Social Security Beneficiaries - It’s Time For a Raise!

It’s that time of year again when retirees are alerted to whether they’re getting a boost in compensation. That right, it’s “cost of living adjustment” (COLA) time for Social Security and Supplemental Security Income payments. Each year the U.S. government assesses the level of inflation and makes a corresponding adjustment to monthly payments for the upcoming year. The intent is for this benefit to not lose ground to inflation such that the “real” (i.e., inflation-adjusted) benefits are the same. The increase in payments from 2024 to 2025 will be 2.5%. 

The level of COLA adjustments has substantial economic effects. At this point, with a growing number of “baby boomers” receiving benefits, there are now greater than 68 million Americans receiving benefits totaling $1.5 trillion per year. As we all know by now, inflation has been rampant in recent years such that adjustments have been abnormally high (see table below). 

So, as we look at the last five years, one’s payment in 2025 will be over 22% higher than it was in 2019. While that may seem like a lot, whether one feels better or worse off largely depends on spending habits and other sources of income. For example, the Social Security Administration (“SSA”) reports that 30% of the average retiree’s income comes from Social Security benefits with 70% coming from other sources. 

It’s notable that the benefit adjustment is based on inflation calculations that incorporate the entire U.S. population. A federal law (the Social Security Act) specifies a formula for determining each COLA. According to the formula, COLAs are based on increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). So, it may not be perfectly appropriate for retirees who tend to spend money on a different basket of goods and services than the average citizen. In our observation, retirees tend to spend more on services (e.g., medical care, senior housing, travel, etc.) which have seen inflation rates that exceed the levels in the table above.

One can’t finish a commentary about Social Security without mentioning the growing strain on the current system. According to the SSA, the number of Americans 65 and older is projected to increase from about 61 million in 2023 to about 77 million by 2035. Presently, benefits are paid from two Trust funds managed by the Department of Treasury. These asset reserves were intended to perpetually cover the cost of the program, but current estimates indicate that the reserves will be depleted by 2035. While this sounds alarming, most experts predict that the depletion of the Trust assets will not end Social Security but, rather, will simply put additional pressure on the Federal budget deficit and force tough conversations about spending. That conversation is for another day but clearly the U.S. Government has some difficult spending decisions coming up in the not-too-distant future. 

2024 3rd Quarter Market Commentary

Top Headline for Q3: Let the cutting begin!

As was widely expected, the Federal Reserve Bank (the “Fed”) cut its benchmark interest rate during Q3 by 50 basis points. This cut marked the first downward adjustment since rates were lowered during the COVID crisis (1Q 2020) and will provide some much-needed relief to any individuals or businesses carrying variable-rate debt. This rate adjustment has significant implications across equity and bond markets as was observed in the large price movements during the quarter. For example, certain interest-rate-sensitive sectors soared during the quarter with publicly traded REITs (XLRE) up 17.1% and Utilities (XLU) up 19.4% during the quarter. Moreover, as the overall “yield curve” shifted down to reflect new expectations, medium to long-term corporate and treasury bonds rallied and were generally up 5-10%, depending on duration. 

General Market Update

US Equities:  The S&P 500 Index rose 5.5% during the quarter while the equal-weight S&P 500 Index (RSP) was up 9.5%. This disconnect is a signal of both a cooling of the red-hot technology sector along with a rally by most everything else, as the equal-weight version is more diversified across sectors and not so top heavy with technology. The technology sector (XLK) finished the quarter slightly down while REITs (XLRE), Utilities (XLU), Industrials (XLI), Financials (XLF) and Consumer Discretionary (XLY) all finished with double digit returns for the quarter. The technology-heavy Nasdaq Composite was up 2.6% while the small company Russell 2000 Index, which benefited heavily from a financial sector rebound, was up 8.9%. 

International and Emerging Market Equities:  International equity markets started to heat up as central banks around the world began, or continued, interest rate reductions. Both the Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, and the Schwab Emerging Markets ETF (SCHE) were up nearly double digits during the quarter. The biggest news on the international front was related to China’s central bank stimulus package which ignited a massive rally in its stock market – up over 25% in under two weeks to close the quarter. The strong performance of China is significant, as it is the largest country allocation within most emerging market ETFs, including SCHE.

Fixed Income and Credit: The fixed-income markets, as would be expected, cheered the rate reduction and rallied during that quarter. Despite a rough first half, most bonds, regardless of duration, are now moderately positive for the year. Inflation continues to improve which led to further reductions in the “long end” of the curve with the 10-year U.S. Treasury yield falling from 4.5% to around 3.8% during the quarter. It seems that investing in the credit market may prove to be more challenging from here. We all enjoyed high rates on our money market accounts and shorter-term bonds, but that opportunity is fading. Moreover, with a 10-year yield at 3.6% and inflation still running at 2.5-3%, it’s hard to get excited about longer-term bonds, and thus we remain overweight in short and medium duration.    

Pro-Inflation Investments: The “inflation narrative” seems to finally be taking hold as assets flow into pro-inflation investments. For example, industrial metals (as measured by the ETF DBB) is up over 15% on the year, and gold (GLD) is now up nearly 30%. Neither U.S. presidential candidate has made any indication that balancing a budget is a priority. As such, investors will likely continue to benefit from having some inflation hedging in portfolios. It’s noteworthy that inflation has fallen materially, but it is not yet at the Fed’s “target” level of 2%. It will be interesting to see if that level is attainable in an environment with such large budget deficits. 

A Look Ahead

Well, the big event for Q4 is the U.S. presidential election in early November. Looking back over the last 100 years, the S&P 500 Index tends to exhibit significant volatility leading into and following elections. This volatility occurs because (1) the market generally does not like uncertainty, and (2) the market shifts rapidly as the policies of the various candidates become clearer.

We also see the potential for significant volatility in bond portfolios. As mentioned above, the 3.6% yield on the U.S. 10-Year Treasury bond presents the potential for volatility. For example, any reversal of the inflation progress would likely send yields sharply up and bond prices down. The risk of inflation is, in fact, the key risk that the Fed will be seeking to avoid as they continue to lower rates. The path of rates also will have significant impacts on all bond portfolios. If the Fed accelerates or decelerates from market “expectations,” we will experience volatility as prices attempt to quickly adjust.

Overall, it seems that volatility lies ahead. In general, active portfolio management benefits from periods of uncertainty, for it presents opportunities to adjust and rebalance portfolios.  This strategy has been effective at both improving returns and lowering portfolio volatility over time. We look forward to the opportunity ahead.

Adding a Financial Advisor to Your Life Transition Team

Life throws a lot at us. We all have daily stressors, but sometimes we face life-altering experiences. This is certainly true in the case of chronic illness, the death of a spouse, or divorce. In each of these cases, in addition to the mental and physical strain, there are financial decisions to be made. Often times, there is very little time to make these important decisions. The strain from these situations is often compounded by the fact that the individual needing to make a financial decision was not the one that generally handled these kinds of questions prior to the crisis. In this instance, a financial adviser can certainly help ease some of the burden. In this article, we’ll look at how, and when, to get an adviser involved.

In the case of divorce, it is quite common that only one person in the marriage handled most of the financial decisions. This presents a unique challenge for the other individual both during and following the divorce. Though most people think to hire a lawyer, we would also recommend bringing a financial adviser into the discussion to be part of the transition team. Patina has experience working with divorced clients and we’re happy to help navigate through this challenging time. Financial advisors can complement the value that lawyers bring regarding the overall financial picture and next steps. For example, during and after the divorce, here are a few questions that often arise that we may be able to assist with. 

• What is my monthly spending budget? 

• Should I sell the current investments?

• What investments do I need?

• Does it make sense to liquidate insurance policies?

• Would it be better to sell rental property or continue renting?

• What retirement savings options exist for me after the divorce?

In the case of chronic illness or the death of a spouse, ideally, an adviser was involved at some point to assist in obtaining life insurance or extended care insurance on the individual. In this case, a payment should be forthcoming. However, it’s not always that simple. In the case of long-term care insurance, clients often have benefits through their life insurance policies that they were not aware of. Moreover, life insurance payments often have options to be paid as a lump sum or potentially paid out over time. These decisions can have a lasting effect on one’s financial future. As such, we would recommend that you get an adviser involved early to assist. Beyond insurance considerations, below are some key questions that an adviser can answer either directly or through an expert referral.

• What insurance policies exist and what are the payout options?

• How do any payments affect the financial plan/budget of the family?

• What documents need updating (e.g., wills, trusts, etc.)?

• How should the event change health/life insurance coverages?

• What benefits are available through Social Security?

 While we hope that you manage to avoid many of life’s challenges, it’s good to have a plan for when a crisis arises. We would be honored to be part of that plan and we’re here to help if you need us.

2024 2nd Quarter Market Commentary

Top Headline for Q2: Nvidia to the Moon!

The 2nd quarter of 2024 saw continued momentum in large cap technology – driven in large part by Nvidia. Nvidia has become the greatest beneficiary of the “Artificial Intelligence” craze as their stock has soared nearly 150% since the start of the year, lifting it to a whopping $3 trillion market cap. Nvidia is not the only winner of the AI enthusiasm, as the semiconductor industry (as measured by the ETF SMH) rose 15.9% for the quarter.

What’s particularly noteworthy about the current surge in the U.S. equity market is that the gains have been driven by a relatively small number of technology stocks. For example, while the cap-weighted S&P 500 Index was up 3.92% for the quarter, the equal-weighted S&P 500 (i.e., the ETF RSP) was down for the quarter. In fact, more than half of the sectors in the S&P 500 Index were down for the quarter including financials, energy, industrials, real estate, health care, materials and consumer discretionary. The big winner was technology, with XLK rising 8.8%. Another way to highlight the outperformance of mega-cap technology is to compare XLK, which is more heavily weighted towards large technology companies, to its equal-weighted counterpart, RSPT, which evenly distributes all technology companies within the S&P 500. As noted above, XLK was +8.8% for the quarter but RSPT was only up 4.3%.

