Members' Wealth Quarterly Update | Q1 2023

As we entered 2023, we at Members’ Wealth were cautiously optimistic and sought to position investors to capitalize on the opportunities that lie ahead. If you recall, higher yields had us excited about the potential returns in cash and fixed income. At the same time, we were being mindful of taking on too much risk (“cautiously optimistic”) in the equity markets for a couple of reasons. First, with the newfound yield in bonds, there was an increasingly attractive alternative to equities, so the need to stretch for return from equities, which are historically riskier, was diminished. Secondly, rates were being moved up aggressively by the Federal Reserve (the Fed) while at the same time, they were shrinking the federal balance sheet, otherwise known as quantitative tightening. The pace of the rate increases along with the simultaneous decline in the size of the balance sheet had never been done before. Therefore, we watched carefully to see what the impact would be.

At first, continued tightening seemed to be working, as the first quarter started out nicely for equity markets, the job market remained strong, and the economy continued to advance. But not so fast…by mid-quarter the continued tightening environment eventually caught up with some of the most at-risk companies, notably some specific banks, and the rise in equity markets quickly abated.

Bailouts, Buyouts, and New Funding Facilities

On the heels of the Fed’s moves noted above, we found ourselves in the middle of a banking crisis (one that we are hoping is a “mini” crisis). Following a period of the Fed being too accommodative for too long, the Fed focused on a rapid tightening phase to squash inflation but may have fallen short in keeping a close enough eye on lagging inflation indicators. A resulting yield curve inversion[i] eventually became too much for some bank balance sheets. That, combined with depositor panic and heightened withdrawals, led to the semblance of a banking “crisis”, which we have not seen in 15 years.

Seeing banks in crisis can quickly bring investors’ thoughts back to 2008. However, we want to bring clarity and focus to what we think are the major differences between now and 2008:

• The 2023 ‘crisis’ does not appear to be as severe as in 2008.
  • 2023 leans more towards a liquidity crisis, meaning bank balance sheets are comprised of good, easy-to-value, easy-to-sell investments such as high-quality US government securities that are currently priced lower than expected
  • 2008 was a credit crisis, meaning bank balance sheets were comprised of truly bad investments marked by complex hard to value securities that were nearly impossible to trade, and often dubious in nature
• Much like the policy playbook back in 2008, the FDIC and the Fed stepped in to restore trust and order to the banking system through:
  • Bailouts: The FDIC and Fed stepped in and guaranteed all the deposits of the most troubled banks (Essentially, in our opinion, backing all bank deposits without explicitly saying so).
  • Buyouts: Efforts were also made to line up suiters for acquisitions of the most challenged banks.
  • New Funding Facilities: In addition, thanks to newly established funding facilities from the Fed, banks can borrow cash from the Fed and lend assets to the Fed at par value

(even though they are priced underwater), effectively turning investments to cash without impacting the bank balance sheet.

• One key difference to note between the response from 2008 to 2023 was how quickly regulators stepped in to stem any potential for contagion at all costs. And now many are calling for backstops by the regulators for all deposits while the risks sort themselves out.

The above-mentioned response to the 2023 crisis has resulted in a reversal of the quantitative tightening that we were previously seeing, since, to make all of this happen, the Fed’s balance sheet had to expand. Fear generally causes a rush to safety which tends to bid up the prices of safe assets (ie: Treasury Bonds) resulting in interest rates dropping across the curve[ii]. These are both easing measures and in effect, both pushed liquidity back into the system.

Interestingly, the Fed ended the quarter with a rate increase on March 22^nd which seems to point to countervailing monetary policy methods. Easing for contagion by providing liquidity to stem the bank crisis while tightening by raising rates to slow inflation and the hotter-than-expected economy and job market. Seems like a recipe for choppiness and uncertainty ahead for the markets. Hopefully, the end of March will usher in nicer weather and usher out the “mini” banking crisis.

What does this mean for you? Risk and Opportunity!

Discussing the differences between now and 2008 is essential in evaluating where we stand today, but equally as important is highlighting the potential opportunities and risks our clients now face.

At this point, the consensus is this mini-crisis is isolated to certain banks that had too much client concentration in a particular sector and/or had too large a percentage of uninsured deposits. However, the larger banks and the banking industry in general, while seeing stock price declines, do not seem to have compromised their overall corporate structures. Banks are in relatively strong financial positions if you look at measurements such as capital requirements, cash reserves, and profitability.

It should also be noted that historically, stress in the banking sector is not an unusual occurrence at the end of Fed tightening cycles as we have seen recently. Thus, while we will continue to monitor the situation closely on your behalf and adjust portfolios accordingly, we think it is best to look beyond the current environment toward potential opportunities.

Investment Opportunities and Risk by Major Asset Class

Cash – Yields continued their climb

There is no doubt that cash yields are nothing short of awesome right now. In fact, we are starting to hear investors get as excited about cash yields as they were about bitcoin, growth stocks, etc. Sentiments such as, “no one has ever lost money holding cash”; “I have no risk with cash” and “why would I buy a 2, 5, 10-year bond with a lower yield when I can just hold it in higher yielding, risk-free cash” are starting to surface.

