Impact

This quarter’s economic perspective of Jon Manchester, CFA, CFP® (Senior Vice President, Chief Strategist – Wealth Management, and Portfolio Manager – Sustainable, Responsible and Impact Investing) runs the gamut from Harry Markowitz to Taylor Swift. 

In late June, at 95 years old, Nobel prize-winning economist Harry Markowitz passed away in San Diego, CA. He leaves behind an immense legacy in the investment field, with his fingerprints in virtually all professionally-managed portfolios today. As the Financial Times put it: “The study of finance can easily be split into two eras: before and after Harry Markowitz.”¹ Prior to the 1952 publication of his groundbreaking University of Chicago PhD dissertation titled “Portfolio Selection,” investment portfolios tended to be assembled in a somewhat haphazard manner, a collection of individual securities each assessed in isolation from a risk and return perspective with scant attention paid to how the puzzle pieces fit together. Diversification was a well-known concept, but Markowitz’s work provided a mathematical approach to evaluate risk/return tradeoffs holistically, at the portfolio level. Rob Arnott, founder of asset management firm Research Affiliates, noted “Before Harry, investing was a bunch of rules of thumb.”²

In awarding him the 1990 Alfred Nobel Memorial Prize in Economic Sciences—shared with Merton Miller and William Sharpe for separate (but in Sharpe’s case, related) achievements—the Royal Swedish Academy of Sciences lauded Markowitz’s pioneering contributions to portfolio choice. Importantly, Markowitz illustrated the importance of how each asset in a portfolio contributes to the overall risk by considering how the securities move in relation to one another. In other words, how correlated are the assets in a given portfolio? This had significant and enduring implications for portfolio management. Adding a high-risk biotechnology stock to a portfolio otherwise composed entirely of low-risk, regulated utilities stocks could in fact lower the risk of the overall portfolio compared to a broad equity benchmark, given the low correlation between the price movements of the two vastly different industries. This enabled investment managers to evaluate a potential investment in the context of the overall risk picture, and gave rise to the construction of more well-diversified portfolios across asset classes.

The adoption was not immediate, however. According to a Financial Analysts Journal article, Markowitz’s ideas took more than 20 years to catch on.³ It required the “shock wave of the early 1970s stock market selloff and the passage of ERISA” to compel investors to build sturdier portfolios, plus the eventual development of faster computing power to handle the necessary calculations.

The investment world has, not surprisingly, evolved at a dizzying pace in the half-century since the inflationary 1970s, but Markowitz’s core architecture of creating optimal, efficient portfolios across the risk-return spectrum still has a place in the latest iterations of his Modern Portfolio Theory (MPT). It does not necessarily help CNBC gain viewers, though, which is why a recent Bloomberg opinion piece on Markowitz observed that “most investment coverage today is about which securities will go up or down in price, not which ones are shrewd bets, and definitely not which ones have desirable correlations to be part of portfolios with attractive risk/return ratios.”⁴

The Big Seven
One can’t help but wonder how Markowitz would assess the current state of the U.S. large-cap equity market. As someone who was reportedly consumed with the statistical properties of portfolios of securities, it’s probably safe to assume he would be intrigued by the very narrow band of stocks carrying the overall Standard & Poor’s 500 Index. The Index returned 8.7% including dividends in the second quarter, taking its year-to-date total return up to 16.9%. Nearly three-quarters of the Index’s 2023 return thus far can be attributed to just seven stocks: Apple, Microsoft, Nvidia, Amazon, Meta Platforms, Alphabet, and Tesla. Three of those companies—Nvidia, Meta Platforms, and Tesla—saw their stock prices soar more than 100% higher during the first half of 2023. Media outlets have started referring to this group as either the “Big Seven” or sometimes the “Magnificent Seven,” which in itself is concerning. When stocks have done well enough collectively to earn a nickname, it might suggest that future profits are fairly well discounted in the stock prices. At present, the Big Seven trades for an average forward price/earnings ratio of roughly 36x. The overall Index trades at a robust 20.5x estimated 2023 operating earnings per share, and Morgan Stanley calculates that the median S&P 500 stock valuation lands in the 89th percentile historically.⁵

