Economy

The key take-away from this chart: adjusting portfolio positions in anticipation of a bad geopolitical outcome is a hit-or-miss strategy. In six of the twelve instances, stocks were in positive territory one month after the event.

Stock market drops concurrent with negative geopolitical events are often significant, as the low point in the chart above depicts, but the duration of the impact is impossible to know, and other influences and countervailing events can affect stock prices, too.

Also, the negative stock market impact of geopolitical events tends to be in line with normal stock market declines experienced in years that did not include a hostile geopolitical event.

Since 1980, the average intra-year stock market drop has been 14.2% (see the first chart in the previous section of this letter).

It is understandable if you are troubled by geopolitical risk and worry about how it might affect your investments. Recent events have been distressing, violent, and cause a strong emotional response for many of us.

However, from an investment perspective, remaining dispassionate is recommended. Sticking to your investment approach and your financial plan will serve you well in the long term.

-RK

The race to win the White House in November 2024 is now in full gear. For anyone who’s accustomed to reading the news, watching TV, or engaging with social media platforms, the font of information on this topic will overflow as we approach November.

At this point, the Presidential election seems to be headed toward a 2020 rematch. The outcome likely will be consequential in many areas, including for the tax and investment environment for individuals and businesses.

Recently, I had the opportunity to participate in a conference call hosted by Goldman Sachs, which featured a leader in the bank’s Office of Government Affairs.

Key takeaways on the current political situation ahead of the November elections:

• The race for the Republican nomination will continue if Nikki Haley wins a plurality of the votes in the New Hampshire primary on 1/23; otherwise the race is “pretty much over”
• In a Biden-Trump rematch, the third-party element is important; currently Robert F. Kennedy Jr, Jill Stein, and Cornell West cumulatively are polling in the mid-teens to low-twenties in the percentage of the popular vote
• Third party candidate support tends to pivot toward the established candidates as election day approaches
• In 2016, third-party candidates accounted for 3-6% of voters in battleground states; in 2020, support for third-party candidates collapsed to about 1.5% of the vote in battleground states
• Third-party voters who pivot have tended to favor Democrats, so if third-party support stays strong, Republicans will likely be the beneficiaries
• In the electoral college, Biden will start with 226 “highly likely” votes and Trump with 219, with 270 required to take office
• There are seven states in the “up for grabs” category: Arizona, Georgia, Michigan, Nevada, North Carolina, Pennsylvania, and Wisconsin
• In 2016, Trump won all seven of these swing states
• In 2020, Biden won 6 of the 7, losing only in North Carolina
• States which had the tightest margins in 2020 were Arizona, Georgia, and Wisconsin, where the cumulative margin of victory was 44,000 votes
• The House of Representatives is down to a 2-seat Republican majority due to recent departures
• Congressional districts are being redrawn in some areas as a result of court challenges from 2020-21, which will likely favor Democrats
• Three Senate seats in “super-red territory” are coming up for re-election which are currently held by Democrats: in Montana, Ohio, and West Virginia
• It seems possible that Democrats could win a majority of seats in the House, and probable that Republicans will win a majority of seats in the Senate
• With a Trump victory, a sweep of the House and Senate is possible, which would put Republicans in control of both houses of Congress and the Presidency
• With a Biden victory, divided government is the likely outcome
• Presidential election years typically correspond with weaker stock market returns

RK

Unlike other commodities, we are constantly reminded of the direction in which the price of oil is headed when we fill up our gas tanks (for those of us who are still driving combustion-engine automobiles). Higher oil prices have a direct effect on our personal budgets and can be a source of financial anxiety when the oil price climbs quickly.

The chart below illustrates the recent oil price climb – up more than 25% during the last three months, which has pushed the price of gas at the pump to well over $4.25 per gallon, for mid-grade fuel, in Massachusetts.

The recent oil price climb may be acting as an anxiety accelerant for some, so taking a closer look at oil market dynamics might help alleviate these concerns. The information presented below comes by way of Clearnomics, an economic research firm.

Rising energy prices are a direct burden on consumers and businesses who spend more on gasoline and other fuels, putting upward pressure on headline inflation. This also indirectly raises prices on all goods and services as production and transportation costs rise, potentially impacting core inflation.

Thus, higher oil prices effectively function as a tax which can slow economic growth and impact corporate profitability.

Why have oil prices risen in recent months?

