Investment Management - First Quarter 2023

Because We Were Inverted!

In the original Top Gun film, Tom Cruise's character, Pete "Maverick" Mitchell, used our title's phrase (though in the singular form) when explaining how he had specific intelligence after his audacious encounter with a MIG 28. The tense scene ended with a memorable moment as Maverick's upside-down F-14 TOMCAT flew a couple meters above the MIG, while his co-pilot snapped a Polaroid. The yield curve is also having a memorable moment, one of the most-watched indicators of a recession, as the spread of the 10-year Treasury yield minus the 2-year yield, has remained inverted since July.

The yield curve normally slopes upwards, since longer maturities require accepting additional risk, and therefore, pay higher rates of interest. Yield curve inversion usually occurs after the Federal Reserve ("Fed") raises short-term borrowing costs, and pessimism rises over future economic growth. Six months ago, investor sentiment was dour following a similar occurrence, which accompanied a nine-month contraction in asset prices. Investors were inundated with recession forecasts because the curve inverted, but so far the economy has been resilient.

During the first quarter, equity markets continued to rebound from those October lows. The total return for the S&P 500 was 7.50%. Mid and small capitalization stocks, tracked by the S&P 400 and S&P 600, rose 3.81% and 2.57%, respectively. The international MSCI EAFE Index jumped 8.47%.

Performanceⁱ for various indices for the three-month (not annualized), one-year, three-year, and five-year periods appears below:

Bond Indices

Equity Indices

Last year's narrative is well known. The Federal Reserve's (the "Fed") aggressive tightening of monetary policy was to curtail elevated levels of inflation. While inflation data peaked, certain categories remained "stickier" than forecasted. Geopolitics focused on Ukraine and potential escalation, while economic growth in China was non-existent due to the country's zero-tolerance COVID policy. Most economists were also too pessimistic on the European Union, since the block was concerned over energy prices. Recently, investors were blindsided by the failure of two large regional banks, Silicon Valley and Signature.

Today, the outlook remains muddled, though there are reasons for optimism. Foremost, we believe the rate of inflation should continue decelerating, due to the lagged effect of shelter costs on the Consumer Price Index ("CPI"). Shelter is the largest positive contributor to CPI, and current rental data confirmed expectations for smaller increases. Lower inflation generally provides the Fed greater flexibility in conducting monetary policy, particularly allowing the Fed to pause interest rate hikes after last year's unprecedented sequence of increases. Fed Fund Futures market is forecasting one additional 25bps rate hike at the Fed's May meeting, though expectations were lowered last month as the regional bank crisis unfolded.

Tight labor markets, along with rising wages, tend to add resiliency to a consumption-based economy. Jobless claims remain low, despite large layoff announcements from several major technology companies. Generally, households are in a strong financial position, when comparing debt servicing costs and outstanding credit to higher wages earned. Internationally, expectations for growth have been revised to a higher level of growth after China reversed many of its zero-tolerance policies. However, geopolitical events still present an overhang, particularly elevated tensions between the U.S. and China.

Since the theme of this letter is related to planes, we would be remiss not to associate our expectations with a few "landing" scenarios that economists use. A soft-landing for the U.S. economy suggests that the Fed was successful in slowing the rate of inflation, with only a limited impact to economic growth and employment. Along with the positive factors already mentioned, there are instances where an inverted treasury yield curve was not followed by a recession. Economic expansions are dynamic and history suggests a powerful bias toward growth. It is no surprise that a majority of sell-side strategists assign this scenario as most probable.

A hard landing is the label used for a negative outcome, where tighter monetary policies cause the economy to contract, along with a substantial increase in unemployment. The entire Treasury yield curve is now inverted, including Jerome Powell's preferred measure using only maturities within the first 18 months.ⁱⁱ  There are several industries that have already stalled due to higher interest rates, housing being a prime example. Manufacturing has weakened, and recent new order data from ISM's Manufacturing Survey indicate new orders are not rebounding. Adding weight to this scenario was the recent crisis among a few regional banks. Silicon Valley Bank's failure triggered massive money movement, even from safe institutions. The result was a dramatic decrease of banks' willingness to extend credit, according to the American Bankers Association.ⁱⁱⁱ

A small number of forecasts discuss the optimal outcome that Fed policy has little or no impact to the U.S. economy. This has been dubbed a no-landing scenario, and appears least likely to occur, especially as credit standards tighten. Though the current expansion has proven to be resilient to date, we remain cautious that a recession has been delayed, not canceled. To reiterate our position, equity allocations will be kept closer to target, and we believe a more balanced approach will be key. We are keeping exposure between growth and value closer than during the pandemic, and we have increased international exposure to be more in-line with weightings in the WFS Benchmark. This is a shift in strategy, as we have been underweight in our exposure to international equities since 2012.