For companies outside the Big Seven, returns haven’t been as gaudy. The median total return for S&P 500 companies was a relatively pedestrian 4.8% over the first half of 2023. Tracing back further to the end of 2021, one trading day short of the market’s all-time peak, only 35% of S&P 500 stocks had higher prices on June 30 compared to then. The remaining 65% were still trying to climb back following an ugly 2022, and that list includes Big Seven members Tesla, Alphabet, and Meta Platforms. All this is to say the list of winners within the U.S. large-cap universe is a fairly exclusive club, and a common theme for outperformers this year has been stocks perceived to benefit directly or indirectly from generative artificial intelligence (AI). Per a Bloomberg article: “The market’s fascination with the power of generative AI has trumped every major issue that could potentially drag down sentiment this year: recession fears, elevated levels of inflation, prospects for more Federal Reserve hikes, geopolitical risks, the debt-ceiling debate and the collapse of a few regional banks.”⁶

Despite the AI frenzy, research from Strategas points out that the real bull market has been in money market flows. Since the S&P 500’s low point last October, investors have directed four times as much into money market funds as compared to equity exchange-traded funds.⁷ Strategas believes those flows reflect a “ton of equity market apathy,” but sharply higher money market yields are no doubt a major factor as well, plus the scramble to avoid holding bank cash above limits insured by the Federal Deposit Insurance Corporation (FDIC). The Federal Reserve’s (the Fed’s) monetary tightening campaign has lifted short-term yields up near 5%, attracting the income-focused crowd. Meanwhile, the distrusted rally in equities continues to climb the wall of worry that Bloomberg outlined, and it has the potential to continue as more investors get off the sidelines and belatedly look to participate in further upside. There are some signs of froth in the markets, however, whether it’s increasingly rich valuations paid for growth stocks or the mid-June initial public offering (IPO) of unprofitable restaurant chain CAVA Group, which saw the stock nearly double on its first day of trading amidst a dearth of listings.

Mind the Lag
Economic growth in the U.S. has aided the markets thus far in 2023 by being neither too hot nor too cold, the precise porridge that can keep bears at bay. Gross Domestic Product (GDP) rose at a 2% annualized pace in the first quarter, adjusted for inflation, and the Atlanta Fed’s GDPNow estimate for second quarter growth is about the same. With many economists initially projecting a mild recession during 2023, the economic data thus far has proved better-than-feared. Bloomberg’s ECO Surprise Index measures the aggregate differentials between the actual values of economic releases and analyst forecasts. After a flattish start to the year, the ECO Surprise Index moved steadily higher in May and June to its highest level since April 2021. While asking if it’s time to cancel the recession altogether, Bloomberg columnist Jonathan Levin observed that economists have started throwing in the towel on a recession starting in the third quarter.⁸ The consensus estimate for Q3 real GDP annualized growth is now roughly flat, up from a trough forecast of -0.9% in May.

There remain ample reasons to be pessimistic. Chief among those is the Fed’s yet unfinished inflation battle. Although inflation has shown significant improvement—with the headline Consumer Price Index (CPI) decelerating to a 4.0% year-over-year growth rate in May—the Fed’s dot plot indicates it expects to raise the target Fed Funds rate by another 50 basis points⁹ to 5.75% at the upper end. Whether or not that happens, there is concern that the economy has yet to truly feel the impacts of tighter monetary policy. There is typically a lag between the policy changes and when economic metrics start to reflect those moves. Given the Fed lifted its target rate by five percentage points between March 2022 and May 2023, the fastest hiking pace in over four decades, it seems reasonable to withhold judgement before declaring the economy immune to higher rates.