General Market Update

US Equities:  As mentioned above, the S&P 500 Index rose 3.9% during the quarter, the equal-weight S&P 500 (RSP) was down 2.6%, the Nasdaq Composite was up 8.3% and the small company Russell 2000 Index was down 3.3%. The large-cap U.S. equity market finished the 2nd quarter brushing up against all-time highs. 

Shockingly, the “Mag 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, Tesla) further increased their overall percentage of the U.S. equity market, now representing 31% of the cap-weighted S&P 500. We continue to overweight Growth and Technology within portfolios as these types of companies likely stand to benefit more in a lower interest rate environment. We are also keeping a close eye on small cap companies as they could also be a group to benefit when/if interest rates begin to drop.

International and Emerging Market Equities:  International equity markets were mixed during the quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was down 0.6% and the Schwab Emerging Markets ETF (SCHE) was up 5.3%.    

Fixed Income and Credit: After a volatile prior 6 months driven by inflation and growth expectations, the credit markets were quiet in Q2. The stabilizing inflation picture seems to have led to price stability across the yield curve as the 10-year U.S. Treasury yield has settled in around 4.5%. The key area of focus now is on the “short end” of the curve as the U.S. Federal Reserve Bank (the “Fed”) contemplates rate reductions. Whether the Fed’s actions match (or don’t match) market expectations will dictate short to medium-term bond price action over the next 12 months. We certainly favor short to medium term bonds in this environment as we see potential for capital appreciation while earning attractive yields. 

Pro-Inflation Investments: Inflation remains an important area of focus. Pro-inflation investments were generally flat for the quarter. While inflation has fallen materially, it is not yet at the Fed’s “target” level of 2%. While the Fed’s rate increases have helped to curtail inflation, continued liberal “fiscal” activity (e.g., large federal budget deficits) are the key reason for inflation hedges in investment portfolios. Gold, as measured by the ETF GLD, followed a strong Q1 with a strong Q2, ending the quarter +4.5%.

A Look Ahead

The overriding themes for the year seem to be (1) when will the Fed begin to lower interest rates and (2) the market reaction to the presidential election cycle. In general, falling rates and “election years” have historically proven to be good for equities. And, thus far in 2024, that has certainly held true as even the expectation of rate drops seems to be buoying the market. We certainly believe the Fed when they say that rate drops are coming, and we’ve seen much improvement on the inflation front. As such, we like stocks in this environment but will be keeping a close eye on seasonality and rebalancing portfolios around opportunities. In average presidential election years there tends to be some volatility in the weeks ahead of the election. We would view that as an opportunity, should it play out this year. 

Retirement Planning

At Patina Wealth, we provide retirement planning as part of our core service. The retirement planning process can yield dramatically different results, depending on who the client is and what stage of their life they are in. Patina has done retirement planning for clients who are several decades away from retirement and for new clients who are already in retirement. As you can imagine, most clients are trying to answer the same question: “Am I on the right track for my savings to outlast me.” That may sound like a strange concept but in the end, that’s what we all need. We need our money to allow us to live a desired lifestyle after our peak income earning years are behind us.

In this article, we will explore the various inputs that are used when determining the probability of long-term financial success. Some of the variables you (the client) will have control over, and others you will not. It is important to remember that once a retirement plan is in place, these variables will inevitably change, and, when they do, it is important to adapt to these changes and consider updating your plan.

First, when we go through the planning process, it often requires a little homework on the part of the client. Important inputs into the retirement planning process that we use in creating a retirement plan are the amount you are currently saving in a workplace retirement plan, or brokerage account, the current balances in these plans, your projected or current social security income (anyone can establish a social security account and see their projected social security income), your future or current pension income and, if applicable, current mortgage expenses, among others.

The one variable that clients have the greatest control over is spending. When thinking about how spending will impact your retirement plan, it is important to try and get a good idea of what that spending number will be once your earned income stops, while also factoring in lifestyle changes and inflation. As you can imagine, this number is easier to estimate as you near retirement. We always like to ask clients to break out their spending by “needs” and “wants”. Needs are typically what a client can’t live without, such as utility bills, mortgage payments, insurance premiums, personal property tax, healthcare costs, groceries, etc. Examples of “wants” could be a certain amount for an annual vacation, a second home or an annual amount for charitable donations.

Another big variable in the planning process is when a client wants to stop working. This decision has a major impact on the retirement plan as that is when earned income most likely stops. At this point, the planning software will begin to calculate when the client is likely to start making withdrawals from their investment accounts. Leading up to that point, it is assumed that all spending is covered by earned income.

Life expectancy is of course a variable that we do not have control over. But, when putting together a financial plan, we can consider a client’s family history. Did their parents and grandparents live long, healthy lives? Or, does the client currently live a healthy and active lifestyle? I think it’s always a good idea to err on the side of assuming a client will live longer than is generally estimated in order to minimize any chance of financial challenges.

Another variable that we don’t have control over is what the future returns of the market will be. This is an important part of the long-term success of a client’s retirement plan. Whether a client is still in their savings years, or if a client is retired, they still need their investment portfolio “working for them.” For example, if a client retires at the age of 65 and then lives until they are 95, they will need their portfolio to help cover living expenses for 30 years (!!) after their earned income has stopped. It is important to keep the client’s portfolio invested in a way that is in line with their risk profile while also achieving goals and maintaining purchasing power.

I like to remind clients that it is important to update their retirement plan when, and if, they have major life changes. One major adjustment would be a job change as this move typically affects not only income but also savings amounts going into retirement accounts. Also, a physical move can be substantial as house or rent payments are typically one of the largest expense items.

In summary, it is important to remember that no part of a retirement plan is set in stone. Things will change either on the path to retirement, or once you are in retirement. The market will inevitably fluctuate, or your spending habits may change. Perhaps you want to take your family on a big vacation or buy that Porsche 911 you always wanted. Having a plan in place makes it all the easier to update and see how these changes will impact your chances of long-term success.  As always, we are here to help with your investment management and retirement planning needs.

2024 1st Quarter Market Commentary

Top Headline for Q1: Where’s The Volatility?

The U.S. stock market began the year how it ended 2023, with a steady climb upward absent any material pullbacks. In fact, according to Bespoke Investment Group, as of the end of Q1 the S&P 500 Index had closed in overbought territory (>1 standard deviation above its 50-day moving average) for 50 consecutive trading days. The last time the index had a longer streak of overbought closes was more than 25 years ago in April 1998 (60 days). In January and March, Federal Reserve Bank (“Fed”) minutes, along with public comments from Jerome Powell and others, confirmed that additional rate hikes were unlikely and that rate reductions were the probable next move. Risk markets welcomed the news with more aggressive buying throughout Q1 leading to a new all-time high for both the cap-weighted S&P 500 Index and equal weight S&P 500.

General Market Update

US Equities:  During Q1, the equal weight S&P 500 Index rose 7.8%, the Nasdaq Composite was up 9.1% and the small company Russell 2000 Index rose 4.8%. It was a strong quarter for most sectors as the general broadening out of market breadth that began to emerge during the end of 2023 continued in Q1. In fact, six out of the 11 sectors within the S&P 500 Index outperformed the Technology sector (Energy, Communication Services, Financials, Industrials, Materials and Health Care).

Despite recent broader participation, market concentration continues to present a risk for the U.S. equity market as the “Mag 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, Tesla) climbed to around 30% of the overall U.S. equity market on a cap-weighted measure. We continue to favor an “equal weight” methodology in the current environment while also having exposure in our “sector overlay” to sectors we believe have more room to “catch up” to growth and technology. It’s noteworthy that a few of the Mag 7 stocks began to show downside risk during that quarter as two of the behemoths fell in value despite a surging overall market. Specifically, Tesla dropped a whopping 29.3% during the quarter and Apple fell 10.8%.

International and Emerging Market Equities:  International equity markets also performed reasonably well during the quarter but continue to lag U.S. markets. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 5.6% and the Schwab Emerging Markets ETF (SCHE) was up 1.9%. 

Fixed Income and Credit: As we’ve mentioned in recent updates, the bond market is likely to exhibit above average volatility as the long-term inflation and interest rate picture continues to take shape. The 4th quarter marked a rapid surge in bond prices, with yields falling, as inflation concerns temporarily dissipated. However, as we moved through Q1, market participants began to get concerned about inflation given the strength of U.S. economic data and “dovish” Fed comments. To put this in perspective, the 10-Year Treasury yield was over 5% in Q3 2023 before falling below 4% by the end of 2023 and now it appears to be pushing rapidly back toward 4.5%. These are substantial moves by historical standards.

Pro-Inflation Investments: Inflation hedges surged in Q1. As we’ve mentioned for some time, there is a building concern over the lack of fiscal austerity by governments throughout the world that is causing a renewed interest in all forms of inflation hedging investments. Inflation hedges seem to be gaining momentum with some real “breakout” type performance in Q1. For example, Bitcoin surged to all-time highs and, on the precious metal front, gold, as measured by GLD, was up 7.6% for the quarter and 20% over the last 6 months. Also, certain commodities are climbing as well. For example, DBA, which represents a basket of agricultural commodities, was up 19.4% in the quarter.

