Asset class recap for February
Stocks had a very good February and returns are now in strongly positive territory across the board for 2024 year-to-date. Bonds have not done as well and posted a second consecutive month of poor returns, as investors are realizing that the U.S. Fed is unlikely to lower interest rates as much as investors expected at the end of 2023.
Investors liked what they saw from corporate earnings reports in February and bid prices up to new record highs. The market became almost effervescent after NVIDIA’s earnings report on February 21 beat expectations. A significant part of the stock market’s price appreciation since Oct 2022 has been due to expected growth in revenues and profitability due to Artificial Intelligence advancements. NVIDIA’s 769% year-over-year net income growth provided evidence that some of the hype may be warranted.
Technology stocks are up an annualized 18.9% over the last 3 years, but many investors do not realize that Tech stocks are not the market leading sector over this period. Energy stocks are up even more, with an annualized return of 26.9%. The import ban on Russian petroleum that resulted from the invasion of Ukraine pushed up oil prices significantly and created strong demand for U.S. oil. The chart below shows rolling 3 year annualized returns for each of the 11 U.S. stock market sectors. The yellow line shows that Energy stocks exhibit a low correlation with other stock sectors.
Banks and Commercial Real Estate Risk
During our Advyzon Conference two weeks ago, a few advisors brought up the topic of potential riskiness in the banking sector due to Commercial Real Estate exposure. Commercial Real Estate faces the double-whammy of a sharp rise in interest rates over the last couple years and a decline in demand for office space because many people are working from home after COVID. Many builders financed commercial construction at low interest rates between 2009 and 2021. Now that interest rates are back up to normal long-term levels, many builders are going to have to refinance their buildings at meaningfully higher interest rates. This potential problem is not just an issue for real estate related borrowers, but any other borrower who has a high debt to income ratio and may have difficulty continuing to make a profit by passing higher interest costs on to clients.
A major macroeconomic factor that is providing an offsetting tailwind for banks is the recent steepening of the yield curve. Most banks borrow at shorter term rates and lend at longer term rates. When the yield curve is inverted (short term rates are higher than long term rates), banks have a harder time generating profits through traditional banking. When the yield curve is upward sloping (long rates are higher than short rates), banks earn a wider spread on traditional lending. A second macroeconomic factor that has benefitted banks and will likely continue to benefit banks during 2024 is strong U.S. GDP growth. When the economy overall does well, banks tend to have lower loan default rates. Although we expect to see challenges for some Commercial Real Estate loans, most other borrowers are doing well. Investment grade credit spreads have been dropping since October 2022, providing evidence that most borrowers are not having trouble covering their financing costs.
There are over 4,000 banks in the U.S. and they can have very unique specializations when it comes to lending. I expect that there will be a few banks that run into difficulty because their loan portfolios are overweight on shorter term, lower credit quality, Commercial Real Estate lending. However, this does not feel like a 2007 / 2008 scenario when lending standards for a majority of lenders were obviously too loose and many sub-prime borrowers who were at high risk of having difficulty repaying loans were approved for loans. Overall, I expect the tailwinds mentioned above to more than offset Commercial Real Estate related loan losses. I continue to predict that 2024 will be bright for the financial sector relative to the market overall.
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