Estate Income Trust returned -2.3%. Largely the cooling effect on real estate doesn’t worry us and we still really like these positions moving forward. Despite rent growth slowing, the rents they collect are still growing by mid-to-high single digits and we expect this to continue while there are far fewer homes than needed in the US. At SFM we expected this moderation in performance, and in fact, we trimmed our client's positions in private real estate a few months ago. Private real estate offers a very attractive mix of risk vs. potential reward because of its strong income and low volatility. The last major position in our alternative space is the investments in Income Structured Products which earned very strong returns of between +5.4% and +15.9% (which is an annualized return of between +21.6%/year and +63.6%/year). These positions continue to pay attractive income of 7% to 11% per year and also benefit from the strong rebound as the US stock market rose in value in the quarter.
Despite the ongoing risk of an economic slowdown in the next year or two, we feel that a calm, balanced, and value-focused approach to investing will continue to provide good risk-adjusted returns for clients. As always, we appreciate the continued trust you place in us, and we welcome any thoughts or comments that you have.
Chris, Glenn, Sam, David, and Molly
SFM Quarterly Chart
Interest Rate Expectations
This chart shows that despite the extremely fast rise in interest rates over the last year from nearly 0% only a year ago to 4.88% currently the markets are anticipating a faster fall in rates than what the Fed is currently planning. The Federal Reserve is projecting another 0.25% interest rate increase in May and then plans to pause and reassess. Current Fed expectations would be to cut interest rates by nearly 2% over the next 2 years with a projection that they will end 2025 with rates at only 3.1%. Meanwhile, the market expects the Federal Reserve to begin cutting interest rates much faster. Current market expectation has a 0.5% rate cut almost immediately over the next 9 months and predicts that we end 2023 at only 4.35%...with a fall to 3.29% at the end of 2024 (a full year before the Federal Reserve projection). Only time will tell who is correct, but in either case, it is wise to prepare for interest rates to decline from here as the Federal Reserve expects interest rates to fall to 2.5% over the long term. The rate of this decline will depend on how long it takes inflation to fall back to more normal levels and how strong the economy is, as future interest rate cuts can be used as a stimulus to boost a potentially lagging economy.
(Chart from JPMorgan Guide to the Markets, 3/31/23)