Last weekend, OPEC+ announced a production cut, causing a surge in crude oil prices and making the current market narrative more confusing.
On the one hand, the footsteps of the recession are getting closer. Despite the temporary relief of the European and American banking crises after the Fed provided temporary liquidity, the erosion of bank profit margins and the tightening of credit in a high-interest-rate environment have not fundamentally changed.
On the other hand, stagflation has not ended. The rise in crude oil prices is likely to prolong the high-inflation level and limit the Fed's pivot.
How should we allocate our investment portfolio?
I. Q1 Asset Performance Review
1. Major asset returns
Source: Bloomberg. Denominated in USD; 2023/1/1-2023/3/31
Looking back at Q1 2023, major global assets have performed well. Major stock indices have all posted positive returns, with the $NASDAQ(.IXIC)$ index up 20%, technically entering a bull market; bonds have also performed well, with US, European, and emerging market government bonds all performing well; Bitcoin has soared more than 70% in a single quarter. In addition, the weakness of the US dollar in Q4 continued, and the euro, yuan, and other currencies all had some gains. There was a significant differentiation in commodities, with $Gold - main 2306(GCmain)$ performing well and energy commodities dropping sharply.
2. Major strategies’ gains
The specific indices are JPM Global Macro: Global Macro Opportunities Fund; Trend Following: Bloomberg GSAM Commodity Trend Index; Equity Neutral: HFRX Equity Hedged Strategy Index; JPM Global Allocation: JPMorgan Global Allocation Fund; Global 6040: Bloomberg Global 6040 Index; GS VIP Hedge Fund: Goldman Sachs Hedge Industry VIP ETF.
source: Bloomberg; 2023/1/1-2023/3/31
II. Market Interpretation
1.Banking crisis has been temporarily alleviated, but the situation of narrowing net interest margins has not changed.
In terms of quantity, the outflow of deposits from small and medium-sized banks has been temporarily alleviated.
$SVB Financial Group(SIVBQ)$ and other small and medium-sized bank crisis that occurred at the beginning of March resulted in a significant outflow of deposits from small and medium-sized banks.
According to Bridgewater's statistics, at least $400 billion of deposits flowed out from small and medium-sized banks and flowed into large banks or money market funds between March 8 and March 15.
Source: Bridgewater
In fact, the outflow of deposits from US commercial banks began in Q2 last year and has reached $1.01 trillion as of March 22 this year. There are two main reasons for this:
a. Excess savings of US companies and residents that obtained from the 2020 fiscal stimulus have gradually exhausted.
b. After the Fed raised interest rates, money market funds and some high-yield online banks can provide higher returns, diverting some deposits.
From the perspective of the deposit structure of commercial banks, large deposits have risen rapidly by $330 billion since early October last year, reflecting the demand of depositors to lock in higher interest rates.
However, due to the fact that small banks like Silicon Valley Bank can meet the special financing needs of depositors (mostly small and medium-sized start-ups), their deposit amounts remained high at the end of last year. It was not until early March this year that the deposit rapid decline began due to its stock issuance financing leading to deposit runs. However, due to the swift action of the Fed, the deposit outflow of small and medium-sized banks in the United States has been temporarily alleviated.
Fed's BTFP program provides short-term financing for small and medium-sized banks for a period of one year, which can prevent the liquidity crisis from spreading to the entire banking system. After obtaining new financing from the Fed, small and medium-sized banks do not have to sell securities such as US Treasuries and MBS held on the asset side at a loss in order to meet the funding needs of some depositors.
However, the situation of banks' net interest margin narrowing may still be worsening.
The cost of financing obtained by these small and medium-sized banks from the Fed is about 4.75%. According to the 2022 annual report of $First Republic Bank(FRC)$ , the weighted average interest rate of all deposits on its liability side is only about 0.4%. This means that if the bank replaces all the depositors' deposits on its liability side with financing from the Fed, it will lose more than 4% of the net interest margin.
According to FDIC data, as of Q4 last year, the net interest margin of banks with assets of more than $1 billion in the US was between 3.69% and 3.91%. If some small and medium-sized banks are in a situation similar to that of First Republic Bank, their current net interest margin may already be negative.
