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Q4 2022 Market Commentary

January 27, 2023

Don’t Fight the Ebb Tide

As the Federal Reserve has continued to raise interest rates in line with its commitment to fight inflation, the tightening of monetary policy and the draining of liquidity from the financial system has revealed some unsavory acts, notably in cryptocurrencies and particularly regarding so-called crypto exchanges. Recently, some of the biggest headlines in crypto have centered around FTX, a well-known crypto exchange with a very public leader. The alleged nefarious acts include client funds being funneled to a related FTX entity, without permission or disclosure to the owners of the funds. These client funds were then used to fund various ventures and acquisitions within crypto while the financial system was awash in liquidity.

As Warren Buffett might say now, the monetary tide is now heading out. As both stock and bond markets have suffered double-digit negative returns in 2022, many FTX clients were looking to make withdrawals, which revealed billions in missing customer funds. It is our sense that there may be other crypto exchanges that have been engaged in similar illicit acts. And it’s not too farfetched to think that they may meet a similar fate as FTX and its clients. From where we sit, we think it is only a matter of time before other similar cases are revealed.

Some of the financial media have proclaimed the collapse of FTX as a “Lehman Moment” in cryptocurrencies. That is a cute comparison and a nice try. Putting firm assets and size aside, we don’t view FTX as a Lehman moment at all. To us, perhaps it’s more of a Bear Stearns moment.

To explain: You may recall that Lehman Brothers failed in mid-September of 2008. Over the course of that weekend, the independent investment banking model ceased to exist. Both Goldman Sachs and Morgan Stanley turned themselves into commercial banks, which allowed them to access the discount window at the Fed; Merrill Lynch was bought by Bank of America; and Lehman Brothers – which was without a potential buyer – filed for bankruptcy. What often gets left out was the collapse of the other independent investment bank, Bear Stearns, which was the first to go away in March of 2008 – a full six months before Lehman. Like Bear Stearns, FTX could be the first ripple in a wave of failures in crypto. Stay tuned.

Brinkmanship: Bond Market vs. the Fed

“Brinkmanship: the art or practice of pushing a dangerous situation or confrontation to the limit of safety especially to force a desired outcome” –

During much of the current monetary tightening campaign, the Fed’s communicated expectations regarding interest rate increases has not matched the bond market’s expectations of what the Fed is going to do. Now that it appears the tightening cycle is nearing a pause, the question becomes how long the Fed will keep rates at its estimated terminal 5% level. This is visually represented in the chart below. As you can see, the bond market currently expects the Fed to be a full 50 basis points, or one half of one percent, below what the Fed is saying the Fed Funds rate will be by the end of 2023 (5.10 vs 4.59).

So why are we bringing up this difference? Historically, the bond market has led the Fed. Said another way, the Fed’s actions tend to converge on where the bond market expects the Fed to be. The difference this time seems to be that the Fed is steadfast and consistent in its communications that rates are headed to approximately 5% and will stay there, as they put it, “for a considerable period of time.” And with respect to inflation, the Fed’s communications have been, “We will keep at it until the job is done.” The question now becomes: who are we to believe? The Fed or the bond market?

To answer this, we need to understand how we arrived at the current situation. Back when inflation was emerging as a key macroeconomic indicator in 2021, it was to be transitory. It was not. Inflation was born from the policies that the Fed put in place to rescue the economy from the pandemic but left in place for too long. The Fed’s credibility is on the line – it cannot afford to be wrong twice about inflation. Therefore, the Fed needs to be believed that will get rates to approximately 5% and hold them there. Unfortunately, the Fed’s planned path may cause a recession of unknown depth and increased unemployment. Furthermore, companies’ earnings expectations may need to be lowered to reflect slowing economic growth and reduced employment. The bond market is signaling in a classic way that a recession is a risk worth watching as shorter maturities are yielding more than longer ones, otherwise known as an inverted yield curve. The most inverted curve since the early 1980s. Keep this in mind as the Fed looks to continue to raise rates in 2023.

Perhaps now, more than ever, paying attention to company fundamentals is key. Measures of profitability and valuation as they relate to a company’s future earnings, and the durability of that stream of cash flows, might again prove to be important ways to construct an equity portfolio in 2023.