Barring client-specific reasons to do otherwise, we are currently reinvesting proceeds from stock sales into fixed income to take advantage of what we see as opportunities in the bond market to lock in yields that have not been available in over a decade. These higher yields are currently available across all maturities. Back in October, the yield on a 10-year Treasury bond peaked at 4.33%. If that is a durable high for yields over the intermediate-term, bonds will return to becoming ballasts for future equity market volatility and will position portfolios well should rates fall. These are broad comments about portfolio management, and investments for individual accounts are dependent on each client's specific circumstances.

West Financial Services continues to add to our teams, and our people continue to be recognized for their accomplishments. We would like to welcome Daniel McManus, CFA, who joined our team as a portfolio manager. Dan earned his bachelor's degree in Economics from Babson College and holds an MBA from Columbia University. In addition, congratulations are in order to Glen Buco for his recognition in the Top Financial Advisers 2023 Hall of Fame^iv by Washingtonian magazine in the February 2023 issue.

Our annual disclosure documents, Client Relationship Summary (Form CRS) and Form ADV Part 2A, have recently been filed with the SEC. There have been no material changes to our Form ADV Part 2A and Form CRS since the filing of previous amendment on October 7, 2022, and March 29, 2021, respectively. Our current Form CRS and Form ADV Part 2A are available on our website and the SEC's website, and can be provided to you in hardcopy form upon request. We have provided performance numbers for the quarter, one-year, three-year and five-year periods, where appropriate.

Follow us on LinkedIn or view our recent blog post. Thank you for your continued confidence in West Financial, and please do not hesitate to refer friends, family or co-workers who you feel may benefit from our services.

President	Chief Investment Officer
Glen J. Buco, CFP®	Glenn Robinson, CFA

ⁱEach of the S&P 500 Index, the S&P 400 Index, the S&P 600 Index, the MSCI EAFE Index, the ICE BofA 1-5 Year Index, the ICE BofA 1-10 Year Index, the ICE BofA 1-12 Year Municipal Bond Index, the Dow Jones Industrial Average, and the NASDAQ Composite (each, an “Index”) is an unmanaged index of securities that is used as a general measure of market performance. The performance of an Index is not reflective of the performance of any specific investment. Each Index comparison is provided for informational purposes only and should not be used as the basis for making an investment decision. Further, the performance of your account and each Index may not be comparable. There may be significant differences between the characteristics of your account and each Index, including, but not limited to, risk profile, liquidity, volatility and asset comparison. The performance shown for each Index reflects no adjustment for client additions or withdrawals, and no deduction for fees or expenses. Accordingly, comparisons against the Index may be of limited use. Investments cannot be made directly into an Index.

ⁱⁱhttps://www.bloomberg.com/news/articles/2023-03-23/powell-s-own-guide-to-recessions-shows-rate-cuts-are-coming?sref=dBWn1Py7. 

ⁱⁱⁱhttps://www.aba.com/news-research/analysis-guides/aba-credit-conditions-index.

^ivTo arrive at the names of the area’s top financial advisers — the fee-only financial planners, fee-based advisers, estate attorneys, tax accountants, and insurance advisers marked with a “best adviser” tag — the Washingtonian distributed surveys to hundreds of people who work in the local financial industry, asking them whom they would trust with their own money. Washingtonian also did their own research, consulting industry experts and publications. The “best adviser” names on this list are the people who received the strongest recommendations. Firms do not pay a fee for employees to be considered or placed on the final list of “Top Fee-Only Financial Planners” or “best adviser”.

West Financial Services, Inc. (“WFS”) offers investment advisory services and is registered with the U.S. Securities and Exchange Commission (“SEC”). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS. The information contained herein does not constitute investment advice or a recommendation for you to purchase or sell any specific security. You are solely responsible for reviewing the content and for any actions you take or choose not to take based on your review of such content. 

This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Certain information contained herein was derived from third party sources as indicated. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. We have not and will not independently verify this information. Where such sources include opinions and projections, such opinions and projections should be ascribed only to the applicable third party source and not to WFS.

Certain statements herein reflect projections or opinions of future financial or economic performance. Such statements are “forward-looking statements” based on various assumptions, which may not prove to be correct. No representation or warranty can be given that the projections, opinions, or assumptions will prove to be accurate.