Perhaps because we are risk managers, we get nervous when others see no risk. Thus, we must continue to warn investors of the risk of cash:

• It has a deleterious effect on cash over time
• Reinvestment risk for cash proceeds. Meaning that you may be unable to reinvest the cash at a rate comparable to your current rate of return if yields suddenly drop. The recent “mini” banking crisis and the biggest ever one-week drop in the 2-year Treasury yield was a reminder and warning sign about how fast the yield environment can change
• Opportunity cost. The reluctance to part with a “risk-free” asset like cash for a better risk-adjusted, higher-returning investment can have investors forgo long-term compounding opportunities

So, while you can enjoy the yield on your parked cash for now, let’s keep looking for better investment opportunities as well. There is no time for complacency.

Ok, enough chatter about the risk of cash. We agree with the excited sentiment (in moderation) and love the yields while they last.

High-Quality Bonds – Stinking Mini Banking Crisis

Just as we began celebrating the higher yield environment for Treasuries, High-Quality Corporate Bonds, and Municipal Bonds, a flight to a quality trading environment (thanks to the mini-banking crisis) sent investors rapidly into the safety of bonds. This in turn drove up prices and wiped out some of that attractive yield we were enjoying not even 90 days ago. Dropping yields gave bondholders some near-term appreciation in the price of their current bond holdings but simultaneously increased their reinvestment risk. Coupon payments, maturing bonds, and any new cash to invest are all having to be invested at lower yields than we were seeing a few weeks ago. But let us keep it in perspective, yields, while lower than earlier this year, are still some of the most attractive we have seen in over a decade. Thus, we still see an opportunity in high-quality bonds as a diversifier to the reinvestment risk investors face in cash with less volatility than equity investors must endure.

High Yield Bonds – Time not timing

High Yield bonds, also known as “junk” bonds, are often thought of as investments that should be timed. Meaning, be in when the opportunity is good and be out when the opportunity is bad. It’s interesting to us that many investors think they can time high-yield bonds but do not think they can time the equity markets. Perhaps we are naïve in our thinking that timing is difficult to impossible in all asset classes.

Many investors, our younger less experienced selves included, have a belief that the best time to invest in high-yield bonds is when yield spreads, relative to treasuries, are wide and subsequently best to sell when spreads are no longer wide and are considered tight. Nevertheless, we can surely see how one can expect higher returns when spreads are wide, and the asset class is considered inexpensive. But remember, it is not all sunshine and rainbows. High-yield investing is essentially lending money to lower-quality companies, therefore, increasing your risk of losing money.

So why even consider high-yield bonds:

• High-yield bonds have low correlation to high-quality fixed income (Treasuries, High-Quality Corporate Bonds, and Municipal Bonds) (See table 1)
• Different risk profile than equities. The return per unit of risk on high-yield bonds, as measured by the Sharpe Ratio[iii], is higher than with equities (See table 2)
• Higher Yield. In case that one was not glaringly obvious given the name

In conclusion, we believe it is best for investors to take a more strategic approach toward this asset class utilizing the guidance of skilled investment professionals who perform ample due diligence and take a conservative approach to the asset class.

Alternatives – a varied bunch

At Members’ Wealth, we use the term alternatives as a catch-all phrase for strategies that fall outside of traditional asset classes such as cash, stocks, and bonds.

While each of the traditional asset classes may be included in an alternative investment, the approach to their utilization can vary significantly from their traditional utilization (i.e. equity market neutral, convertible bond arbitrage, etc.). Alternatives also utilize non-traditional asset classes such as commodities and real estate etc. Given the immensity and heterogeneity of the alternative landscape, we prefer to narrow our focus by highlighting a particular opportunity in the alternative realm each quarter.

This quarter’s alternative spotlight focuses on Commercial Real Estate:

• Risk: The commercial real estate market has faced significant trouble following the COVID-19 pandemic. The widespread closure of businesses, the trend toward increased remote work, and overall economic uncertainty have led to or accelerated an already decreasing demand for commercial spaces which includes office buildings, retail spaces, and hospitality venues.
• Opportunity: Other sectors in commercial real estate such as multi-family properties, distressed properties that can be repositioned, and industrial, logistics, warehouse, and distribution centers may offer less risky opportunities. It is our sense that commercial real estate may be an area ripe for allocating to experienced investors, repositioning, and disciplined investing.

There are several ways to consider investing in alternatives, but it is not for everyone. If you are interested in learning more, we would be happy to discuss the opportunities more in-depth as well as if it would be an appropriate investment for your portfolio.

Equities – Not the only game in town anymore

Once the sting of the 2008 financial crisis started to fade, the cult of equity as the only way to invest grew stronger and stronger. In our opinion, it is still pervasive in the investor psyche. Old habits are hard to break.