First, the U.S. economy has been much steadier than expected. Weakness in oil prices earlier this year partly reflected fears around an imminent recession. The fact that a recession has not materialized has helped to propel oil prices higher.

Second, Saudi Arabia and Russia recently announced that oil production cuts of 1.3 million barrels per day would be extended until December. This amounts to 1.3% of global production – not an insignificant sum – and adds to previous cuts.

The two countries are among the largest in OPEC+ and have led other cuts in order to prop up oil prices, as well as in response to slower GDP growth and weakness in China. Some economists estimate that this could result in a global deficit of more than 1.5 million barrels per day in the fourth quarter of 2023.

It’s important to maintain perspective around these cuts. The relevance of OPEC as a price-setting cartel has declined over the past decade, partly because cuts by each country are voluntary and difficult to enforce, and because the U.S. has become the top producer of oil in the world.

U.S. oil production is nearly back to its pre-pandemic level of 13 million barrels per day. While there are many nuances in terms of the types of oil produced and consumed in the U.S., Europe, and elsewhere, the fact that the U.S. has been a “swing producer” has shifted the dynamics of the energy markets considerably.

Another tailwind for oil prices is declining oil inventories. For instance, the Strategic Petroleum Reserve (SPR), a large emergency supply of oil in the US, is at its lowest level since the mid-1980s.

This is primarily because oil was drawn from the SPR to offset high prices last year when gasoline was averaging more than $5 per gallon nationwide. The federal government would need to purchase 376 million barrels of oil to restore the SPR to its 2010 peak level. While there is no set timeline for doing so, this deficit naturally places upward pressure on oil prices.

So it seems like events are conspiring to keep the price of oil higher for longer. How worried should we be about higher oil prices?

According to David Kelly, Chief Global Strategist at JP Morgan Asset Management, “investors should probably not worry too much about the recent spike in oil.”

Kelly, who presents his research team’s findings frequently to the advisor community, contends that, barring some further shock, there should be limited upside to energy prices from here.

The main reason: signs of slower economic activity around the world, according to JP Morgan. The global composite purchasing managers index (calculated from regular surveys filled out by big businesses) hit its lowest level in seven months in August, with outright declines in manufacturing and a moderation in services growth.

Both China and Europe are seeing very sluggish growth, offsetting strength in India and Japan. And JP Morgan is expecting the pace of economic growth to slow in the US as we move into 2024. All of this should dampen the demand for oil and gas, as should longer-term investment in energy transition.

So for those among us who experience oil-related anxiety, taking a few deep breaths, and anticipating less acute pressure on oil-market dynamics in the months ahead, may help.

-RK

In my April letter, I discussed the turmoil in the banking sector resulting from risk management shortcomings that led to failures of several sizable US deposit-taking institutions.

I concluded with the following statement: “if summer arrives without additional failures, I’ll feel comfortable calling “all clear”. Summer has arrived, and I’ll stand by that “all clear” claim.

As part of their regulatory responsibilities, officials at the Federal Reserve conduct an annual stress test for the largest US banks, designed to evaluate the resiliency of the banking system under challenging economic conditions.

The process is similar to an exercise stress test for humans. The regulators’ treadmill for banks include the following assumptions:

• severe global recession
• US unemployment rate rising to 10%
• commercial real estate prices declining by 40%
• house prices declining by 38%

The bank stress test was developed after the global financial crisis and was first applied in 2011. The assumptions are severe. For some time after 2011, large lenders struggled to earn passing grades.

But good news: all twenty-three large US banks that were recently evaluated passed their stress tests. This means balance sheets remain strong enough for the banks to continue to lend to households and businesses for the duration of a downturn.

You can read the details of the test on the Federal Reserve’s website at: Dodd-Frank Act Stress Tests 2023.

Although this news is unlikely to translate to large stock price gains, it does indicate that the financial market plumbing is in good working order and that the bank problems from earlier this year likely have been contained.

RK

Congressional leaders came to an agreement in late May to suspend the debt ceiling until January 1, 2025 – removing the near-term risk of a US default and sparing the American people political wrangling on the issue for the next 18 months or so.

According to projections made by the Congressional Budget Office, the Fiscal Responsibility Act of 2023 reduces budget deficits by $1.5 trillion over the next 10 years, mainly by imposing caps on discretionary spending.

In terms of the Federal budget, roughly 1/3 is discretionary and funded though the annual appropriations process, where Congress must pass bills to provide money to carry out the programs.