A Look Ahead

As we mentioned during our last update, there is a large amount of capital invested in money markets and short-term bonds. Many investors have enjoyed the high risk-adjusted returns of short-duration income investments in this environment. However, as we look forward, it seems clear that the next move in short-term interest rates by the Fed will be down. As such, the interest rate environment is expected to look materially different in twelve months than it does today. These shifts are likely to have significant impacts on all markets. Our expectation is that 2024 will be a year of above average volatility in markets as the yield curve moves from being “inverted” (i.e., where short rates pay more than long-term rates) to a more normal upward-sloping curve. If inflation continues to drop, and the Fed responds by gradually lowering interest rates, both bond and equity markets should react favorably. Both markets will continue to try and predict when this will happen, causing increased volatility. We think using this volatility as an opportunity to rebalance should bring value to Patina Wealth clients.

Navigating the Bond World

The past few years have called into question how best to use bonds in a portfolio. Historically, bonds have been viewed as a much-needed anchor for portfolios, providing a counterbalance when stocks become volatile. The classic “60/40” (i.e., a broadly diversified portfolio comprised of 60% equities and 40% bonds) has produced top-tier risk-adjusted returns historically. However, in 2022, the 60/40 produced one of its worst years in history as stocks and bonds tumbled together for the first time in decades. Moreover, 2023 was a lukewarm year for bonds with gyrating interest rates and tightening economic conditions. So, is it time to abandon bonds? We believe that answer is no, for bonds are still an important component of portfolios. The amount, of course, should vary depending on an investor’s risk profile. However, we anticipate that the next decade will be a “bond pickers” market where it will be critically important to manage risk through portfolio construction (i.e., making strategic decisions about bond types and bond maturities).

Let’s first look at why bond maturities matter. Bond professionals refer to a bond portfolio’s interest rate sensitivity as “duration,” which is directly driven by the maturities of the individual bonds in the bond portfolio. In short, duration is a measure of the average time to receive all payments from a bond portfolio. Duration is important because, while longer duration bonds tend to pay higher yields, they are more sensitive to movements in interest rates, and therefore are more volatile. Let’s look at an example. Vanguard offers many exchange-traded funds (“ETFs”) that represent baskets of different types of bonds. The most popular ETFs for corporate bonds are the following:

While all of the above bonds fall into the “corporate bond” sector with similar credit risk characteristics, the durations are radically different. The chart below shows how these ETFs performed during a period of rapidly rising interest rates (i.e., 2022). In such an environment, the long-duration portfolios suffered the most, being down -25.5% while short-duration corporate bonds were down -5.6%. It’s clear from this chart how important it is to understand interest rate movement in building bond portfolios, as the moderate gains in yield did not buffer portfolios from plummeting bond prices.

Beyond duration, it is critical to understand the underlying credit risk of bond portfolios. Turning again to the ETF world, below are three ETFs that have moderate portfolio durations but very different credit risk profiles. For example, U.S. Treasury Bonds are considered the lowest risk bonds in the world. See below where we contrast Treasury bonds with both “investment grade” corporate bonds, that carry some economic risk, and “high yield” bonds which represent significantly higher economic risk.

Generally speaking, bonds with higher credit risks pay higher coupons (as shown above). So, investors may be tempted to “reach for yield” (i.e., buy bonds with the highest paying coupon while underappreciating the risk). Timing is critical for those looking to hold higher-risk bonds as the loss in price can greatly, and rapidly, overcome any moderate gain from higher coupons.  For example, in reviewing the market panic during COVID (12/31/2019 – 3/31/2020), we can see how these higher risk bonds are prone to sudden and significant drawdowns. The bond holding with the most credit risk out of the three listed above, SPDR’s High Yield Bond (JNK) had an intra-quarter drawdown of -24.5% before finishing the quarter -12.7%.

In summary, as interest rates remain at decade highs, we’re excited about the opportunity to deploy bonds in investment portfolios. We think bond price volatility, driven by credit and duration risk, will provide substantial opportunities in the coming years for carefully constructed portfolios.

2023 4th Quarter Market Commentary

Top Headline for Q4: The End of Rising Rates!

After a rough 3rd quarter, stocks saw continued weakness to start the 4th quarter. The equal weighted S&P 500 Index (RSP) saw a drawdown from late July through late October of -13.4%, before equity markets bottomed and began an impressive rally to end the year. Perhaps what was more impressive was the broadening out of market participation after the first nine months were dominated by mega-cap technology. Markets surged in Q4 as participants correctly anticipated a “dovish” tilt to actions by the Federal Reserve Bank (the “Fed”). In December, Chairman Jerome Powell effectively affirmed what markets anticipated (that is, they’re likely done raising rates). 

The move in the bond market was even more striking as bond prices turned up sharply in October and rose through year-end as rates fell. In fact, the 10-Year U.S. Treasury Bond yield briefly eclipsed 5% in October before plummeting to under 4% at year-end on rising bond prices – a remarkable move over such a short period of time. The Treasury market did not offer much time to capture a 5% long-term yield.

In summary, 2023 was a testament to the resilience of the U.S. equity market as investors overcame a great deal of fear and uncertainty. The narrative shifted in 2023 from how much more the Fed would hike rates, to when the Fed would stop hiking rates, to how much rates would potentially drop in 2024. The market faced headwinds including high inflation, the ongoing Russian-Ukraine war, a regional banking crisis, conflict in the Middle East and the seemingly never-ending prediction of the country entering a recession. Entering 2023, investors were coming off a year where the Fed was still waging its fight against inflation and had hiked the Federal Funds Rate from 0% to 4.25% to end 2022. Over the first seven months of 2023, the Fed would continue to raise the Federal Funds Rate four more times, to a target of 5.25 – 5.5%. Despite the continued rate hikes, as a forward-looking indicator, the stock market paid more attention to falling future inflation expectations. The annual inflation rate was around 6% at the start of 2023 and ended the year near 3% - welcome news as we head into 2024.

General Market Update

US Equities: During Q4, the equal weight S&P 500 Index (RSP) rose 11.8%, the Nasdaq Composite was up 13.6% and the small company Russell 2000 Index also rose 13.6%. It was a strong quarter for most sectors. A few standouts include the interest rate sensitive REIT sector (e.g., XLRE was up a whopping 18.8%) and long duration equities, like technology, fared well (e.g., XLK was up 17.7%). The 4th quarter’s performance capped off a strong year for equities as the broad indices all finished well above historical averages.

As we’ve mentioned before, much of market performance during 2023 was driven by the “Magnificent 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, Tesla), which now make up about 30% of the cap-weighted S&P 500 Index. This is one of the highest levels of market concentration in history and one of the reasons why we don’t reference it as a relevant performance benchmark for a diversified portfolio. During the second half of 2023, Patina Wealth began to overweight sectors selling at more favorable prices and indices with an “equal weight” methodology. This strategy started to pay off in Q4 as the equal weighted S&P 500 (ticker: RSP) ended Q4 +11.8%. Moreover, sectors such as financials and industrials, and asset classes such as small caps, that lagged the overall market for much of the year, began to “catch up” as market performance and participation began to broaden out. The financial sector (XLF) surged +13.9% during the quarter, the industrial sector (XLI) was +13.1% and small caps were +13.6%.

International and Emerging Market Equities: International equity markets also performed well during the quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 11.0%, and the Schwab Emerging Markets ETF (SCHE) was up 7.1%. Although international markets joined the rally in Q4, some significant headwinds remain. Specifically, many European countries continue to wrestle with low economic growth and high inflation. Also, China is facing substantial challenges both from a hangover of real estate overbuilding as well as investor fears surrounding government intervention in the technology sector.

Fixed Income and Credit: As mentioned above, Q4 was a huge quarter for fixed income investments with long maturities (i.e., high “duration”). By way of example, VCLT (an ETF that holds a basket of long-duration corporate bonds) was up 13.9% on the quarter. It’s striking how quickly the bond market sentiment shifted. In three short months, uncertainty around the future of inflation dissipated, and the long-term bond market yields shifted quickly to reflect a much lower future expectation for inflation.

Pro-Inflation Investments: Inflation continues to fall toward the Fed target of 2% with positive data coming in Q4. However, with the rate still hovering around 3%, the work is not over, and many economists suggest that 3% is more likely for the next decade than 2%. One factor working against the Federal Reserve Bank’s efforts is U.S. Government fiscal spending. The 2023 budget deficit is projected to be above $2 trillion with a similar number projected for 2024. Similar deficit spending is occurring throughout the developed world. Our belief is that more austerity will be required to return to a 2% inflation world and that inflation-protection may benefit portfolios. 

A Look Ahead

With the abrupt move in the long-bond market in Q4, there is some diminished opportunity for additional bond price appreciation going forward. With the 10-Year Treasury rate below 4%, many economists would say that it is “fairly priced,” meaning that it is reflective of long-term growth/inflation. It is tough to be too bullish on longer-term bonds here given the 4th quarter move and the present level of the 10-Year yield. More conservatively invested portfolios will continue to be diversified across duration.

On the equity front, it will be important to stay nimble. While it would not be a surprise to see some sort of consolidation early in 2024 after such a surge to end 2023, we believe the breadth of participation in the latest rally from sectors that underperformed growth and technology for most of last year is a positive sign. There is still a large amount of cash sitting in money market funds that could find its way into the stock market and thus provide a tailwind for equities.

The Federal Reserve Bank actions will continue to loom large. Not only has the market assumed that the rate hiking campaign is over, but the futures market shows that the market has also “priced in” substantial rate cuts for 2024. While this is all bullish news for the equity market, it is important to note that any material shift toward tighter conditions could create some downside volatility.

2024 is shaping up as another active year in the markets as cash-heavy investors look to deploy funds based on insight from Fed actions, inflation readings, and developments on the geo-political front. Volatility provides opportunity for active managers like Patina Wealth. We will continue to seek opportunities for strategic rebalancing in an effort to improve return and reduce risk.  Best wishes for a prosperous 2024!

