From the desk of Basepoint Wealth's CIO W. Allen Wallace, read about our current positioning, market outlook, and what barometers and indicators to understand and consider.
“A story has no beginning or end: arbitrarily one chooses that moment of experience from which to look back or from which to look ahead.”
― Graham Greene, The End of the Affair
Dear Family, Friends, and Clients:
Congratulations on completing another trip around the sun! While it may be arbitrary, convention dictates that we must measure our progress at 365-day intervals, even though our goals may stretch 50 or more laps into the future. Given the short-term nature of our evaluation period, little insight will be gleaned about our progress toward reaching our ultimate destination; however, it is still instructive to sit back and reflect periodically about how we are positioned given the world around us, and to take a deep look at the current risks and opportunities.
Although there are still a few trading days left, so far 2023 has been a decent year for our clients. While we didn’t repeat the homerun comparative performance of 2022, we did achieve high single digit positive returns in most accounts, and some accounts that are more aggressively positioned stretched into double digit gains. Most of these returns have accrued in the last 2 months of the year. The first 10 months of this year were terribly boring for us due to our limited exposure to large cap technology stocks. There was a significant fall in longer term interest rates from October through December, which has prompted a sharp spike in both equity and fixed income prices.
Most of our domestic equity funds have performed in the plus 25% range this year (large value is 15%, small cap is 11%); our international funds are up around 17%; gold is up 11%; silver and oil are flat; and our bonds are up 6-8%. We still hold a significant amount of cash, which is currently earning around 5% to sit on the sidelines. Our positioning was one of cautious optimism, with a keen eye on limiting losses if the tide changed direction and having flexibility to add risk exposure if prices became more enticing. More conservative accounts had a bumpy early year because they are more sensitive to interest rates, which peaked in October and then sharply dropped heading into the holiday season. The iShares 20 Year Treasury fund (TLT) was showing a YTD loss of 15% as of October 19, and has rallied to a positive 3% showing for the year as of today.
While this year’s performance may not be written about dotingly in history books, the general results should lead most clients closer to reaching their goals. In an interview with an institutional investing magazine a pension fund manager was asked how he achieved performance in the top 10% of returns for all pension funds over a decade. His answer was telling: “By never being in the top 10% for any single year.” He went on to comment that doing things to get into the top 10% in any single year necessarily puts a manager at risk of being in the bottom 10%. Consistent positive returns accumulate over time and leave sporadic and alternating high and low returners in the dust given sufficient patience and time.
We began shifting our allocations in early November, and the following changes are being phased in as we meet with clients:
Our long-only equity exposure has increased. Even though the market indices are at all-time highs, many of the stocks that interest us have been flat or negative until recently. This has allowed valuations to become more reasonable even while the headline stock market numbers have climbed.
We have increased international equity exposure. International valuations are significantly more desirable than domestic valuations. International exposure held in local currency also provides a temporary hedge against a declining dollar.
We have shifted assets from cash to fixed income to take advantage of higher rates.
We have extended duration on our bond portfolios. This is a fancy way of saying that we are using longer-term bonds. Since rates have increased, we have an opportunity to lock-in higher rates for a longer period of time. We still need to be careful because rates could certainly continue to rise from here, but it doesn’t matter to us if we are being paid an adequate amount of interest. Short-term fluctuations in bond portfolios matter little unless they are in the form of credit defaults.
We have continued to minimize credit risk. We have added mortgage bonds (peaked at 8% earlier this year); inflation-adjusted bonds (real rates have swung from -2% to positive 2%); more asset-backed securities; and some carefully selected preferred stocks. These allocations are in mutual funds because we want a team of analysts managing the portfolios.
We are reducing alternatives exposure. The existence of positive real rates has made traditional investments more attractive and has made our long-short and merger arbitrage positions less important. We have very slightly moderated our silver exposure but have maintained our gold exposure. Our most aggressive allocation now has a small amount of real estate exposure.
We have shifted our natural resources exposure from a portfolio of individual stocks and a closed-end oil fund to a single open-end oil mutual fund. This was due to liquidity concerns in the closed-end fund given our percentage ownership, and our conviction that the death of oil has been prematurely declared.