The other two-thirds of the Federal budget comprises mandatory spending, such as Social Security, Medicare, and interest on the federal debt. Mandatory spending is ongoing and occurs each year absent a change in an underlying law that provides funding.

The debt ceiling deal does little to put our federal finances on a path of long-term sustainability, since the budget is far from balanced. But it does ensure our federal obligations will be met.

And thankfully a government-induced, calamitous outcome for the financial markets has been avoided.

RK

The debt clock is ticking louder.

The nonpartisan Congressional Budget Office recently revised its projections for federal revenues and expenses.

According to the CBO there is now “significantly greater risk that the Treasury will run out of funds in early June”.

Treasury Secretary Janet Yellen said on May 1 that the US government could become unable to pay its bills as soon as June 1 if Congress doesn’t raise the debt limit soon.

These new estimates set a shorter timeline than many experts previously had been forecasting.

House Republicans approved legislation last week that would raise the borrowing limit for about a year, but parts of the legislation are unpalatable to Democrats.

In other comments she’s made recently, Treasury Secretary Yellen is not mincing words: “A default on our debt would produce an economic and financial catastrophe. A default would raise the cost of borrowing into perpetuity.”

President Biden has called top lawmakers from both sides of the isle to the White House for a meeting on May 9 to try to forge an agreement for a debt limit increase.

The situation remains tenuous, with extremely high stakes. As investors, how should we think about this?

The bond fund manager PIMCO has a group of researchers dedicated to understanding how public policy impacts financial markets, and they recently shared their thinking on the debt ceiling.

Here are some takeaways on the debt ceiling issue from a recent PIMCO note:

• More than 70% of Americans support avoiding a default, even without spending cuts – according to a recent CBS News / YouGov poll
• Because popular sentiment supports raising the debt ceiling, default is not a political winner, and leadership on both sides of the aisle know this
• If past is prologue, a resolution will likely happen at the eleventh hour and only after some brinksmanship
• The average peak-to-trough performance of the S&P 500 in the month before a debt ceiling resolution over the past dozen years has been about -6.5%
• A debt ceiling deal is the most likely outcome

From my perspective, it is inadvisable to significantly alter long-term investment strategies designed to support long-term financial plans, in anticipation of political events, especially those that have a low likelihood of transpiring.

The key to managing through possible larger-than-normal stock and bond price swings is to hold enough in liquid reserves (cash and short-term investments like money markets and short-term bond funds) to meet your near-term cash needs.

RK

Turmoil in the banking sector persisted throughout April and continues into May.

As deposit flight persisted at First Republic Bank, the pressure on the bank’s financial situation proved untenable. During the last trading day of April, the bank’s stock price cratered.

Over the weekend, regulators seized First Republic, and after a short bidding process, sold the lender to JP Morgan before the markets opened on Monday, May 1.

Three of the four largest-ever U.S. bank failures have occurred in the past two months. First Republic, which had more than $250 billion in assets at the end of the first quarter, ranks just behind the 2008 collapse of Washington Mutual Inc. Rounding out the top four are Silicon Valley Bank and Signature Bank, both of which failed in March.

While the immediate crisis may be over for the largest US banks, trouble still seems to be bubbling for mid-sized and smaller regional lenders. Los Angeles-based PacWest Bancorp, which had over $40 billion in assets at year-end 2022, experienced a precipitous stock price drop in the past week and is said to be ‘exploring strategic options’.

Persistent problems in the financial sector can be a source of concern for everyone. For folks who’ve been saving and investing for a while, worry about a 2008 financial crisis re-run in 2023 is understandable.

Key points to keep in mind, and reasons to believe that the US financial system is on firmer footing today, are:

• The biggest US banks are better fortified compared to fifteen years ago, with significant liquidity and healthy balance sheets
• Regulatory and private sector action has helped contain damage through swift wind downs of troubled institutions
• Shareholders of the failed banks have borne losses
• Most importantly, depositors have been protected

For a more in-depth explanation of what’s going on in the financial sector, I found the most recent memo from Howard Marks, Lessons from Silicon Valley Bank, to be helpful.

Marks has been investing in the credit markets for decades and is a sort of ‘Warren Buffet of Bonds’. He believes that another widespread banking crisis, a-la-2008, is unlikely.

