Inflation remains well above our longer-run goal of 2 percent. Over the 12 months ending in January, total PCE prices rose 5.4 percent; excluding the volatile food and energy categories, core PCE prices rose 4.7 percent. In February, the 12-month change in the CPI came in at 6 percent, and the change in the core CPI was 5.5 percent. Inflation has moderated somewhat since the middle of last year, but the strength of these recent readings indicates that inflation pressures continue to run high. The median projection in the SEP for total PCE inflation is 3.3 percent for this year, 2.5 percent next year, and 2.1 percent in 2025. The process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy.
โJerome Powell, 23rd March, 2023
Recent Market Developments
The financial landscape has shifted significantly since my last market update.
Over the past weeks, a choir of tech executives serenaded Twitter with the classic "Screaminโ Fire! (In A Packed Theater),โ igniting a firestorm that led to a regional bank's government takeover. A global bank experienced turmoil, resulting in a rushed merger, and regional banks across the U.S. struggled to maintain stability.
And yet, today, there's an eerie calm.
Yesterday, Chairman Powell announced a 25 basis point interest rate hike for March, which was met with a positive market response. In his statement, he highlighted the government's dedication to fighting inflation, even amidst the ongoing banking sector instability. Powell suggested that the rate hiking cycle could soon end as banks begin to reduce loans for homes, automobiles, and other purchases.
As we progress through the year, the central question remains: Will the Fed pause, modify, or maintain its current target rate?
The Butterfly Effect: Unintended Consequences of Monetary Policy
The Butterfly Effect posits that small events can lead to significant impacts. Although the COVID-19 pandemic was far from a small event, its repercussions continue to be felt in many unforeseen ways.
In March 2020, the U.S. economy came to a halt. Congress and the Federal Reserve responded by flooding the financial system with PPP loans, quantitative easing, and 0% rates to support citizens and corporations. By June 2022, the U.S. Consumer Price Index (CPI) had skyrocketed to 9.1%, while the U.S. unemployment rate had plunged to a remarkably low 3.6%.
Considering the Fed's dual mandate of maximum employment and price stability, the appropriate policy seemed clear: To cool the economy, the Fed needed to raise interest rates in response to high inflation and a tight labor market. This initiated their rate hiking cycle, starting with a 25 basis point increase in March 2022.
A year later, the Fed Funds rate has climbed from zero to 4.75%, and inflation has dropped to 6% year-on-year. This trend suggests that inflation will likely continue to decelerate as global supply chains normalize, consumer spending slows, and higher mortgage rates impact housing activity. The Fed hopes to achieve this without triggering a U.S. recession, but the recent closure of two large regional banks serves as a reminder that sudden monetary policy changes can have unintended consequences.
SVB: A Case Study in Unintended Consequences
Silicon Valley Bank (SVB) has dominated headlines. During the pandemic, tech executives and venture capitalists deposited surplus funds in local banks like SVB.
These banks purchased high-quality, low-yielding securities to generate profits. Some assets were categorized as "available-for-sale" securities, while others were classified as "hold-to-maturity" (HTM) securities, intended for long-term holding until full maturity.
By 2023, the Fed had aggressively raised rates, tech sector profits tanked, venture capital funding dried up, and customers sought out higher rates. As a result, depositors withdrew their funds in search of cash and greater liquidity. This forced SVB to liquidate securities to raise capital, revealing substantial unrealized losses on its balance sheet.
Soon after, the bank was placed into FDIC receivership, and government agencies intervened to support depositors and provide banking system liquidity by accepting collateral โ such as U.S. Treasuries and mortgage-backed securities โ at "par" value. While government intervention can prevent a run on deposits, stabilizing bank stocks may take longer as investors adopt a "sell first and ask questions later" approach.
We can expect that as clarity emerges, share price volatility in the sector should diminish, although the process may be gradual. Importantly, the risks in the banking sector appear to be non-systemic, with larger, well-diversified banks maintaining stable tier 1 capital ratios and more manageable quantities of HTM securities.
The Road Ahead: Implications for Fed Policy and Investment Strategies
The most pressing question now is how recent events will influence Fed policy. At the March 22 FOMC meeting, the central bank decided to raise rates by an additional 25 basis points to a target range of 4.75% to 5%. However, they also hinted that the rate hiking cycle might be nearing its conclusion, with a majority of officials projecting only one more rate hike ahead. This projection implies that the terminal rate, or the rate at which the Fed ceases tightening, will lie between 5% and 5.25%.