Our small cap fund has been replaced.
These changes may increase short-term volatility, but they will greatly increase the amount of income that we are generating in terms of both interest and equity earnings. Given the higher income stream, shorter term volatility is less concerning, and may give us opportunities to reinvest future income at lower prices. We still maintain more than adequate liquidity to cover needs for living expenses, emergencies, and opportunities.
The big question everyone is asking is “when is the recession”. Is it a soft landing, a hard landing, no landing? The only reasonable answer to these questions is: “I don’t know”. Many recessionary signals have been flashing for the last 12-18 months. While it is easy to see that a recession is coming, determining the timing is almost impossible. We are always heading toward the next recession, but for all we know, it is 10 years away. The only thing that we can do is position ourselves to be prepared for an unknowable future.
Historically, the Treasury Yield Curve has been a fairly reliable predictor of a looming recession. We usually have 12-24 months to wait after the initial inversion. The current inversion began in July 2022. In the normal course of events, the yield curve un-inverts right before the recession begins, and this usually happens after the Federal Reserve has raised rates for the last time in the cycle. There has been a little diminishing confusion about when this last rate hike will occur, but it is beginning to look like this has already happened and rate cuts are being priced in for next year.
The yield curve is still inverted:
Source: US Treasury
The Conference Board publishes a monthly index of Leading Economic Indicators. These indicators are intended to tell us where we are heading and tend to be predictive of recessions, as opposed the Coincident Economic Indicators that tell us where we are, and the Lagging Economic Indicators that tell us where we have been.
The Leading Economic Index is currently negative:
Historically, the LEI has been a good predictor of recessions:
The grey shaded areas in the chart indicate recessions. As illustrated in the chart, the current negative signal in the LEI has had a long duration but has very little depth. While this does not mean that a recession has been avoided, there has been a change in the direction of the LEI. As long as we remain in negative territory caution is warranted.
A couple of other things that need to be taken into consideration:
The Federal Reserve is currently generating losses instead of gains. When the Federal Reserve makes a profit, the funds are transferred to Treasury to pay the bills. Due to large unrealized losses on the Fed’s balance sheet, and negative cash flows from lending activities, the $100 Billion that used to go to the Treasury each year is no longer available. This will need to be funded by additional bond issuance, which may put pressure on longer-term rates. This loss will not swing to a profit anytime soon. Never fear, however, because the Fed doesn’t really care about losses, they optimistically accumulate them on their balance sheet as a “deferred asset”, which is written down once they resume generating profits. Once the deferred asset is fully amortized, the cash flow to Treasury begins again. This may take years to play out.
The US Treasury failed to take significant advantage of low long-term rates. Over 1/3 of the total US debt matures in the next 12 months and will need to be refinanced at higher rates. An even greater percentage will go from almost no interest to 4-5% over the next 5 years. This will greatly increase the burden of interest expense on the US Treasury and will facilitate a need for either higher taxes, lower government spending, or increased debt ceilings; none of these things are positive for the economy.
The Federal Reserve is not the only bank holding The Old Maid. Before the recent decrease in long-term interest rates, there were over $650 Billion in unrealized losses accumulated on bank balance sheets in the US. This is a large pile of dynamite begging for a fuse. We were given a glimpse of what this looks like last year with the failure of several banks. Merideth Whitney once said that the financial crisis in 2008 was caused by $80 Billion of unrealized losses, which she considered an “unfathomable amount of losses”.
Mortgage rates reached 8% this year. Typically, a large spike in mortgage rates would be expected to cause a decline in housing prices. Housing prices have remained relatively stable due to supply shortages and lack of sellers sitting in mortgages at 3% interest. If unemployment picks up and workers are forced to relocate, we may see a quick shift in the stability of housing prices. In addition, many people were using Adjustable-Rate Mortgages heading into this rise in interest rates. Some reports show that 2025 is a big year for rate adjustments. Stay tuned for fireworks if 20% of outstanding mortgages suddenly shift from 3% to 8%.