In addition to gaining a degree of reassurance from his analysis, I found Marks’ perspective on the psychology of what’s going on to be particularly insightful. He concludes his memo by saying:

“When psychology swings in the direction of hopelessness, it becomes reasonable to believe that bargain hunters and providers of capital (i.e., investors with a long-term perspective) will be holding the better cards and will have opportunities for better returns.”

RK

The turmoil from the mid-March banking crisis seems to have calmed down in early April.

To get a better understanding of what’s going on and how concerned we should be, it can be helpful to hear an insider’s point of view.

It just so happens that the nation’s preeminent banker, Jamie Dimon, at the country’s largest bank, JP Morgan, discussed the matter in his latest letter sent last week to shareholders.

I’ve found Dimon’s communications to be refreshingly plain-spoken for a big-deal financial person, and he has the respect of his peers, as he was Treasury Secretary Janet Yellen’s first call when problems surfaced in mid-March.

Here are key points on the current banking crisis from the JP Morgan Annual Report, penned by Dimon, that provide a degree of comfort that the March tempest is unlikely to be a precursor to a 2008-style tsunami:

• The current crisis was the result of regulatory shortcomings and risk-management failures at a handful of banks
• The most prominent risks were hiding in plain sight, including interest rate exposure and uninsured deposits
• The current crisis is not yet over, and there will be repercussions from it for years to come (tighter regulation likely will follow)
• However, recent events are nothing like what occurred in the 2008 global financial crisis (which barely affected smaller banks)
• Back then, the trigger was $1 trillion of consumer mortgages that went bad, held by many financial institutions, and included the accelerant of enormous leverage (excess debt)
• Today’s crisis involves far fewer players and fewer issues that need to be resolved

If you’re interested in hearing his take on the recent bank issues, you can watch Dimon’s CNN interview.

From my perspective, to be confident that a banking crises has been resolved, we typically need to see three conditions met:

1. Government support
2. Resolution of failed entities
3. Passage of time (with no additional failures)

We have seen significant government support through a new Federal Reserve lending program and the swift resolution of three of the failed entities – Silvergate Bank, Signature Bank, and Silicon Valley Bank. Also a large foreign bank, Credit Suisse, was taken over by its main competitor, UBS, following governmental intervention.

As for the third condition: if summer arrives without additional failures, I’ll feel comfortable calling “all clear”.

When well-laid plans didn’t come to fruition, Rooster Cogburn, a US Marshal and fictional character in the Western film True Grit, exclaimed: “Well, that didn’t pan out.”

A financial drama in the West of the US played out last week, where two California-based lenders that took big, mismatched bets got into hot water. Unfortunately, those situations didn’t pan out, either.

Silvergate Bank, a smaller bank catering to the crypto economy, was taken over on Thursday, March 9. Silicon Valley Bank, a much larger lender (19th in the US by asset size) was shut down on Friday, March 10.

The tremor in California was part of a fast-moving, system-wide quake.

Signature Bank, the 29th largest bank in the US was shut down on Sunday, March 12. And First Republic, the country’s 14th largest bank, got support from the Federal Reserve and from JP Morgan.

No other medium- or large-sized banks failed on Monday, March 13. Overall, the stock market remained relatively calm. But Treasury bond prices shot higher – what Wall Street people call “a flight to quality” – and bank stocks tumbled.

The table below (data from the Federal Reserve) presents the 30 largest lenders by asset size in the US as of December 31, 2022. Orange highlights show the banks that recently got into trouble.

Government Steps In

Following government actions on Sunday, March 12, a brief press conference was held Monday morning March 13 where President Biden emphasized the following:

1. Depositors will be protected
2. Investors will not be protected
3. No losses will be borne by taxpayers
4. The administration will order a full accounting of the situation
5. More regulation is likely to follow

When compared to the Global Financial Crisis of 2008, the current situation has significant differences.

First and foremost, this time government action has been swift, decisive and coordinated. In 2008, it took months for authorities to develop a plan and to act.

Second, the current problem emerged at deposit taking institutions, the issues are transparent, and depositors are being protected.

In 2008, the problems started with real estate lenders and migrated to brokers, and the issues were largely hidden from view or misrepresented for some time. When trouble finally hit retail deposit-taking institutions, the problem had grown so large that the entire financial system was at risk.

Third, investors who hold stocks and bonds of the troubled banks will not be supported, and management of failed companies will be shown the door.