There is also the inconvenient truth that the U.S. Treasury yield curve has been consistently inverted for a year now, with the two-year yield at 4.89% as the second quarter ended, versus 3.83% for the 10-year note. Historically, this has suggested a recession lies ahead. The Conference Board’s Leading Economic Index (LEI) hasn’t inspired confidence either, moving lower 14 consecutive months through May. Projecting that the U.S. economy will contract over the Q3-2023 to Q1-2024 timeframe, The Conference Board said the “recession likely will be due to continued tightness in monetary policy and lower government spending.”¹⁰

This dour outlook for economic growth remains at odds with the surprisingly sanguine economic data we’ve seen. Notably, few cracks have emerged in the all-important labor market. Retail sales advanced at a 1.7% year-over-year rate in the three months ending in May, which might qualify as desirably lukewarm. Perhaps music superstar Taylor Swift deserves some credit for the economic resilience. As her current tour rolls around the country providing a boost to local economies—which some have compared to hosting the Super Bowl—one study estimated the Swifties will generate $5 billion in economic impact, more than the GDP of 50 countries.¹¹ While admittedly small in the context of a roughly $26 trillion U.S. economy, Swiftonomics is clearly not the problem. We just need her to continue touring the states indefinitely, until generative AI is ready to take over completely.

1 “Harry Markowitz, economist, 1927-2023,” www.ft.com, 6/30/2023.
2 Ibid.
3 “Harry M. Markowitz: Profile of an Industry Leader,” www.cfainstitute.org, Q4 2017.
4 “Nobel Laureate Harry Markowitz Was a Misunderstood Economist,” www.bloomberg.com, 6/26/2023.
5 “US Equity Strategy,” Morgan Stanley Research, 6/26/2023.
6 “Big Seven Powering $5 Trillion Nasdaq 100 Rally,” www.bloomberg.com, 6/30/2023.
7 “Key Charts For 1H Client Letters & Look Ahead,” Strategas ETF Research, 6/27/2023.
8 “Is It Time to Cancel the Recession Altogether?,” www.bloomberg.com, 6/27/2023.
9 A basis point (bp) is 0.01%.
10 “LEI for the U.S. Declined Further in May,” www.conference-board.org, 6/22/2023.
11 “Generating $5 billion, the Taylor Swift The Eras Tour has an Economic Impact Greater than 50 Countries,” www.bloomberg.com, 6/8/2023.

This quarter, we feature the economic perspective of Jon Manchester, CFA, CFP®, Senior Vice President, Chief Strategist – Wealth Management, and Portfolio Manager – Sustainable, Responsible and Impact Investing.

March 31, 2023

When U.S. president Franklin Delano Roosevelt (FDR) first took office in March 1933 he was 51 years old and tasked with the monumental challenge of somehow lifting the country out of the Great Depression. He had work to do on nearly every front. At the top of that list, however, was shoring up the nation’s beleaguered banking system. Roughly 4,000 banks had closed in the first few months of 1933 alone, adding to a series of bank runs and failures in prior years.¹ One of FDR’s first moves was to declare a national banking holiday, a euphemism for temporarily shutting down the banking system. That was followed days later by the passage of the Emergency Banking Act (EBA), which importantly gave Federal Reserve Banks the right to issue emergency currency to struggling banks in the form of Federal Reserve Bank Notes. His inaugural “Fireside Chat” took place on March 12, 1933 and began with FDR calmly saying over the airwaves, “My friends, I want to talk for a few minutes with the people of the United States about banking.”²

By June 1933, FDR was only three months into his term, but it may have felt like three years to him, following what is now considered the most productive first 100 days of any presidency and the benchmark against which all future presidents would be measured. Congress passed 77 laws during that frenetic special session, including 15 landmark bills that were the bedrock of FDR’s First New Deal. Among the flurry of legislation were bills creating the first of what some referred to as FDR’s alphabet agencies: the Civilian Conservation Corps (CCC), Tennessee Valley Authority (TVA), and others. For a man known by his initials, perhaps it was fitting that his office spawned a whole host of federal government agencies known primarily by theirs. Not everyone was a fan of the bulked-up bureaucracy. Former New York governor Al Smith reportedly groused that Roosevelt’s government was “submerged in a bowl of alphabet soup.”³