So, how should investors approach their investments in this environment? My focus remains on diversified portfolios designed to stay invested throughout the entire business cycle. In times of market turbulence and uncertainty, investors should consider various strategies to mitigate risk and capitalize on potential opportunities. Here are some recommendations:
Quality-based factors: Concentrate on stocks with strong balance sheet liquidity, robust free cash flow, and lower volatility. These companies tend to have more stable revenues and earnings, which can help buffer your portfolio during turbulent times.
Treasury bonds: Holding a portion of your portfolio in U.S. Treasury bonds can provide a safe haven during market volatility, as they typically have a low correlation with equity markets and can serve as a reliable source of income.
Money market funds: Invest in money market funds for short-term, liquid, and low-risk investments. These funds generally offer a more stable return than equities, making them suitable for investors seeking to preserve capital in uncertain times.
Fundamental-weighted indexes: Consider investing in fundamental-weighted index funds or ETFs, which focus on stocks with strong fundamentals such as earnings, dividends, or cash flow. This strategy can help limit exposure to overvalued or speculative stocks that may underperform during market downturns.
Factor-based funds: Explore factor-based funds that target specific investment factors, such as value, momentum, quality, or low volatility. These funds can help diversify your portfolio and potentially improve risk-adjusted returns during uncertain market conditions.
Diversify across asset classes: A well-diversified portfolio can help reduce overall risk and improve long-term performance. Consider whether your mix of equities, fixed income, and alternative assets is appropriate for current market conditions. Including a healthful mix of international issues and US treasuries can ensure a smoother ride with better risk-adjusted returns.
Rebalance regularly: Regularly review and rebalance your portfolio to ensure it remains aligned with your investment objectives and risk tolerance. This practice can help you maintain a balanced portfolio and avoid overexposure to any single asset class or investment. For investors using treasuries instead of corporate bonds, rebalancing during a crisis allows for realizing of โcrisis alphaโ from flight-to-safety flows into treasury funds, and deploy that capital toward equities when prices drop.
By incorporating these strategies into your investment approach, you can fine-tune your portfolio for the current uncertain landscape, while still positioning yourself for long-term growth. Attractive core fixed income yields may also help to dampen portfolio volatility, providing a stable source of income during market fluctuations, but an equally factor-weighted mix of treasuries and low-volatility equities has (and likely will continue to) return more over the long run.
As a reminder, only equities have ever managed to outpace the rate of inflation over any rolling 30-year period. This is not true for fixed income, which should instead be treated as a ballast for an equity portfolio, and a safe place to store realized gains from equity investing, that can be protected during downturns and insure a smoother return-path.
(Note: This post was checked for accuracy by ChatGPT4.)
โAvery
P.S. (I am currently using a mix of SPY 0.00%โ , MGC 0.00%โ, FNDF 0.00%โ, GOVT 0.00%โ, FNDX 0.00%โ. (Note: Some of these funds went ex-dividend, and as such, display a larger price change loss than they otherwise would. For example, MGC generally is within a few hundredths of a percentage point of $SPY, as it holds the largest ~150 companies by market cap.) I currently have some funds allocated to BND 0.00%โ, but do not advocate this for others, and think GOVT 0.00%โ is more appropriate.
P.P.S. While I would like recommend Avantisโ offerings, liquidity on the majority of their ETFs has been too poor. A common pitfall among retail investors is to ignore the cost of this spread, which can cause a needless setback in returns - and a negative compounding effect for those dollar-cost-averaging. FNDF 0.00%โ has a mutual fund cousin, and 1-cent spreads.
A few people have asked why I'm not using Avantis funds. The market currently has very low depth-of-book (despite high trading volume.) Volume and liquidity are not synonymous, and without enough depth-of-book and proper market making/trading in Avantis securities, the spread is too wide to recommend them. $FNDF offers nearly identical factor exposure as $AVDE, and trades at a 1-cent spread. As such, I've been leaning toward $FNDX and $FNDF for large caps. $AVUV still remains a good option for small-cap value, but I am not confident that this factor will be persistent and pervasive throughout the current market cycle, as financials have been hit and may continue to be hit. Instead, I'd recommend a fund like $MGC - and avoiding the size factor instead of pursuing it. This is the only prudent way to pursue a value portfolio without introducing unnecessary volatility at this time, in my opinion.
Great take as always, thank you Avery!
Glad you are back writing here, evergreen :).
Have a great weekend!