Not surprisingly, after years of low-interest rates, even traditional non-equity investors were dragged “kicking and screaming” to the equity markets in search of return. They uncomfortably stayed there from 2010-2020. Now that rates have gone up, these investors seem to be leaving the equity markets to rest peacefully in bank CDs, money markets, annuities, US treasuries, and other traditionally safer investments. Who knows, they may never come back.

On the other hand, the long-term equity investor remains loyal to equities. During that same decade of 2010-2020 what the world witnessed was an increase in the average equity allocation in investor portfolios. As an example, an investor prior to this time period may have held an average of 60% in equities, but by the end of the decade, the equity allocation average was higher, say 70% (due to both appreciation and lack of other suitable investment opportunities). Long-term equity investors will continue to stick with an equity allocation, but perhaps, just not as much. They seem to be slowly but surely winding down that extra marginal 10% “overweight” to equities as they refamiliarize themselves with actual yields in fixed-income investments.

We had a running joke at our old firm, when someone asked, “Why was the market up today?” We would simply say, “well there were more buyers than sellers.” Not an incorrect answer but also not what the inquisitive client was looking for.

Turning this to today, we are of the mindset that a large portion of the marginal buyers of equities, including both the kickers and screamers as well as the over-allocators, have pulled back on equities and will not be returning any time soon. As a result, a supply/demand rebalance has occurred. Same supply of equities, less demand, thus lower prices. In our opinion, this is a good thing for the equity markets in terms of identifying well-priced opportunities for the discerning equity investor. It’s probably not a good thing for those waiting for the equity markets to come roaring back to the market high that was set approximately 15 months ago. Yes, you read that right – it has now been 15 months since the stock market, as measured by the S&P 500, hit its all-time high. Carefully selected equity investments are still good long-term investments, but for now, are no longer the only game in town.

Tax and Estate

Retirement account contribution deadlines - Clients can make prior year (2022) contributions for Traditional, Roth, SEP, and Simple IRAs up until the tax filing deadline of April 18^th, 2023. For SEP and Simple IRAs, you have up until the due date of your business’s income tax return for the year, including extensions (See table 3).

According to the recently published Wall Street Journal Tax Guide 2023[i], the IRS has recently had a healthy shot in the arm in the form of increased revenue for a multi-year strategic plan to improve customer service with more representatives answering the phone and more staff at in-person taxpayer assistance centers. You can thank the Inflation Reduction Act. There is also a shift to more online services which allows people to respond to IRS Notice Letters through personalized accounts in place of mailed responses.

Filing tax returns electronically will result in quicker processing and issuing of tax refunds versus paper filings. The scanning process at the IRS is not fully up and running to digitalize paper filings.

While all that is good news, IRS enforcement is also expanding to conduct increased audits with a focus on high-income households, large corporations, and partnerships and to collect unpaid taxes. They are focused on closing the gap between taxes owed and taxes collected.

The process will not be quick since hiring and training accounting specialists will take time and resources. But change is coming, so make sure to cross your t’s and dot your i’s.

Eyes Forward

2023 has started off better than most had expected with both equity and bond markets positive for the first quarter. However, one quarter does not make a year. Thus, we will continue to move forward, like always, with one eye on risk and the other on opportunity and with both eyes focused on helping you accomplish your goals.

Thank you for your continued support and we look forward to seeing you at your next review meeting.

Thank you,

Your Members’ Wealth Team

Dane Czaplicki, CFA   |  Colleen Mahoney
Tim Thomas  |  Marie Feindt, J.D.

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CS Planning Corp., doing business as, Members’ Wealth LLC provides investment advisory, wealth management, and other services to individuals, families, and institutional clients. Advisory services are offered through CS Planning Corp., an SEC registered investment advisor. Members’ Wealth does not provide legal, accounting or tax advice. Please consult your tax or legal advisors before taking any action that may have tax consequences.

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Footnotes

[i] In finance, an inverted yield curve happens when a yield curve graph of (typically) government bonds inverts and the shorter-term bonds are offering a higher yield than the long-term bonds.

[ii] What is the relationship between interest rates and bond prices? It is a negative relationship, as bond prices go up, interest rates go down. Bond prices are more sensitive to decrease in interest rates than increases in interest rates.

[iii] The Sharpe ratio compares the return of an investment with its risk.

[iv] ICE BofA US High Yield Index - The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market. One cannot invest directly in an index.

[v} S&P 500 - The Standard and Poor's 500, or simply the S&P 500,[5] is a stock market index tracking the stock performance of 500 largest companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. The S&P 500 index is a free-float weighted/capitalization-weighted index.

[vi] The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market

[vii] Saunders, L., Rubin, R., and Ebeling, A. “WSJ Tax Guide 2023”. The Wall Street Journal, February 2023. https://s.wsj.net/public/resources/documents/Tax_Guide_2023.pdf.

Advisory services are offered through CS Planning Corp., an SEC registered investment advisor.