Blog post by Empower Wealth

The great impasse: VanEck’s 2023 Q1 Summary

Please Note: This report was created and provided by VanEck.

The events of the past few weeks are a reminder how fragile markets and banking systems can be. The events also served as a reminder of the lengths central banks and financial regulatory authorities will go to, to ensure the system remains robust. The US Federal Reserve (the Fed) moved swiftly to insure the deposits of smaller banks while the Swiss Financial Market Supervisory Authority deemed it was necessary to reorder the investment hierarchy to ensure UBS’s takeover of Credit Suisse. This could be the Ides of March, the deadline for settling debts in Rome. It is also associated with misfortune and doom.

Central banks are at an impasse, raising rates to fight inflation, while creating liquidity to ensure banking systems. Markets too, are at an impasse. Long-term rate expectations have fallen, but recessionary risks have increased.

Last quarter we posited that equity investors don’t seem to have received the age-old memorandum, ‘don’t fight the Fed’. The yield curve remains inverted, a widely regarded indicator for a recession, yet equities have been holding up. Now bond markets are fighting the Fed too. The Fed is saying no rate cuts in 2023. Not so bond investors, the expected three-month T-bill rate in 18 months’ time dropped to a nadir below the previous record. This was in January 2001, about two months before the US economy fell into recession.

Ultimately, you ‘don’t fight the Fed’. Remember, a pivot is in response to an economic slowdown. If the slowdown is a hard landing, risk assets do not have a strong track record pricing a recession. With the exception of the two 1970’s bear markets, recession-driven bear markets rarely start more than six months before the recession starts. This could be the most anticipated period of equity market weakness that the market hasn’t positioned for.

Heading into 2023, consensus thinking seemed to be that we were one piece of good news away from a Fed pivot. Yet, equities rallied in January with no major news as a catalyst. It seemed that there was a surge of money supply globally at year-end that offset the Fed’s tightening. However, those forces—US Treasury buying of bonds, Japan QE, China money supply growth—are unsustainable.

Market movements subsequent to January reflect this. Over the quarter, the safe haven asset, Gold has rallied. International equities, led by Europe and Japan have had strong quarters. Sectors driving this global equity performance were IT, telecommunications and consumer discretionary.

We continue to think investors should focus on liquidity, focus on balance sheets and cash flow and avoid highly volatile and speculative assets. We continue to see support for gold. Asset allocation has come back to the fore, as prudent investors focus on what can go wrong, rather than to attempt to forecast what might go right. Risk management is everything. Liquidity will be key to take advantage of opportunities that present themselves.

An asset crisis, not a credit crisis, yet

Over a decade of free money and soaring leverage was never going to end without consequences. While markets argued about hard or soft or no landings, investors worried about the amount of leverage in the financial sector, concerned it would break before the real economy did.

Recent weeks have seen a couple of high-profile bank failures, and plenty of hysteria. The canary has been sent down the coal mine.

Confidence losses can be self-fulfilling, especially where bank runs are concerned. Markets can also be self-serving. If they see an opportunity to force a policy payday, be it a return to cheap money or a government handout, they will have no compunction about forcing it.

Nonetheless, neither Silicon Valley Bank nor Credit Suisse look like the sort of systemic blow-ups that will signal the end of the financial cycle. Both look like idiosyncratic examples of woeful risk control and poor management. The former case, too little attention to a narrow, correlated deposit base coupled with poor interest rate hedging. In the latter, a series of terrible, costly, poor credit decisions.

In other words, in both cases, the trifecta of financial failure: leverage, hubris and other peoples’ money.

Of course, if markets continue to panic, or exploit fears to create the impetus for authorities to act, we could still see more bank runs. But this is more like Long Term Capital Management (LTCM) in 1997 than Lehmans in the Global Financial Crisis (GFC).

A little history, LTCM was a 1990s hedge fund started by kings of the US bond market and Nobel Prize winners. It used huge leverage, provided by Wall Street banks, to exploit tiny anomalies in market pricing. A classic “pennies in front of the steamroller” strategy.

In 1997, when it all went wrong, the Fed was forced to cobble together a rescue package, including almost all of Wall Street’s banks, lest the US Treasury market implode. All well and good but, in the panic, the Fed also swung back to easing – despite a clearly late-cycle economy.

The extra fuel on the fire saw the economy and markets accelerate, in turn leading to the blow-off and crash of 2000. The proxy for activity we’ve used is retail trade.

Approaching this crisis, we were pleased to see the Fed’s actions in late March, even though the market is more sceptical.