The Strategic Petroleum Reserve has been plundered to under half capacity. This has most likely been a major contributor to stagnant oil prices over the past 18 months. Someday, that will need to be refilled, which may reverse the price of oil. In addition, we are now less prepared for a foreign oil shock, a war, or a very large natural disaster.
Inflation has moderated over the past year, but some measures have accelerated over the past 3 months. Inflation doesn’t always travel in a linear fashion and the risk of inflation reigniting is measurable. Keep in mind that the media has been talking about disinflation, which is significantly different than deflation. When the average person hears that inflation is declining, they expect lower prices, but this really means that the rate of increases has slowed, not reversed. The higher prices are permanent unless we go all the way from inflation to deflation, which is currently unlikely.
Student loan payments began again on September 1 after 3 years of deferment. There is a 1-year grace period that will allow students who do not resume payments to avoid default, however, interest is accumulating again. A recent report showed that 40% of borrowers skipped their October payment. The total amount of student loan debt in the US is $1.766 Trillion, and the average monthly payment is $503. Imagine being 30 and suddenly needing an extra $503 each month to pay your student loan and having your mortgage adjust from $1,016 to $1,768. This $1,255 increase in monthly expenses is 20% of the median household income of $74,580. With the US personal savings rate currently at 3.8%, this type of increase in monthly fixed expenses would cause a very large decrease in disposable income for a great number of young Americans.
There has been a large increase in the price of stocks involved in Artificial Intelligence. This price increase seems to be premature in relation to the readiness of AI to be put into wide and useful action. This is a much smaller version of the runup of internet stocks in the late 1990s, but still similar in appearance.
The political environment is spicy. I couldn’t think of a more dignified way to describe it. There is significant contention between the two political parties, and more importantly there are fractures showing within each party. This could lead to an unexpected outcome in this year’s election.
While I am not a big fan of random market performance barometers, there are occasions where causation may be present. For instance, the super bowl indicator tells us that an AFC win means a bear market, and an NFC win means a bull market. This indicator has been correct 41 out of 56 times and is complete rubbish. Conversely, the election year indicator, which states that the stock market will rise in an election year, has been correct 19 out of 23 times since 1928 (2 of the misses were during FDR’s reign), and this indicator may have some validity since the levers of fiscal and monetary policy may be manipulated to delay a recession until the election is over. In addition, political ad spending in 2024 is projected to be over $16 Billion. This doesn’t consider additional campaign employees, legal and accounting costs, travel expenses, and any other money expected to change hands during the election cycle. Historically, when a Democrat is elected the market rises 7.6% and when a Republican is elected the market rises 15.3%. While we will not change our positioning due to historical indicators, we should be aware that it is possible that any impending recession may be delayed until after the election, and that pausing the start may increase the severity.
On behalf of the entire Basepoint Team, I would like to wish you the best for a happy holiday season. As we finish passing ‘Go’ on another year, we continue to be cautious, but also opportunistic. Our goal is not to avoid all fluctuations, it is to position your capital in the way that most likely leads to adequate future returns. Sometimes potential return is worth the risk, sometimes it is not. The shifts we are making currently are an attempt to take advantage of positive real interest rates and decent equity valuations in all but the largest stocks in the United States. We will continue to be flexible and will make additional corrections as needed. If you have any questions about your accounts, goals, or allocation, please do not hesitate to contact your Wealth Advisor, or me personally.
This article is for informational and educational purposes only and is not an offer to sell or a solicitation of an offer to buy the securities or instruments named or described in this report. The charts, graphs, and formulas included are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Decisions to buy or sell a position should be based on an investor's investment objectives and risk tolerance and should not rely solely on this report. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult a qualified financial adviser before implementing any strategy discussed. Supporting information related to the recommendation, if any, made in the research report is available upon request. Past performance may not be indicative of future performance.
The information in this report has been obtained from sources believed by Basepoint Wealth, LLC to be reliable and accurate. We cannot guarantee its accuracy, completeness, and validity and cannot be held liable for any errors or omissions. Any opinions or estimates contained in this report represent the judgment of Basepoint Wealth, LLC at this time and are subject to change without notice.