Sam Harris - Crozet/Charlottesville           John Mumper - Richmond
(434) 214-0407                                          (804) 380-1050
Sam@PatinaWealth.com                           John@PatinaWealth.com

Skepticism Drives Us to be Better Advisors

Many of our clients have heard us say we are skeptics of our own industry. Sam Harris, Founder of Patina Wealth, has worked in the investment industry for more than 23 years. We have seen many ways investors can be taken advantage of. As a result, we choose to align ourselves with our clients’ and to act as a partner in their financial lives. Our goal is to be someone who they can trust to act in their best interests and provide objective advice.    

As you might expect, this isn’t always the case in our industry. We love what we do and work hard to bring value to our clients. Unfortunately, the investment industry can be a scary place where unscrupulous participants take advantage of investors. We despise this activity and strive to bring awareness to these pitfalls to help people avoid them. We hope you share these thoughts with friends and family as we collectively try to move the industry in a better direction.

One of the biggest issues in the industry has to do with conflicts of interest. To understand this issue, one first must understand that the investment advice industry is generally broken into two main categories (1) registered investment advisors (“RIAs”) and (2) broker dealer representatives (“BD Reps”). Below are some of the issues that are common to broker-dealer firms.

1. Commissions – Some BD Reps accept commissions from the funds that they are buying on your behalf. These are funds with “loads.” For example, on a million-dollar purchase, a $10,000-50,000 payment (i.e., “kick back”) to the BD Rep is not uncommon. Obviously, this creates a horrible conflict of interest as BD Reps may be encouraged to buy a fund on your behalf that provides the biggest payment as opposed to the one that is in your best interest. A good way to find the answer to this is to simply ask them how they are paid.

2. Self-Promotion – Broker-dealer firms often have proprietary products (e.g., mutual funds, exchange-traded funds (“ETFs”) and insurance vehicles). Generally, BD Reps receive incentives to place money in products created by the firm that employees them. This activity also creates a huge conflict of interest leading to your money being invested in products that may not yield the best results.

3. Trading Fees – While this issue is less common today, BD Reps once earned much of their compensation by placing trades. So, “churning” (i.e., trading more than is appropriate) was a common issue that eroded account performance while yielding profits for BD Reps.

Patina Wealth works hard to avoid any of these types of conflicts of interest. As a Registered Investment Advisor, we have a “fiduciary duty” to you, which means that we must always place your interests ahead of our own. In fact, this is true for all Registered Investment Advisors, so as a general rule, you may be better off choosing a Registered Investment Advisor over a BD Rep. Patina also only gets paid by you, its clients. Patina will never accept commissions and is not compensated by any other source that could create a conflict of interest.  We also do not get paid for placing trades, and we only use investment products that don’t have a transaction fee. Lastly, we have no affiliated firm that offers products; therefore, we are free to place your money in the best available product from a variety of fund managers.

Some of the other issues that are present in the investment management industry are a bit harder to spot. Below are a few of the issues that we advise investors to be on the lookout for.

1. Poor Service – Investment professionals have a history of taking on too many clients, thereby causing service levels to drop. At Patina Wealth, we limit the number of clients per financial advisor so that service levels remain high. We think it’s important to be available to clients when they need ad hoc consultation, and we encourage it.

2. Ineffective Portfolio Construction – The investment landscape is an increasingly complex one. New investment products are being launched every day that allow more targeted portfolio exposures (e.g., to sectors, factors, geographies). Unfortunately, many investors are invested in funds that have very broad market exposure and, typically, size-weighted indices. While it requires additional work and diligence, we see the opportunity to add value through more active management and rebalancing using more targeted funds including sector specific products.

In summary, the financial advice industry has a checkered past but has been moving in the right direction. It’s up to investors and industry participants who align themselves with clients to keep the momentum going. If we can ever be of assistance on this front, please let us know. 

Bonds: The Battery Back-Up For Your Portfolio

Over the summer we installed a battery back-up for the sump pump in our basement. After the installation, our area proceeded to go into a drought, not recording a meaningful rainfall for more than 6 weeks. Still, that money was the best money I’ve spent in years. Why? Not because I needed it, but because of the peace of mind it gave me, should I need it. Even though I already had a sump pump that had worked great for six years, we’ve been lucky that our power hasn’t gone out when it was running. Though, that thought crossed my mind every time I heard it working to pump out excess water from around our foundation during heavy rainfalls.

You may be wondering how this relates to investing. Well, having some fixed income or bond exposure in a portfolio can serve as your portfolio’s battery back-up! The U.S. equity market has been functioning great for a long period of time (minus a moderate pull back in 2022). In fact, it’s been on such a strong run for over a decade that we may have forgotten about the need for a back-up. The amount of fixed income in a portfolio, along with the portfolio duration, should vary depending on an investor’s risk tolerance and investment objectives. But, in times of volatility you’ll be glad you had some exposure as fixed income can serve as a volatility buffer and provide some much-needed rebalancing power.

Let’s look at some of the biggest equity drawdowns in history and see how bonds performed during the same time period. The chart below from Northern Trust shows six major drawdown events in reverse chronological order. According to Northern Trust, the average equity drawdown across these six events was -49.2% while the average bond return during these six events was +12.0%.

Data Credit: Northern Trust

Fixed income tends to serve as a buffer for volatility for a number of reasons. For one, weak stock performance is often accompanied by poor economic performance (i.e., a rise in unemployment). These impacts often lead to interest rate reductions by the Federal Reserve Bank which, in turn, tends to increase bond prices. Volatility and uncertainty can also lead to a “flight to quality” (i.e., a time where the safety of short-term U.S. treasury bonds make them the most popular investment in the world).

History has shown that investing in the stock market has proven to be profitable over the long run but brings substantial volatility as well. Having some bond exposure in a portfolio can help to lower portfolio volatility and provide “dry powder” for rebalancing (i.e., preserve capital for adding to equity investments following drawdowns). While bonds are expected to underperform equities over the long run, they serve a critical function in portfolios. That is, just like a battery back-up to a sump pump, they stand ready to assist when you need them most.

Sam Harris

Founder | Private Wealth Advisor | Fiduciary

Patina Wealth

2023 3rd Quarter Market Commentary

Top Headline for Q3: “Higher for Longer” Finally Hits Markets

Equity and bond markets took a “bearish” turn in Q3. Markets had been ignoring the “higher for longer” calls from the Federal Reserve Bank (“Fed”), but that changed abruptly in Q3. Market participants finally capitulated to the Fed and “repriced” to new rate expectations. For example, at the start of 2023, market participants were still considering the possibility of a Federal Funds Rate reduction in 2023 and were expecting at least four reductions in 2024. However, by the end of Q3, the market was pricing roughly a 50% chance of an additional rate increase in November of 2023 and only 2 reductions in 2024 – a dramatic shift in expectations. 

Market price movements can largely be explained through these changes in expectations as reflected in the treasury bond yield curve. For example, the 10-Year treasury bond yield rose approximately 80 basis points in Q3 – a massive move with immediate adverse consequences. As expected, bond markets felt the pain with long-dated bond indices reaching double digit declines. Moreover, the stock market started to feel the pinch with nearly all sectors negative for the quarter.

General Market Update

US Equities:  During Q3, the market cap weighted S&P 500 Index fell 3.7%, the equal weighted S&P 500 fell 4.9%, the Nasdaq Composite dropped 4.1%, and the small company Russell 2000 Index fell 5.5%. Nearly all sectors tumbled during the quarter with the energy sector (XLE) being the one bright spot – rising 12.2% as higher oil prices pushed up stock values. It’s interesting to note that the “tech” outperformance that explained the year-to-date gains through Q2 persisted through Q3, but to a lesser extent (i.e., the tech leaders have yet to give back much of their recent outperformance). A few of the big losers in Q3 were high dividend “income” sectors including utilities and REITs, which appear to be losing investors to very attractive short-term treasury bonds and money market yields.

International and Emerging Market Equities:  International equity markets also performed poorly during the quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was down 4.7%, and the Schwab Emerging Markets ETF (SCHE) was down 2.8%. The pain may not be quite over in Europe as the European Central Bank and Bank of England also maintained a “hawkish” rhetoric with more rate hikes possible. 

Fixed Income and Credit: As mentioned above, Q3 was a very rough quarter for fixed-income investments with long maturities (i.e., high “duration” risk). Q3 saw the unusual circumstance of having the “long end” of the yield curve rise following a Fed increase in the Federal Funds Rate. Normally, a rise in the Federal Funds rate would curtail the economy and cause growth expectations to fall leading longer-term rates to decline. It’s clear that the market is not convinced that inflation is fully under control. It seems that the lingering issues are (1) uncertain residual effects from the massive COVID cash stimulus and (2) questions related to the Federal Budget deficit and lack of fiscal austerity.   

Commodities, Precious Metals, Inflation: The data shows that inflation continues to fall globally. Moreover, central banks in Europe and North America seem committed to bringing it back down to the 2% target rate. However, investors are generally concerned that fiscal policy lacks austerity. We are running massive deficits and increasing the money supply, which is inherently an inflationary activity. The activity runs counter to the Fed’s inflation-reduction efforts. As such, we remain supportive of pro-inflation assets as a hedge against currency devaluation and above-trend inflation.    

A Look Ahead

With the capitulation from market participants regarding the Federal Funds Rate expectations, bond markets have de-risked to some degree. In other words, it’s getting harder to imagine a greater degree of pessimism regarding future Fed policy. Our view is that it may be an opportunity to begin adding some longer-dated bond exposure to portfolios. 

