Weekly CEF Commentary | March 19, 2023
Weekly CEF Commentary | March 19, 2023
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Macro Picture
Stocks were mixed on the week despite withstanding several bouts of volatility with the S&P up 1.4% but the Dow down slightly. The Nasdaq was moderately higher at +4.4%. YTD, the S&P sits at +2.5% but the Nasdaq is up +11.4%. The VIX continues to move higher reaching 24.6 from 23.5 last Friday.
The big news on the week was the risk of contagion from the banking sector. A group of 11 of the largest US banks- after some prodding from the US government and their guarantees- organized a rescue plan for First Republic Bank. Under the plan, the group will deposit $30 billion with First Republic for an initial period of 120 days.
After Thursday’s close, First Republic’s board of directors announced it had suspended the dividend on its common stock. It didn't stabilize the stock, however, as it fell another ~18% on the week.
The other larger headline was European banking giant Credit Suisse (CS) was also experiencing problems. CS is a much larger bank relative to Silicon Valley or First Republic. The Swiss National Bank stepped in with an infusion of capital of $54B.
The Labor Department reported that headline consumer inflation had moderated in February in line with expectations to 6.0% on a year-over-year basis, its slowest pace since September 2021. Thursday brought surprise news that producer prices had declined 0.1%, due in part to a sharp decrease in transport and warehousing costs.
Interest rates continue to tell lots of stories. A flight to safety has been occurring which has- once again- included buying treasuries. Remember, for most of 2022 a flight to safety was not towards treasuries but the dollar (and to a much lesser extent, gold).
The 10- yr hit as low as 3.37% on Thursday, the lowest since late January. The 2-yr continues to show a fed pivot with the yield on the note falling- at one point- nearly 100 bps. It ended the week at 4.14% after cresting at 5.07% last month.
I loved this quote from JP Morgan:
“Everything everywhere…”, “When the tide goes out,” etc., etc. Everyone seems to have their favorite idiom to describe what’s been happening in markets this past week. In reintroducing the Crisis Watch title, our preference was to reference a set of children’s books. All this aside, there seems to be a degree of unanimity that central banks are somehow culpable and that we’re at a point where the past year’s tightening is now “breaking” things. Maybe, but maybe not. We think poor decisions are at least as strong a correlating factor between Silicon Valley Bank’s demise and the ongoing travails at Credit Suisse than is the interest rate cycle. What we will acknowledge, however, is that liquidity can only paper over some cracks for a while, but not forever, and there’s no doubt that tighter financial conditions amplify downside risk when bad decision-making becomes clear for all to see.
Current market expectations are changing rapidly. Obviously, nothing is set in stone and can change back quick but we now have rates priced in for June of this year. Terminal rate expectations are down to 4.88%, which is where we will be if the Fed hikes by 25bp next week. By year's end, Fed funds is predicted to be back below 4% (-100bps) and below 3% by the end of 2024 (-200bps).
I would not expect that Fed pivot to happen- unless we have a more widespread and sustained banking crisis. Right now, it appears that this is being driven by customer behavior. This is markedly different from 2008 when it was driven by poor credit decisions.
The sucking sound of deposits from small banks to large will likely not stop, especially at banks with a large percentage of uninsured deposits. Depositors are waking up to the fact that FDIC insurance only covers the first $250K in the account and moving their money accordingly.
They are also realizing that their Schwab, Fidelity, TD, E-Trade, IB, etc. accounts are covered by SIPC (except in the case of pure cash in some instances). Thus, they are moving checking and savings accounts to a brokerage account and investing in money market funds.
One only has to look at the Services measures of CPI to know that the Fed is unlikely to pivot anytime soon.
Shelter inflation lingers as a powerful updraft to the monthly numbers, and in February, rent of primary residence rose 0.8% m/m. High frequency data point to a deceleration, but it has yet to materialize. Still, the Fed has specifically focused on core services less shelter (about 25% of consumer spending), an area theoretically sensitive to higher wages. In February, this sub-series also moved in the wrong direction, posting a 0.4% m/m gain (0.6% m/m when medical insurance was excluded).
Some Links To Read:
CEF Market Review
Discounts blew out last week as retail investors shunned risk and increased cash positions amid a flight to safety. Taxable bond discounts are wider by 1.8% (a two standard deviation move). Muni discounts hit double-digits, an area they haven't been in since late 2018 (and even then they were there barely a month). Equity discounts are also getting cheaper... finally!
We have been railing against taxable CEF discounts for some time and we are finally seeing some traction in that regard. But now we are seeing credit spreads start to widen as well. That's a sign that we could be approaching a better time to invest in taxable CEFs.
NAVs were all over the place with preferreds falling almost -10%. Real estate, MLPs, and dividend equity NAVs were down significantly.
Conversely, government and muni strategies were up on the week as rates fell back on recession/ banking sector fears.
Coincidentally, preferreds becomes more expensive on the week with the average preferred CEF seeing the discount close by over 2.2%. EM Income, convertibles, senior loans and real estate saw discounts widen fairly significantly, ranging from -2.7% to -4.2% for the week.
US equity CEFs are now the richest CEF sector at +0.31 (which isn't that rich at all). Preferreds and MLPs are also in the positive side of z-scores but again, just barely so not expensive at all.
Real estate, loans, and equity sectors are the cheapest at the moment.
We saw the Core work the way it is supposed to work last week as defensive/ durable and indestructible assets offset breakable asset weakness.
High yield and senior loans got clobbered on the week as investors moved towards safety. High yield spreads nearly hit 5% despite being sub-4% on March 7th.
Loans are also getting hit as the terminal rate breaks lower- though it has been bouncing around the last several days between 4.6% and 5.0%. Leverage loan prices took a high last week falling nearly -1.5%. The LSTA US Leveraged Loan Price Index fell to $92.83, from almost $95 two weeks ago.
A flight to quality could continue.
Commentary
I still believe a recession is coming and it makes sense to have decent cash levels available along with very durable assets. Right now I have about 25% in cash and cash equivalents and another 6-7% in treasuries of intermediate or long-term maturities.
The Clearbridge recession dashboard is nearly all red- and it would be unprecedented for it to show these data points and a recession not come. Just the job market and truck shipments remain the only factors that haven't turned yet.
That said, remember we don't make large, binary calls. In other words, we are not ALL IN or ALL OUT of markets. We do make adjustments based on a risk-return model framework allocating to bond sectors where we see the most amount of upside for the least amount of risk.
Right now, high yield is the worst of those models. We would want to own high yield later this year when spread (we think) widen out materially from here. Once the high yield master index (FRED DATABASE) widens out to at least 600 bps, and preferably 700 or 800 bps, we would want to buy in materially.
So, keep defensive but don't go to all cash or anything massive like that. If the banking system cools down and thinks normalize, at least for a time, riskier assets could zoon.
PIMCO released their monthly UNII update.
Coverage levels improved like we thought that they would given the rebound in the dollar.
Valuations have improved on the PIMCO funds which was our largest concern last month when investors were freaking out about the low coverage ratios.
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Statistics
Sector:
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