One of those 15 landmark bills was the Banking Act of 1933, enacted that June. It established the Federal Deposit Insurance Corporation (FDIC), another of the alphabet agencies, and a particularly critical one viewed from the lens of today, 90 years later. Informally called the Glass-Steagall Act after its sponsors—Senator Carter Glass of Virginia and Representative Henry Steagall of Alabama—its main purpose was to separate commercial banking from investment banking. Interestingly, the provision that created the FDIC was much more controversial, even drawing veto threats from FDR.⁴ He signed the bill, however, and the FDIC was born, with deposits insured up to $2,500 initially at member banks. That coverage was soon doubled to $5,000 in 1935 and is $250,000 today.

The sudden demise of both Silicon Valley Bank (SVB) and Signature Bank in March 2023 were stark reminders of both the importance of FDIC insurance and its limitations. As the second and third-largest bank failures in U.S. history, trailing only Washington Mutual in 2008, government officials determined the one-two punch required a new approach to stabilize the banking system. In a joint statement between the Treasury department, the Federal Reserve, and the FDIC, it was announced all depositors would be made whole as a “systemic risk exception.”⁵ In other words, the $250,000 FDIC insurance cap was waived, in an effort to prevent a widespread banking panic. The FDIC has travelled a great deal from its humble roots as a late add-on to the Glass-Steagall Act.

Available for Sale

Whether the banking turmoil ultimately proves a tempest in a teapot seems largely dependent on the same variables we’ve been discussing for a while now: inflation and interest rates. Persistently high inflation and a sharply inverted yield curve is not the desired formula. Shortly after the bank failures, the Federal Open Market Committee (FOMC) decided to continue the inflation fight by raising the target Fed Funds rate to an upper limit of 5.00%. Some expected the Fed to pause in the wake of the banking instability, but in their statement the Committee said they remain highly attentive to inflation risks. They did acknowledge that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.”⁶ Meanwhile, longer-term interest rates declined in March. The benchmark 10-year U.S. Treasury Note yield fell from nearly 4% at the beginning of the month to below 3.5% when the first quarter hit the finish line.

Nonetheless, the 10-year U.S. Treasury Note yield remains well above its levels from 2020-21, when it didn’t top 2% and spent much of 2020 below 1%. Therein lies a significant part of the problem for Silicon Valley Bank and other banks who invested heavily in low-yielding government paper during that time frame. According to the Federal Reserve Bank of St. Louis, just prior to the pandemic, roughly 20% of bank assets consisted of investment securities – primarily mortgage-backed and U.S. Treasury bonds.⁷ By the end of 2021, security holdings had increased to 25%, and many of the purchases were longer maturity bonds, which are more vulnerable to rising interest rates. When Silicon Valley Bank depositors fled in mass, the bank was left technically insolvent due to significant losses on the bonds in its investment portfolio. Although you can argue that uninsured SVB depositors were acting rationally, it brings to mind the famous quote often attributed (perhaps wrongly) to famed British economist John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”

The tighter credit conditions mentioned by the Fed could pose a challenge for economic growth and corporate earnings. Notably, after an enormous spike in money supply during 2020—as measured by M2, which includes cash, bank deposits, money market funds, and other types of deposits readily convertible to cash including certificates of deposit—it is now falling at the fastest rate since the 1930s.⁸ This can be partly attributed to a normalization of money supply following the extraordinary fiscal and monetary stimulus measures during the pandemic, but it is something to monitor as 2023 progresses.

Higher borrowing rates and tighter lending standards have the potential to dampen economic growth in a hurry. The Chicago Fed’s National Financial Conditions Index takes into account 105 indicators of financial activity, a wide variety of interest rate and credit spreads, plus other metrics. It has been moving higher over the past year, indicating tighter financial conditions, which the Fed wants to see for the inflation fight, but runs the risk of inducing the much anticipated recession.