The equity market remains more challenging. On a positive note, any reduction in tightening, perceived or actual, would likely buoy stocks higher. In fact, certain beaten-down sectors like REITs and utilities would likely move sharply higher. However, if the Fed sticks to “higher for longer” (e.g., raises further and/or holds rates at current levels deep into 2024) it’s likely to cause slow and steady damage to certain sectors of the stock market. Most notably, unprofitable small caps look particularly vulnerable. While estimates vary, some analysts calculate that as much as 1/3 of the Russell 2000 small cap index are “zombies” (i.e., they earn less than they pay in interest payments). These companies will face substantial headwinds as bonds mature and need to be re-issued at much higher rates. Overall, it’s an environment that calls for a tactical approach in the equity market, and we look forward to trying to take advantage of these opportunities.

Market Cap-Weighted vs. Equal-Weighted Indices

The U.S. equity market’s growth in 2023 has reminded us of the sometimes striking differences between “equal-weighted” and “market cap-weighted” indices. Market cap-weighted indices are those that vary position sizes based on the relative size of different companies. For example, Apple, a company valued at over $3 trillion, represents a much larger portion of the index than Ford, a company valued at around $50 billion. The most often referenced index in the world, the S&P 500 Index, is a market cap-weighted index. An equal-weighted index, as the name implies, holds an equal amount of each company subject to periodic rebalancing. As investors, we can purchase either of these indices in a single exchange-traded fund (“ETF”) security (e.g., SPY for the S&P 500 market cap-weighted and RSP for the equal-weighted). Both of these indices will allow you to invest in the same companies, but in a dramatically different way.

 So, which index is better? Well, these indices behave differently in different types of markets. When the equity market is rising, market cap-weighted indices tend to outperform. This occurs because the index effectively adds more of the top performing stocks as they get larger. Thus, the index tends to capture large “momentum-driven” moves. In fact, this situation is exactly what we are seeing during 2023. The hottest stocks in 2023 are the “mega-cap” stocks (e.g., Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Tesla). As seen in the diagram below from Statista, most of the gain in 2023 is coming from these 7 stocks – a stunning 84.3% of the total gain through June 7.

By riding the momentum wave, the market cap-weighted S&P 500 index has handily outperformed its equal-weighted counterpart this year through August 11, 2023 (see chart below).

The problem with market cap-weighted indices is that momentum can go in both directions. Momentum tends to lead to “index concentration” (i.e., a small number of stocks make up an increasingly larger share of the index). Not surprising, this is exactly what has been happening in 2023 following a slight drop in 2022. As of August 2, 2023, the 7 largest companies in the market cap-weighted S&P 500 Index make up over 27% of the index, while the other 494 companies make up the other 73%. Apple and Microsoft alone make up 14% of the index. Below is a chart showing how these seven stocks have become more and more concentrated as a percentage of the market cap-weighted S&P 500:

Another method to compare the S&P 500 market cap-weighted and equal-weighted versions is to look at equity sector exposures between the two. Below is the equity sector exposure of each (SPY on the top and RSP on the bottom) as of June 30, 2023. Given the high concentration of mega-cap technology in SPY, its largest sector is Information Technology with a weighting of 28.3%, whereas RSP only has a 13% weighting to the same sector. These charts show how RSP has a less concentrated exposure to some sectors and is arguably more diversified.

Depending on the specific risk profile of the investor, portfolio construction can vary significantly from one investor to another. Therefore, it is important to know what is in your portfolio and what you are comparing your portfolio to when looking at trailing performance. Using the examples above, an investor owning SPY and RSP may have exposure to the same companies, but in a much different way. In regards to diversification, not many investors should have 27% of their portfolio invested in seven companies, and therefore comparing performance to the market cap-weighted S&P 500 Index is likely not a good comparison. Knowing how your portfolio is constructed can help an investor determine if they are exposed to the appropriate amount of risk or diversification.

2023 2nd Quarter Market Commentary

Top Headline for Q2: Surging Markets Led by Big Tech

Markets surged again in Q2 – ignoring a “hawkish” Federal Reserve Bank (“Fed”) and slowly deteriorating macro-economic conditions. However, the real story of 2023 requires a look at individual stock performance. The gains in the first half of 2023 can be attributed to a small number of stocks and, more specifically, the Artificial Intelligence (“AI”) craze kicked off by ChatGPT. Chip manufacturers, deemed the biggest beneficiaries of AI, saw some of their best gains ever as evidenced by Nvidia which rose 190% year-to-date to reach a whopping trillion-dollar valuation. Technology, as measured by XLK, gained over 40% in the first half of the year and was led by chip manufacturers along with some familiar “mega cap” names (e.g., Apple, Microsoft, Google and Meta which were up 50%, 43%, 36% and 138% respectively). At quarter end, Apple, our nation’s largest stock, sits at over a $3 trillion valuation.     

Shockingly, most of the entire gain for 2023 can be traced to 7 stocks – the 5 above plus Tesla and Amazon. The rest of the market, in aggregate, has gained very little. This divergence has been on full display when comparing “market-cap-weighted” indices (i.e., indices where larger companies command larger allocations) to “equal weight” (i.e., indices where all holdings have the same weighting). The market cap weighted S&P 500 Index (SPY) is up 15.9% year-to-date while the equal weighted version (RSP) is only up 6.9%. At this point, many investors may be wondering why their stock portfolios are not keeping pace with the “market,” as measured by the market-cap-weighted SPY. Most investors shouldn’t keep pace with the market during large surges in either direction. The job of advisors is to reduce volatility through portfolio construction and diversification of asset classes. For example, the 7 stocks above now comprise over 25% of SPY – a dangerous level of concentration and something that shouldn’t be considered a truly diversified portfolio. This type of index concentration has rarely persisted in history and is typically reconciled through a drop in the mega-caps or a relative rise in everything else.   

General Market Update

US Equities:  The positive 2023 momentum continued in Q2 with the S&P 500 Index up 8.3% during the quarter and the tech-laden Nasdaq Composite up 12.8%. The small company Russell 2000 Index climbed 4.8% and, as would be expected from a mega-cap stock surge, remains well-behind the large-cap indices year-to-date. It’s also interesting to note the divergence between “growth” and “value” stocks. For example, as seen in the chart below with Large Cap Growth in green and Large Cap Value in blue, we’ve witnessed an enormous divergence in these “factors”. We continue to see great opportunities to add value through strategic rebalancing.

International and Emerging Market Equities:  International equity markets continue to grind higher but, not surprisingly, continue to lag the tech-heavy U.S. indices. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 3.6% in Q2 and the Schwab Emerging Markets ETF (SCHE) was up 1.0%. Inflation continues to be a substantial problem in developed markets as evidenced by recent central bank rate hikes. The European Central Bank and Bank of England (“BOE”) raised rates in May and the BOE did an unexpected 50 basis point increase in June. Looking outside of Europe, we will be keeping an eye on China in the 2nd half of the year. The economic jolt expected from the “re-opening” provided less of a tailwind than expected. In fact, China’s central bank lowered its short-term funding rate in June for the first time in 10 months suggesting deteriorating conditions.

Fixed Income and Credit: As has generally been expected, bond markets have largely trended sideways as the market anticipated an end to Fed rate hikes. During Q2, market participants seemed to accept the Fed’s “higher for longer” mantra (i.e., expectations changed from rate cuts in 2023 to expecting short-term rates to remain at current levels) and this caused a slight pull back in bond prices/rise in yields. 

Commodities, Precious Metals, Inflation: Inflation is falling globally, however, the Fed’s pause coupled with continued hiking in Europe suggests the global developed markets are making less progress. The Fed’s call for “higher for longer” on the rate front has the potential to do economic damage (e.g., increase bankruptcies, lower profits, increase unemployment) which would be very deflationary. Fiscal policy (i.e., the government’s budgeting/spending decisions will also weigh heavily) as continued deficits are inflationary. We remain supportive of pro-inflation assets having a small allocation in portfolios right now, as a hedge against potential global currency devaluation and possible structural inflation led by changing demographics. 

A Look Ahead

We have a very interesting story unfolding in the equity markets. We have hints of danger (i.e., one of the most inverted yield curves in history, persistent inflation, rising corporate bankruptcies and a Fed willing to cause economic damage in its effort to combat inflation). However, the U.S. stock market is surging on the promise of productivity gains from advancements in AI – arguably one of the world’s greatest innovations. While it is difficult to predict market moves in the short-term, there is value in capitalizing on volatility through rebalancing and we expect to be busy on this front in the next 12-18 months. 

On the rate front, it again becomes a Fed-watching exercise. If the Fed deviates materially from expectations (i.e., 1-2 more hikes with no cuts in 2023) then equity and bond markets are likely to react sharply. We continue to see short-term assets as attractive given the Fed’s actions along with quality longer-duration credit given the potential for cuts over the next several years.

Regional Bank Pain

Recent headlines have been dominated by the stress in the U.S. banking system. As we reported in our quarterly update, both Silicon Valley Bank (“SVB”) and Signature Bank failed in Q1 and were taken over by the Federal Deposit Insurance Corporation. These failures were followed in Q2 by the fall of First Republic Bank, marking the 2nd largest bank failure in U.S. history. These headlines have all of us wondering – what bank is next and when will it end?

As more evidence surfaces regarding the cause of the failures, two key issues have emerged. First, it is becoming clear that certain banks did not properly hedge interest rate risks on holdings, which hurt their ability to meet withdrawals. Secondly, social media accelerated the “bank runs” (i.e., customers racing to withdraw money). When banks take deposits, they can lend the money out, or they can invest in securities like U.S. Treasury Bonds and mortgage-backed securities. The value of these securities changes as interest rates rise and fall, and banks normally hedge this price risk. However, the Wall Street Journal has reported that for the 24 large banks in the KBW Bank Index, the unrealized losses on long-term holdings had grown by about $300 billion during 2022. Per the Wall Street Journal chart below, certain banks, like SVB, have large losses relative to their size given a lack of interest-rate hedging.