According to Bridgewater's estimate, if only 10% to 20% of bank's deposits on the liability side are replaced with short-term financing at a market rate of 4.75%, the proportion of banks with negative net profit and negative interest margin assets will increase significantly. As shown in the figure below, 80% of First Republic Bank's deposits have already been replaced with financing at market rates.
source: Bridgewater
Therefore, the situation of banks' net interest margin narrowing may still be worsening. Once the May FOMC meeting adds another 25bps, the interest cost of banks' liability side may also increase by 25bps. Since the deposit interest rate on the liability side of banks is mostly short-term interest rates, while the credit interest rate on the asset side is mostly long-term fixed interest rates, according to JPMorgan's financial report, if both short-term and long-term interest rates rise by 100bps, the core net interest margin will lose $2 billion; if the short-term interest rate rises by 100 bps while the long-term interest rate remains unchanged, the net interest margin will lose $2.8 billion.
In the upcoming earnings season, how major banks evaluate their net interest margin under different interest rate curve scenarios after the banking storm will be the focus.
Source: JPMorgan Chase FY2022 10-K
If the Fed does not pivot and the problems of banks continue to ferment, the expectation of the US economy entering a recession will deepen further.
Therefore, a reasonable assumption is that credit tightening in banks is imminent. For one thing, small and medium-sized banks may tighten credit standards; for another, investment and consumption needs of enterprises and residents may decrease, which may also reduce the demand for credit. From the latest data, the overall credit scale of US banks is still expanding, but there is a downward trend in consumer loans.
In summary, we expect that market speculation about a recession will continue, especially when unfavorable data appears in bank earnings or credit scale. Assets related to recession trading, such as gold and long-term US Treasuries, will benefit. However, based on the fact that both the Fed and US banks are likely to reduce their purchases of US Treasuries, and the TGA account balance of the US Treasury has fallen to pre-pandemic lows and US Treasuries are under pressure from lower demand while supply increases. We prefer $Gold - main 2306(GCmain)$ in our recession trade selection.
2. Behind the OPEC+ production cuts, there are low capital expenditures and high free cash flows of oil and gas exploration companies.
Over the weekend, OPEC+ announced production cuts, causing $WTI Crude Oil - main 2305(CLmain)$ to spike more than 7%. Since energy-related subcomponents account for over 7% of the CPI, its price increases will slow inflation back to 2% and limit the Fed's shift to rate cuts. This would both reinforce future recession expectations as mentioned earlier and imply stagflation in the US is not over.
Behind the OPEC+ production cuts lies an investment opportunity for energy companies. The reason for this is that global investment in oil and gas exploration has been hovering at low levels since reaching its peak in 2014, even though $Brent Last Day Financial - main 2306(BZmain)$ have doubled since their low point in April 2020.
Historically, similar periods of low investment in oil and gas exploration occurred between 1985 and 2002 due to uncertainty in energy demand, resulting in energy companies having a large amount of free cash flow, which they could use for dividends or share buybacks.
The white and yellow lines in the graph below represent the free cash flow of the two largest companies in the US energy sector, $Exxon Mobil(XOM)$ and $Chevron(CVX)$, respectively, with corresponding coordinates on the right axis. The orange and purple areas in the graph represent the capital expenditures (negative values) of these two global leaders, respectively, with corresponding coordinates on the left axis. It can be seen that the free cash flow of both companies is currently at its highest level in nearly 30 years, while their capital expenditures remain low.
source: Bloomberg
By subtracting the capital expenditures from the free cash flow for each quarter for both companies, we get the orange and purple bars in the graph below. It is clear from the graph that low capital expenditures and high cash flow periods often correspond to periods of rising total return indices that include dividends for both companies. At the same time, the rise of these two companies is not too affected by the fall in Brent crude oil prices $Brent Last Day Financial - main 2306(BZmain)$ (blue line), unless the oil price collapses, their stock prices will not see a significant retreat.
source: Bloomberg
Similarly, global capital expenditures in metal mining have also remained stagnant, even though gold and silver prices have risen by more than 20% since November last year. This also means that the shortage of energy and metal commodities may continue for some time before a new economic growth engine can significantly boost demand. Therefore, both energy and metal mining companies are good investment choices during a period of stagflation before a deep recession occurs.
Allocation recommendation: 50% money market fund+10% US oil stocks +10% US AI stocks+15% Greater China stocks +15% gold.
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