RCM Managed Asset Portfolio - Q1 2023
RCM Managed Asset Portfolio
By Christopher Chiu, CFA
Banks, the Pricing of Assets, and the Broader Economy
I should start by discussing the recent happenings around banking, since that is what is on the minds of many people.
As many of you know Silicon Valley Bank and Signature Bank of NY were closed down by regulators in March as they were unable to fulfill their commitments to their depositors and experienced bank runs. These bank runs were brought on by higher interest rates, as customers started to pull deposits to invest in higher interest rate instruments like T-Bills or CDs elsewhere. This resulted first in rumors of a lack of liquidity (the ability to pay back depositors) and then an actual inability to pay back all depositors at the same time.
People will look for some kind of malfeasance in the banks’ collapse, but I am inclined to think it was simply a lack of prudence. As I told a colleague recently, the savings and loans crisis of the late 1980s occurred as a result of a similar interest rate phenomenon. Banks had made mortgage loans all throughout the 1970s but then the Federal Reserve hiked interest rates from 1979 to1981 in order to fight inflation. As a result, the interest these banks had to pay out on deposits eventually became more than the yield they could earn from their loan book. A similar mismatch of assets to liabilities is occurring today. So what we are seeing is not unique; we have been through such challenges in the banking industry before.
What led to the savings and loans crisis in the late 1980s was not malfeasance. Banks were just making loans during the 70’s at the prevailing interest rates at the time. Banks must conduct their business given the environment they are in. (It’s all they have to work with.) Likewise, banks of today made their fair share of loans while interest rates were low for more than a decade. And now they must deal with the ramifications of higher interest rates. So long as higher rates prevail some depositor flight will result. This speaks to why so many banks today may be considered weak--though they may not have been considered weak two years ago when rates were much lower.
However, even as there was a savings and loans crisis in the late 1980s, we got through that crisis without lasting damage to the broader economy. And I think the same thing should happen today. While today’s bank situation continues to evolve, sometimes rapidly, more than likely if matters start getting worse, regulators will step in to bolster confidence in the financial system because everyone uses the same financial system. And we only have one.
Pricing of Assets
The recent events in the banking industry serve as a backdrop for the wider economy and its effect on the equity market and bond markets (your investments!) So far, the broader economy is largely unaffected, and though investor sentiment remains largely negative, we remain somewhat more optimistic than most.
There are many things we look at to gauge the health of the overall investment environment. These can be grouped into four main categories. We look at (1) the valuation of current and possible investments, (2) charts and technical indicators of individual stocks and the market, (3) economic data, and finally (4) prices.
Unfortunately for most investors, they don’t have the time to examine all of these. And so what they work with is what is easiest and most available--(4) price. They get their monthly statements or logon to see how their accounts are doing and maybe make judgements on the state of things purely on that. If their account is going up, then all is well, but if it is going down then something must be wrong.
Short-term prices may indicate that something is wrong but often they do not. Since prices in the short term may move chaotically and not always in a positive way, they are not often the best indicator of the way things will go over a longer run. For most investors reacting to short-term price moves can be detrimental. It may cause them to cash out and limit their gains over the long term, change investment programs at the wrong time, or sell low only to chase higher prices at a later date.
This is why price is only one of our considerations. Before making such decisions on your own, I would suggest first having a detailed conversation with your financial advisor at RCM Wealth Advisors.
The Broader Economy
To give you a better sense of what investment conditions are really like, I share with you, as I usually do, what can be understood without a lot of financial knowledge. These are some factors reflecting the economic cycle.
First the good news. Remember housing is one of the biggest parts of the US economy and its health is indicative of the health of the economy overall. While single family homes continued to go lower, they have rebounded in the last three months without reaching recessionary levels. This is partly explained by the fact that there is generally a shortage of homes in the United States. Demand remains robust overall, even if not in all parts of the country. This is particularly true of the South. It is possible that as inflation and mortgage rates soften, buyers will continue to return to the market in search of affordable homes. But this indicator is something we continue to monitor.
The next picture is of industrial production which tends to slide prior to and during a recession. Industrial production undeniably started sinking late last year. But then it has gone sideways the last two months. So recent moves are still inconclusive because there have been dips in industrial production without an imminent recession (as in 2015.)
A special comment is necessary here on the longer term limits of industrial production capacity in the US. You will notice that industrial production in the US is close to its previous peak and that peak has not really been exceeded for the last fifteen years (since before the start of the Great Recession in 2008.) What this really speaks to is whether this period of low growth is the economic reality we now face and whether the period of rapid growth and rapid inflation the last two years is more of an anomaly, resulting from a fiscal policy error. Unless the production gains and growth rates become continually greater as they had from to 1945-2007, there are many reasons to think we will eventually return to this equilibrium of low growth and low inflation, since there isn’t an increasing demand for the inputs of production beyond our current capacity.
Finally, there is one of the best predictors of recession I have found—heavy truck sales. These are trucks that weigh 14,000 lbs and more (semis, utility repair vehicles, cement trucks, etc.) The reason why this indicator is so useful is that it starts breaking down way before a recession and once it breaks down rapidly a recession always follows. Once sales reach 500,000 vehicles sold per month and starts to decline rapidly it usually means the economic cycle is coming to an end, as buyers are willing to delay purchase of expensive vehicles until absolutely needed.
In the month of February 2023 heavy vehicle sales declined to 450,000. It remains to be seen whether heavy truck sales continue to decline rapidly, but if they do, it is likely a recession is not that far off. We do have some time though before something definitive turns out.