Looking forward from here, one alarming fact is that money continues to leave regional banks. Banks had been paying very little interest, and as the Federal Reserve Bank (the “Fed”) raised the Federal Funds Rate, money began leaving banks for higher paying alternatives (e.g., Money Market accounts and short-term bonds). Bianco Research created a chart (below) that shows weekly deposit flows from U.S. banks, excluding “Jumbo CDs,” and it shows a steady exodus of deposits following the “wake up call” from SVB.

Banks are under considerable strain both from deposit outflows and from a profit margin perspective. The Fed stepped in with a new program, the Bank Term Funding Program (“BTLP”), to reduce panic by providing liquidity. With this program, the Fed is agreeing to provide loans to banks to meet redemptions based on the cost-basis of bank assets (e.g., Treasury bonds and MBS securities) rather than the current value of those assets. The Fed’s report to Congress on the BTLP confirms the cash need as $83 billion in loans were outstanding as of April 30th. This is an important tool given the massive unrealized losses that have been incurred by banks as described above. 

While the BTLP is a good short-term solution to reduce panic and enable banks to meet withdrawals, it doesn’t address the current structural issue. That is, a flat or inverted yield-curve (i.e., a situation where longer-dated treasury bonds have a lower yield than short-term bonds) challenges the profit margins of banks as they are forced to compete for deposits at high rates but have limited options for earning attractive yields on longer-term assets. It’s likely that more strain is to come throughout the course of the year as this economic reality begins to appear in quarterly bank profits. It’s clear that the Fed’s plan to hold the Federal Funds Rate at/near current levels will be challenging to the banking sector. Stock prices confirm the strain as KRE (the regional bank ETF) was down as much as -38% YTD through May 4th.

Our general belief is that the Fed is driving the ship regarding future bank failures. Keeping the Federal Funds Rate elevated is perpetuating an inverted yield curve, which may be potentially unsustainable long-term for a functioning banking system. While they can provide unlimited capital to help banks survive, these emergency loans compress profit margins for banks and may also be unsustainable in the long-term. Given the Fed’s comments that no rate cuts are planned for 2023, we would expect more pain to surface. However, our sense is that the Fed may be pushed into some cuts during the 2nd half of 2023 to stabilize the situation.     

2023 1st Quarter Market Commentary

Top Headline for Q1: Silicon Valley Bank

Financial headlines in Q1 were filled with news of a potential banking crisis as Silicon Valley Bank (“SVB”), our nation’s 16th largest bank, was taken over by the Federal Deposit Insurance Corporation (“FDIC”). SVB’s failure was particularly striking in how quickly it occurred. On Wednesday, March 8th, SVB was perceived to be healthy, and by Friday, March 10th, its doors had been closed permanently. The speed of the failure highlighted a new normal for modern banking where advancements in mobile banking tools allow for capital to flow freely between financial institutions. In fact, it is estimated that over $150 billion in deposits were withdrawn from SVB in under 48 hours. The SVB failure was followed by the failure of Signature Bank with rumors of more to come. It was a rough quarter for the banking sector as evidenced by the regional bank ETF, KRE, which fell nearly 25%.

Despite the banking turmoil caused by SVB, the first quarter was a strong one for risk assets. With the Fed now projected to pause in raising rates following the May meeting, the equity market and other rate-sensitive assets were positive. Most notably, “long duration” U.S. equity assets were up the most with the technology sector rising over 20% during the quarter.

General Market Update

US Equities:  The S&P 500 Index was up 7% during the quarter, while the Nasdaq Composite was up 16.8%, and the Russell 2000 Index climbed 2.3%. Being market cap weighted, the S&P 500 and Nasdaq Composite both enjoyed significant outperformance from their top two holdings, Apple and Microsoft. The two companies represent a whopping 13% of the S&P 500 Index, and 23.8% of the Nasdaq Composite. During the first quarter, Apple was +27.1% while Microsoft was +20.5%. This is noteworthy given how “top heavy” these two indices are. The divergence between the S&P 500 and Nasdaq as compared to the Russell 2000 was quite striking. The surge in the Nasdaq can be attributed to its technology exposure while the small cap Russell 2000, with its heavy exposure to regional banks, was held down by a broad collapse in bank stocks.

International and Emerging Market Equities:  International equity markets continue to rise following a strong 4th quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 8% in Q1, and the Schwab Emerging Markets ETF (SCHE) was up 3.6%. Inflation continues to be a substantial problem in Europe along with indications of social unrest. It’s unclear of the exact long-term implications of these developments but inflation could hinder corporate profits, and we’re watching for further developments. China continues to bolster emerging market indices as its “re-opening” provided an economic jolt, which is coupled with a government that has backed off from its previous policy of suppressing activities of large technology companies. 

Fixed Income and Credit: As we all know by now, 2022 was a horrible year for bond investors. During the 1st quarter, however, the market participants concluded that May would be the final increase in rates and that rate reductions were coming later in 2023. Long term rates, as measured by the U.S. 10-Year Treasury bond peaked at over 4% in October 2022 before beginning a downward trend that continued through Q1 and finished at 3.49% on March 31. The change in expectations pushed most bond prices higher with long-term bonds being the biggest winners (e.g., VCLT was up 6.1% and VGLT was up 6.8%). 

Commodities, Precious Metals, Inflation: Q1 marked a very interesting moment for real assets. Gold, to very little fanfare, approached its highest price in history. New “highs” for assets tend to mark “breakouts” where assets subsequently move to substantially higher levels. It was particularly noteworthy that Gold achieved this level during a period of falling inflation expectations. Gold, and precious metals more generally, will be interesting assets to watch throughout 2023. Commodities generally fell during the quarter as many of these assets continue to move back toward long-term averages after spiking following COVID. 

A Look Ahead

Market participants very clearly moved into a “bullish” stance during Q1. Futures markets indicate that participants expect May to be the last increase in the Federal Funds Rate and, more importantly, that the Federal Funds Rate will be lowered over 100 basis points before the end of 2023. This shift in sentiment runs counter to the Fed’s recent commentary in which they suggest that the Federal Funds Rate will need to be held at current levels throughout 2023 (i.e., NO reduction). The tension between market expectations and Fed actions will likely lead to volatility in both equities and bonds as the true path of rates reveals itself. 

It is also noteworthy that corporate earnings are expected to fall, and a recession is predicted. At this stage, the equity market may have some asymmetric risk to the downside given the direction of earnings and the perhaps overly aggressive assumption that the Federal Funds Rate will be coming down. If the Fed holds firm at current rate levels, earnings deteriorate, and/or the banking crisis worsens, we could see a sharp market reaction to the downside. We will be watching this closely.

Longer term rates have likely stabilized for now. At this point, it will take some extremely negative news on the inflation front to test the October high in yield and low in bond prices. As a result, we favor continuing to add some duration to bond portfolios for income-seeking investors with a long-term horizon.

5% Yields!

On February 17th the 1-year U.S. Treasury Bond surpassed a 5% yield – a potentially impactful milestone. This threshold is one that U.S. Treasury Bonds haven’t seen since pre-2008 and is a stunning 4 percentage point climb from one year ago. Moreover, it appears that they may not be done rising as both the 3 and 6-month U.S. Treasury Bonds have both joined the 5% (annualized) club. In this post we will examine why this level may have big implications for investment portfolios.

So, why does 5% matter? We would argue that 5% is an important milestone for two reasons. First, the direct impact is that U.S. Treasury Bond levels affect the value of assets. Second, rate levels affect expectations of future rate changes, which can in turn amplify the first effect.    

Regarding direct impacts, 5% is not particularly noteworthy. However, rates continue to rise and higher rates should, in theory, lower the value of the stock market because it lowers the value of future cash flows and affects corporate profit margins. Moreover, rising rates should lower the value of bond investments as these investments price-adjust to remain competitive with the prevailing level of interest rates. Look no further than 2022 to see the rising rate impact at work. In 2022 the classic 60/40 portfolio (i.e., 60% stocks and 40% bonds) had one of its worst years ever. This impact is exactly what would be expected as these results coincided with one of the fastest increases in the Federal Funds Rate that we’ve ever seen. So, to the extent that rates keep rising, one may expect further pain for the stock and bond markets.

There are, of course, other secondary adverse repercussions to asset prices. For example, rising Treasury Bond yields affect consumer borrowing costs for things such as car loans and mortgages, which, generally lowers demand for these items and, typically lowers home values. These types of impacts can cascade into a recession as consumers spend less and business profits fall. Also, Federal Reserve Bank research shows that falling security prices (e.g., think falling home values and 401k values) tend to also reduce consumer spending to the detriment of the economy.

The indirect impacts of rising rates (i.e., market expectations) can be even more pernicious. And, it is here where the 5% level may be meaningful. When we talk about market expectations which involve future projections, we are bringing emotion into the equation. Emotion and investing don’t mix well, and this type of environment (i.e., rising levels of uncertainty) is where we can often find irrational selling. On the expectation front, hitting a big milestone like 5% has a reverberating effect as the press amplifies the message which shifts narratives. We are, in fact, seeing a narrative shift right now. Market expectations can be seen in the futures markets (i.e., securities that represent future transactions). Action there is noteworthy. Until recently, the market believed that the Federal Reserve Bank would make fewer rate increases than they implied. We now see a bit of panic creeping in as the market is now guessing that the Fed will make more rate increases than they have stated. This is a big shift in market expectations, and expectations are critical as they drive investment decisions. If the market begins to think that rates are going much higher (i.e., no end in sight), it could lead to a substantial sell-off in securities markets.