In 2008, part of the ‘solution’ initially was to try to boost stock prices and work with incumbent management teams that had caused the problems.

What actions has the government taken to stem the current crisis?

After taking over Silicon Valley Bank and Signature Bank, the Federal Reserve designated them as systemic risks to the financial system, which gave the Feds authority to backstop uninsured depositors at both institutions. This means people and companies with bank accounts will be able to get their money back in a timely manner.

The Federal Reserve then introduced a new lending facility, called the Bank Term Funding Program, which allows banks to pledge certain assets, like US Treasury bonds, in exchange for loans of up to one year.

This new Fed-run lending facility allows commercially viable banks to avoid selling assets at a loss and helps banks get cash to meet their customers’ demands for their deposits.

Causes of the Crisis

In basic terms, the seeds of the recent bank failures were sown through rapid growth, concentrated customer bases, and shoddy risk management. If you can recall the bank run at Bailey Building and Loan in It’s a Wonderful Life, then you have a reasonable sense of what happened last week.

In the case of Silicon Valley Bank (SVB) and Signature Bank, though, Sam Wainwright wasn’t available to advance the billions of dollars needed to keep the institutions afloat.

SVB seems to be a victim of its own success. SVB developed a niche focus working with technology companies and individuals involved in the tech space. It claimed to have served a majority of US startups.

Following the pandemic, SVB grew like gangbusters, and plowed a lot of its deposits, which are short-term obligations, into relatively safe, but longer-term assets like US Treasuries. It bought Treasuries when interest rates were very low. As interest rates climbed in 2022, bond prices tumbled, and losses mounted for SVB.

When SVB sold a bunch of bonds and realized a large loss last week, customers took notice. When SVB tried to raise fresh capital through a stock offering, investors declined. As herd mentality took hold of the tech crowd that banked at SVB, many demanded their deposits all at once, and the gig was up for SVB.

In addition to customer concentration, SVB depositors tended to keep a lot of money at the bank. At a well-diversified bank, typically half of the deposits are covered by FDIC insurance – the $250,000 deposit guarantee.

In SVB’s case, more than 90% of deposits were above the limit, and therefore uninsured, which made the bank more vulnerable to a run. For Signature Bank, which had niches in the technology sector and the crypto space, nearly 100% of deposits were uninsured.

The debt ceiling is a cap on the total amount of money that the federal government is authorized to borrow. Congress last agreed to raise this cap to $31 trillion in late 2021.

Lifting the debt limit does not authorize any new spending, it simply allows the government to pay bills already incurred.

Some members of Congress are trying to tie an approval for an increase in the debt ceiling to an agreement for greater fiscal stringency.

In a letter to Congress on Thursday, January 19^th, Treasury Secretary Janet Yellen said that the US had reached its debt limit and has begun taking “extraordinary measures” to enable the government to stay current on its bills.

The special measures include suspending investments in government benefits plans, such as the Civil Service Retirement Fund.

The actual moment when the federal government can no longer meet its obligations on time is a function of the Treasury Department’s cash flow, which could change depending on things such as the receipt of tax payments.

Yellen estimates that the government could run out of money, and may have to declare default, sometime in June 2023.

The US has reached inflection points regarding the debt ceiling in the past. In 2011, Congress engaged in a contentious stand-off over spending and the debt that got close to a default situation.

The brinkmanship a decade ago had a negative impact on the financial markets and resulted in a downgrade of America’s credit rating by Standard & Poor’s, one of the main US credit rating agencies.

Last week, Speaker of the House Kevin McCarthy and President Joe Biden held a meeting focused on the debt ceiling issue. The tone following that meeting was constructive, with McCarthy saying “I think, at the end of the day, we can find common ground.”

Given that the government appears to have enough flexibility to stay current on its obligations until June, it’s likely that we’re just at the ‘beginning of the day’ on this issue.

Investors will probably have to suffer through more political posturing, and possibly brinkmanship similar to what occurred in 2011, before the situation is resolved.

The stakes in this political game of chicken are high: Yellen has said that a US debt default would “cause irreparable harm to the US economy, the livelihoods of all Americans, and global financial stability.”

My sense is that cooler heads will prevail in Washington and the US will avert the worst outcome. But if the impasse on the debt ceiling persists into spring and summer, it will become more problematic for financial markets, and more likely cause bouts of volatility and downside for investment portfolios.

RK