Apr 10 2023
April 10, 2023

2023 – 1st Quarter

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The Federal Reserve continued to be the driver in the stock market for the first quarter.  The market appeared to have bottomed in October of last year.  The bad news is the uptick was on the back of just ten stocks while the broader market continued to underperform.  That is not a good indication of the ongoing market performance. The ten performing positions were tech stocks that rose on the hope the FED would slow, stop or pivot on its rate increases.  Hope, of course, is not a good strategy for investing.

The FED has now raised interest rates 5 percent in one year.  The FED promised there would be pain.  That pain is the one thing the FED has gotten right.  Employee layoffs continued during the first quarter and layoff notices are picking up speed as we enter the second quarter.  The most notable impact of the FED rate hikes was the failure of three US banks and fear that more would follow.  Keep in mind that it starts with bank failures and ends with a recession.  The FED has suggested a soft landing.  So that means we should expect a hard landing.

In 2022 banks were sitting on piles of depositor cash.  The FED encouraged banks to invest that cash into US government bonds.  When the FED stampeded their interest rate hikes the banks found themselves sitting on bonds that had lost a great deal of value.  As interest rates go up bond values go down.  As interest rates rose you probably noticed very little movement in bank savings account rates.  Depositors noticed as well and began pulling their money out of the banks and into money market accounts.  To meet the withdrawal demands the 3 failed banks began selling their treasury positions at market losses.  That sparked the run on the banks.  The FED has since announced that it would provide for banks to have access to funds to back withdrawals based on giving full value for the government bonds the banks are holding.

Surprisingly, the FED never considered the impact of their rate increases on the banks’ bond positions.  It is important to note that the 3 banks that failed were heavily invested in tech and bitcoin.  When tech and bitcoin values dropped, the banks found themselves with clients who needed money, could not borrow it, and so began withdrawing it from the banks.

We may see banks raise their savings/checking account interest rates to hold depositors.  But that will mean they will also raise the rates charged for loans.  The crunch on bank liquidity has already seen a tightening of loans for new construction.  Worse yet, existing loans borrowed at low interest rates, are now facing much higher interest rates to refinance.  The commercial real estate market will have heart burn.  There are tough times ahead for the overall US economy.  That is being reflected in declining sales, declining wages and layoffs. 

The FED’s next scheduled meeting is in May and it’s a toss-up whether there will be a .25% rate hike or no rate hike.  The FED probably is aware of the economic damage resulting from raising rates from zero to five percent.  It is fully aware inflation is not under control.  Most recent numbers show the core rate increased six percent over the past twelve months.  And that is on top of the inflation that occurred during the twelve months previous.  The FED has truly boxed itself in.

The OPEC+ members announced the first week of April that oil production would be reduced by another one million barrels of oil a day.  That sparked an immediate jump in oil prices and will soon be reflected at the gas pump.  That adds to the inflation problem confronting the FED.  Meanwhile, oil production in the US is about one million barrels a day below pre-COVID production.

Elsewhere in the global economy, things are worse.  Asia has found itself dealing with deflation.  All things electronic will get even cheaper.  The Chinese will not be pulling the world out of this recession.  The Chinese economy is on its knees.  Chinese exports have not recovered following the COVID lockdown.  Factories are shutting down and unemployment is escalating.  The Chinese real estate market is in a freefall.  Europe is fighting an inflation rate running around ten percent.  Industrial production in Germany is scaling back and some industries have begun relocating outside of Europe to locations where energy supplies are more dependable.

Warmer weather in Europe and fertilizer reserves held in food production areas helped avoid energy and food shortages in 2022.  But the loss of fertilizer production in Russia, Ukraine and China, along with record droughts and flooding across the globe, will mean famine in parts of the world.

The Russia/Ukraine conflict will intensify now that spring has arrived.  The question of who will win is over shadowed by possibility the fighting spread to surrounding countries or globally as China is now inserting itself in support of Russia.

The global economy is breaking down.  So, it’s not a surprise that countries outside of the US sphere of influence are working to create trading currencies to replace the US dollar.  The success of that effort to decouple from the dollar would have an impact on the US.  Inflation would continue to be a problem.  The massive federal government debt would become an even bigger issue.  Gold and oil prices would go higher.

Congress is now facing a deadline to increase the US government debt limit.  That showdown between Dems and Republicans will be an aspect of market returns in the second quarter.  Failure to raise the debt limit would lead to a devaluing of US debt.

During the first quarter, I continued to add to the TLT, long treasury position.  Yields on long term treasuries have been dropping which pushes up the value of the TLT holdings.  I took some gains in the XLE and USCI, the energy and commodity positions.  However, we remain overweight in both.  Our underperformers during the quarter were the financials, reflecting the banking issues, and oil.  The overperformer was gold.  Gold reflected a lack of confidence in the FED, the US dollar and the general state of the economy.  Oil dropped in part to fear of dropping demand due to the economic slowdown and another twenty-six million barrels pulled from the US strategic petroleum reserve and sold to offset higher summer driving gas prices.  Oil prices are now moving back up in the wake of the OPEC+ decision to reduce production.

We remain overweight in energy, commodities, treasuries, financials, and value positions, such as utilities.  The emphasis will remain on the US market.  Careful attention will be paid to the bank sector as we move into the summer.  Long-term interest rates could reverse and move up.