Our general belief is that we’re nearing the end of rates climbing for this cycle and that it’s likely a favorable time to be adding bond exposure and adding duration risk (i.e., longer-dated bonds that will appreciate with decreases in interest rates). We would anticipate continued challenges in equity markets as weaker balance sheet companies wrestle with higher borrowing costs. Bankruptcies are expected to rise after a very quiet decade. Asset class weightings and sector exposures are likely to be more critical than ever. Overall, 2023 is shaping up to be another interesting and challenging year. However, volatility creates an opportunity and we’re excited about the potential that lies ahead. 

Bye Bye Inflation?

Talk of inflation has dominated the conversation lately, but those days may soon be behind us. Inflation has significant effects on our lives as rising costs erode purchasing power. It can result in a dangerous cycle as reduced consumer spending can contribute to sluggish economic growth and, eventually, recession. Moreover, our “cost of capital” (i.e., the rate we pay for mortgages, personal loans and business loans) rises with inflation thereby further limiting spending in other areas. Inflation is feared by the federal government and, as we have seen from the US Federal Reserve Bank (the “Fed”), they will fight it aggressively. Actual inflation and “inflation expectations” (i.e., where the public thinks inflation is heading) can have significant impacts on investment portfolios. So, let’s review where we’ve been and see if we can gain some insights about where we are headed.

In looking at the year-over-year change in inflation as measured by the Consumer Price Index (chart below) we see that inflation has been quiet (i.e., running at or below 2% for most of the last decade). Then we saw a dramatic rise after the COVID pandemic with a spike up to nearly 9% before dropping back down to under 6.5%.

Most economists agree that the peak in year-over-year inflation is behind us as the chart would suggest. The key remaining questions are typically (1) How quickly will it fall? and (2) At what level will it stabilize? We’ve commented in prior articles that Government stimulus was unprecedented during COVID. As such, we have no historical analog to offer guidance (i.e., no one knows exactly how this story is going to end). As an example, look at what the US Government did to the money supply in response to COVID. “M2” which represents cash and checking account balances increased around 40% in only 2 years (i.e., about $6 trillion dollars). While the government tends to blame inflation on COVID, their substantial stimulus clearly played a role and will continue to have an impact along with their future actions.

So, where do we go from here and what might be the impacts on investment portfolios? Inflation is generally bad for both stock and bond portfolios. Why? Well, inflation tends to drag interest rates higher which thereby lowers the present value of corporate earnings and increases borrowing costs thereby lowering corporate valuations. Moreover, bonds simply move inversely to prevailing interest rates so, as rates rise, bond prices generally fall. The 10-year US Treasury bond (chart below) may offer some clues on the path forward from here. What’s interesting about the chart is that long-term treasury bonds (e.g., the 10-year yield) never spiked as much as inflation. For example, yields plummeted with COVID (a perceived deflationary event) but the peak yield once inflation started was only about 50% higher than its 10-year average yield. In contrast, inflation (i.e., the CPI) spiked to about 500% of its decade average. The bottom line is that the bond market always viewed inflation as a short-term event and rose to just over 4% with a sky-high inflation reading of 9%. This price action might indicate that it will be tough for long-term bonds prices to fall much below levels seen in late 2022.

Now, with peak inflation and long-term bond yields likely in the rear-view mirror, it may be time to begin adding “duration” (i.e., bonds with longer-dated maturities) back into investment portfolios, depending on one’s risk profile. Longer duration bonds have larger price movements in response to changes in interest rates. So, if one believes that bond prices will rise to bring yields back in line with 10-year averages we may have a buying opportunity.

The equity picture is a trickier one. While the Fed has indicated that rate increases may be ending, it is noteworthy that they are still aggressively tightening and most economists see a recession in the next 6-18 months. While time will tell if now is a good entry point into the equity market, some sectors and factors are performing quite well. For example, value stocks are making a resurgence as would be expected and certain inflation beneficiaries are performing well (e.g., energy and commodity producers).

2023 is shaping up to be an interesting year for managers like Patina who utilize a tactical overlay to equity and bond portfolios. The volatility and rapidly shifting conditions should provide opportunities to add value. We look forward to monitoring market conditions and will attempt to capitalize on the opportunities ahead.

2022 4th Quarter Market Commentary

A Special Thank You.

To all of our clients and friends of Patina, we would like to take a moment to thank you for your continued support. While 2022 was a challenging year for markets, we were able to grow our business by over 40%. Most of our growth comes from client and friend referrals, which we appreciate very much. We plan to continue to build your trust by working hard to deliver top-tier service levels and performance. We believe that our dynamic asset allocation approach, where we look for rebalancing opportunities across equity sectors and bond durations, was a big value-add during 2022. We think this type of active approach will be critical going forward as we’re likely to see continued heightened volatility and inflation. Best wishes for a happy and healthy new year.

Top Headline for Q4: Light at the End of the Tunnel?

Markets were at the mercy of the U.S. Federal Reserve Bank (the “Fed”) for most of 2022. With inflation running higher for longer than expected post COVID, the Fed aggressively increased interest rates throughout 2022. After starting the year with the Federal Funds Rate near zero, we finished 2022 with a target rate of 4.25-4.50%, representing one of the fastest rate-hiking cycles ever. Predictably, equity and bond markets sold off hard in response to the rate increases and rallied with each perceived pause. However, markets now see some light at the end of the tunnel and are predicting that we’re near the “terminal rate” level (i.e., the highest Federal Funds Rate before a rate decrease occurs). As the table below shows, the Fed has slowed the pace of hikes and has admitted that they are nearing the end of the increases. While a few more small increases are expected, the key question is how long rates will be held around current levels should we enter a recession or see continued equity market pain.

Schedule of 2022 rate hikes by the Federal Reserve Bank.

When looking at winners and losers from 2022, it’s a predictable story based on interest rate movement. On the equity side, as would be expected, the higher interest rates punished growth (e.g., the large cap value ETF (SCHV) was down only around 7% while the large cap growth ETF (VUG) fell over 33%). On the bond side, “long duration” assets were hurt the most having one of their worst years on record. 

While the equity market drops tend to get a lot of headlines, it’s the volatility in the bond market that is the most historically noteworthy. The whipsaw from COVID shutdowns to COVID economic stimulus, followed by spiking inflation and aggressive Fed action, battered the bond market and added near record levels of volatility. For example, after starting the year around 1.5%, the 10-year treasury bond yield spiked to over 3.5% in June before falling to around 2.6% in August only to spike again to over 4.2% in October and finish the year just under 3.9%. This is an incredible amount of volatility in a short period of time and highlights the uncertainty around inflation and interest rates throughout the year.

General Market Update

US Equities:  2022 finished with the S&P 500 Index down 19.4% and saw all equity sectors down except for Energy. Not surprisingly, the big winners from the 0% interest rate world proved to be the big losers as rates climbed and liquidity tightened. For example, as measured by the SPDR ETFs, technology, consumer discretionary, communications and real estate faced declines in the 25-40% range. Moreover, all of the previously invincible tech behemoths (i.e., Meta f/k/a Facebook, Apple, Amazon, Microsoft and Google) all faced massive declines led by Meta, which was down over 64% for the year.

The equity market seemed to stabilize a bit during Q4 as quality value names gained ground. The S&P 500 Index was up 7.1% during the quarter, while the Nasdaq Composite was down 1.0% and the Russell 2000 Index climbed 5.8%. The divergence in equity sectors throughout 2022 provided an opportunity for Patina’s dynamic sector weightings, and we were active in rebalancing throughout the year. Portfolios benefited from a heavier sector weighting toward “Value” sectors such as Energy, Financials, and Industrials, as well as sub-sectors such as Oil & Gas Exploration and Oil Services.

International and Emerging Market Equities:  After taking a beating in recent years relative to the US equity market, international markets appear to be stabilizing and outperforming in recent periods. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 16.7% in Q4, and the Schwab Emerging Markets ETF (SCHE) was up 8.3%. Energy inflation issues plaguing Europe have subsided a bit, and the “re-opening” of China should provide a continued boost for emerging markets. Moreover, the US dollar may have reached a near-term peak relative to foreign currencies which would provide an additional tailwind for non-US markets. Lastly, foreign markets have benefited relative to the U.S. for having a lower allocation to “growth” names. 

Fixed Income and Credit: 2022 was a brutal period for fixed-income investors. Fraught with extreme volatility, the bond market endured one of its worst years ever. For example, the long-term corporate bond market, as measured by the ETF VCLT, was down over 25%. However, while volatility remains, the long-term bond market seems to have ended its rapid descent with VCLT up 5.0% during Q4. We were successful in generally predicting the bond market route, and throughout 2022 Patina clients benefited from a substantial overweight to shorter-duration bonds. As an example, the short-term corporate ETF, VCSH, was down 5.6%, significantly outperforming the previously mentioned long-term corporate bond ETF.

Commodities, Precious Metals, Inflation: Real assets and inflation hedges will continue to play a role in investor portfolios in the coming years. While the post COVID inflation spike seems to be dissipating, economists continue to debate where long-term inflation expectations will land in the coming years. In a bit of good news, the last two Consumer Price Index (CPI) reports for 2022 both came in slightly below expectations, thus giving investors a sense of optimism heading forward. It was noteworthy that the gold ETF (GLD) was up 9.7% during Q4. This movement was unexpected as “real yields” were up during the quarter across the entire bond curve – an environment that typically leads to falling precious metal prices. Global investors may be beginning to question how governments are going to pay for budget deficits and underfunded obligations (e.g., social security) without currency devaluation.