Market Incongruences

While the yield curve continues to suggest a slowdown lies ahead, equities shrugged off the banking tremors and put together a surprisingly strong first quarter. In fact, in case your phone didn’t notify you, the tech-heavy Nasdaq 100 Index hit bull market territory near the end of March. The Standard & Poor’s 500 Index returned 7% price-only in Q1-23, with last year’s sector laggards—Communication Services, Technology, and Consumer Discretionary—the leaders as part of a fairly strong rotation into growth stocks.

The equity market’s resilience seems underpinned by a familiar carrot: the promise of lower interest rates. According to the CME FedWatch Tool, Fed Funds futures are now pricing in a greater than 50% probability that the FOMC pauses at 5.00% over the next two meetings in May and June, respectively, before potentially cutting the target rate in the back half of 2023.⁹ The highest probability currently assigned to the December FOMC meeting is 4.25%. This rising expectation that the Fed will reverse course has encouraged investors to move into longer duration, growth stocks.

History shows that equities tend to perform well following a peak in the Fed Funds rate. This doesn’t hold 100% of the time, however, and there are reasons to be cautious this time around. Inflation isn’t kicked yet, for starters. The Consumer Price Index (CPI) was still running at +6.0% year-over-year as of February, and the Personal Consumption Expenditures (PCE) core price index at +4.6%. Both have improved, but the Fed knows it isn’t time to declare victory yet. They may be able to pause, but the futures market could be mistaken in projecting a lower Fed Funds rate this year. Equity market valuations are another potential headwind. The S&P 500 Index closed Q1-23 at nearly 19x projected 2023 operating earnings. The excess valuation levels of 2021 have been corrected, but U.S. large-cap stocks are not cheap. In fact, Goldman Sachs Research said in late March that the S&P 500’s forward valuation ranked in the 82nd percentile since 1980.¹⁰ Other areas of the equity markets are less demanding from a valuation perspective.

With the fixed income and equity markets offering contrasting signals, it would seem one group of investors has to be wrong, assuming returns don’t move in tandem as they did in 2022. The odds appear more stacked against equities given restrictive monetary policy and what’s expected to be a more cautious lending environment, plus modestly elevated valuations as a starting point. Economic growth in the U.S. may be muted. The Conference Board’s Leading Economic Indicators (LEI) Index declined for an eleventh-straight month in February 2023. Per the release: “The Conference Board forecasts rising interest rates paired with declining consumer spending will most likely push the US economy into recession in the near term.”¹¹ They expect just 0.7% real GDP growth this year.

It is safe to assume that FDR would strike an optimistic tone at this moment. Perhaps we could all use a genial Fireside Chat to remind us that the employment picture is exceedingly strong, housing prices were up 3.8% year-over-year in January, according to the S&P Case-Shiller Home Price Index, and the banking system remains sound in part thanks to an alphabet agency created 90 years ago. This doesn’t look like another credit crisis, but even FDR would admit there are obstacles to overcome if risky assets are to perform well.

1 “The First Fifty Years: A History of the FDIC 1933-1983,” www.fdic.gov

2 FDR Fireside Chat, www.fdr.blogs.archives.gov, 3/12/1933

3 “Safire’s Political Dictionary,” William Safire

4 “Banking Act of 1933 (Glass-Steagall),” www.federalreservehistory.org

5 “Joint Statement by Treasury, Federal Reserve, and FDIC,” www.federalreserve.gov, 3/12/23

6 “Federal Reserve issues FOMC statement,” www.federalreserve.gov, 3/22/23

7 “Rising Interest Rates Complicate Banks’ Investment Portfolios,” www.stlouisfed.org, 2/9/23

8 “Column: US money supply falling at fastest rate since 1930s,” www.reuters.com, 3/30/23

9 FedWatch Tool,” www.cmegroup.com, 4/4/23

10 “US Weekly Kickstart,” Goldman Sachs Research, 3/24/23

11 “LEI for the U.S. Continued to Decline in February,” www.conference-board.org, 3/17/23