A Look Ahead

The “Fed Watching” is likely to reach a crescendo in 2023. It seems clear that we’re near the terminal rate which should help equity and bond markets stabilize. However, equity markets could face continued headwinds if rates remain at elevated levels versus having an actual “Fed pivot” (i.e., a reduction in rates). Moreover, there is a lag on rate increases hitting corporate margins, and a rough patch for US corporate earnings is expected during 2023. We will be closely watching for heightened volatility as we enter 2023 but anticipate increased stability as we exit 2023. With the increased volatility and continued uncertainty, choosing the right sectors and factors and taking advantage of rebalancing opportunities will be more important than ever. We are excited about the opportunities ahead in 2023.  

Inflation Boosts Retirement Savings Potential

By this point, we’re all feeling the effects of inflation. Energy, food, rent and other key expenditures have been surging of late. While economists can argue over the causes (e.g., excessive Federal Reserve Bank intervention vs. COVID effects) it’s clear that we are experiencing it and that it is proving more persistent than previously expected. Many provisions of the tax code have cost-of-living-adjustments (“COLA”) which are intended to offset inflation impacts. In 2001, this became true for retirement savings as contribution limits became pegged to inflation. The IRS recently announced the amount investors can contribute to their retirement accounts for 2023. 

Before we look at discretionary retirement savings plans, let’s first take a quick look at Social Security. The Social Security Administration announced a COLA adjustment from 2022 to 2023 of 8.7% which amounts to the largest increase in over 40 years. This change will take effect in January of 2023 which will be well-received by retirees on fixed incomes who are one of the groups most adversely affected by inflation.

Moving on to discretionary retirement savings, there are several key changes. The contribution limit on individual retirement accounts (“IRAs”) increased from $6,000 to $6,500 (an 8.3% increase). Moreover, the contribution limit for employees who participate in 401(k), 403(b), and most 457 plans increased to $22,500 from $20,500 (a boost of 9.8%). For those who participate in a small business retirement plan, the amount individuals can contribute to their SIMPLE IRAs increased to $15,500, up from $14,000 (a whopping 10.7% increase). In addition, the amount one can contribute to a SEP IRA increased to $66,000 for 2023, up from $61,000 (cannot exceed 25% of gross income). The “catch up” provision for savers over 50 years of age had some slight modifications as well. Participants in 401(k), 403(b) and 457 plans saw their “catch up” contribution increase to $7,500, up from $6,500. Simple IRA “catch up” contributions increased to $3,500, up from $3,000. The “catch up” provision for savers over 50 years of age did not change for Traditional and Roth IRAs, and remains at $1,000.

Getting into the details a bit, we also saw substantial improvements in eligibility thresholds and “phase out” ranges (i.e., income levels at which either tax-deductibility or eligibility is reduced). As a reminder, there are two types of IRAs (i.e., traditional and Roth). Traditional IRA contributions can often be tax-deductible while Roth contributions cannot. Roth IRAs, however, are not subject to specific requirements on withdrawal timing, and withdrawals are not taxed. Therefore, required minimum distributions (“RMDs”) for traditional IRAs start in the year when taxpayers turn 72, while Roth IRAs have no such requirement. Eligibility for each IRA type depends on income (i.e., your “modified adjusted gross income” from one’s tax return). In summary, the income phase‑out ranges for tax-deductibility of traditional IRAs in 2023 are as follows:

• For single taxpayers covered by a workplace retirement plan, the phase-out range is increased to between $73,000 and $83,000, up from between $68,000 and $78,000.

• For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is increased to between $116,000 and $136,000, up from between $109,000 and $129,000.

• For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the phase-out range is increased to between $218,000 and $228,000, up from between $204,000 and $214,000.

As mentioned, Roth IRAs are never tax deductible but there are income levels above which one can no longer contribute to a Roth IRA. The income phase-out range for taxpayers to be eligible for a Roth IRA contribution are as follows:

• For singles and heads of household, the phase out range is between $138,000-$153,000, which is up from $129,000-$144,000.

• For married couples filing jointly, the phase out range is between $218,000-$228,000, which is up from $204,000-$214,000.

Taking advantage of these increases can help reduce the amount of taxes you pay while at the same time helping you save for retirement. Please contact us if you would like to discuss these opportunities in more detail

2022 3rd Quarter Market Commentary

Top Headline for Q3: Resolute Central Banks Sinking Risk Assets

The challenging market environment continued in Q3. Central banks, most notably the U.S. Federal Reserve Bank (the “Fed”) have been firm in their stance that inflation is enemy number one. In attacking inflation, the Fed has aggressively increased interest rates beyond most of our expectations which, as would be expected, has pummeled long-term fixed-income assets and risk assets generally (e.g., stocks). As measured by the S&P 500 Index, the U.S. stock market was down 24.8% through September 30. Similarly, the bond market, as measured by the Bloomberg U.S. Aggregate Index was down 14.4% through September 30.

The Fed effectively controls short-term interest rates but has less control over long-term rates which are a key driver of “risk asset” performance. Long-term rates are driven more by long-term inflation expectations which are a function of factors like demographic changes, GDP growth and changes in productivity. It is noteworthy that the yield curve is currently inverted. Long-term rates are refusing to follow the path upward, resulting in short-term rates that sit above long-term rates. This process can lead to short-term volatility as the market tries to establish a foothold. We saw this process play out in recent months. After peaking at about 3.5% in mid-June, the rate on the 10-year treasury bond dropped dramatically to about 2.5% in early August. The 10-year continued its volatility, hitting 3.99% on September 27th, before ending the quarter at 3.8%. The impact of long-term rates on the stock market was on full display during the quarter. As interest rates dropped early in Q3, stocks were in rally mode. But, as rates shot higher, stocks responded by dropping precipitously. The long-term fixed income market has already “priced in” an aggressive tightening path by the Fed. As a result, we believe the fixed income market is looking more attractive than it has over the past couple of years.

 General Market Update

US Equities:  As has been the case most of the year, there were very few places to hide in the equity market in the 3rd quarter. The S&P 500 Index was down 5.3% during the quarter; the Nasdaq Composite was down 4.1%; and the Russell 2000 Index dropped 2.5%. Although most sectors are down, there is a clear “loser” this year. The rising rates have punished the Technology sector more than others as earnings from these companies are pushed further into the future and are thus hurt the most by a rising discount rate. As evidence, the Technology ETF, XLK, was down 6.3% for the quarter and is down 31.2% YTD. The market selloff in September was especially sharp. After bouncing from June lows, the S&P 500 fell a staggering 9.3% in September alone. During the 3rd quarter, we continued to rebalance and worked to take advantage of the market volatility. IRA portfolios saw a "defensive" rebalance earlier in September which set aside some cash and shifted some equity allocation to more defensive sectors of the market. Late September, we deployed another rebalance after the S&P 500 had dropped by an astounding 15.3% from August 16th to September 27th. We believe, according to several indicators, that the market currently sits at an attractive entry point in the short term. We will continue to monitor markets and adjust portfolios accordingly. 

International and Emerging Market Equities:  The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was down 10.6% in Q3 and the Schwab Emerging Markets ETF (SCHE) fell 11.7%. In general, foreign markets have a lower allocation to the technology sector. However, other issues persist. For example, Europe is presently facing a more severe inflation problem than the U.S. along with rising geo-political tensions and an energy crisis sparked by the Russia-Ukraine conflict. Elsewhere, China has witnessed a total collapse of its real estate sector and lower growth as rolling Covid lockdowns continue throughout the country.

Fixed Income and Credit: The bond market slide continued during Q3 across all durations. However, as covered above, the long-term bond market appears to be trying to stabilize. Long-term corporate and treasury bonds have now fallen close to 30% for the year and are now attractively priced by many measures. Many longer-dated bonds are trading at a yield that is above long-term inflation expectations. This suggests a positive “real” yield which could indicate that the carnage may soon subside. Patina clients benefited from a substantial overweight to shorter-duration bonds during the quarter and in 2022, and we will look to increase exposure to duration as the markets continue to stabilize. 

Commodities, Precious Metals, Inflation: Inflation has proven to be higher and more persistent than most people predicted. However, several indicators suggest that inflation has now peaked. As an example, home prices fell for the first time since 2012. Similarly, rent prices have also begun to come down. The key questions going forward are “How far will inflation fall and how fast?” The Fed’s “target” is 2% but many economists think inflation will settle at a level higher for the foreseeable future. Inflation in commodities has been more episodic than persistent, and rising rates are likely to hurt demand and ease pressures. Inflation hedges, such as precious metals, have oddly underperformed during the present environment as investors have been slow to move away from traditional investments. If a period of “stagflation” (i.e., low growth & above average inflation) persists, it is likely that inflation hedges will benefit.

A Look Ahead

As we enter Q4, more attention than ever will be on the Federal Reserve Bank of the United States. Chairman Powell has indicated that there is no way to combat inflation without causing some pain to the economy. Although he won’t mention the word recession, this is what he is referring to. The key question is “How much damage is the Fed willing to cause before they inevitably pause?” Any pause in interest rate increases or a hint of a pause will be supportive of risk assets. Most notably, we would likely begin to see a flood of capital into longer-dated fixed income securities. It’s likely to remain challenging for the equity market should the Fed push the economy into a recession. On the equity front, choosing the right sectors and asset class styles (Value/Growth) will be more important than ever.

Please feel free to reach out during this heightened period of volatility. We are more than happy to walk through portfolio allocations and the rationale behind various positions. We’re hopeful that much of the storm is behind us at this point and are excited about the opportunities ahead.