Accretive Q1 Client Letter

Dear Clients and Friends of Accretive,

At the end of the first quarter, billable assets under management at Accretive totaled approximately $242 million.  As a result, we are waiving 7.5% of our management fee for the second quarter of 2023 under our Client Alignment Program™ (CAP).   As a reminder, our CAP program is subject to annual renewal.  In March, we updated our Form ADV to reflect renewal of the program through March 31, 2024.

First Quarter Recap

Markets continued to recover lost ground in the first quarter as the year got off to a decent start.

Equity markets rose despite economic data that suggested the economy was slowing along with troubles emerging in the banking system, both within the US and outside our borders.  In the US, stock indices large and small posted increases; however, larger cap stocks were stronger than smaller ones.  Outside the US, markets also gained.  Foreign developed markets were the leader and better than developing markets, owing to a somewhat weaker US dollar.  To the extent the dollar continues to weaken, that would be a tailwind for foreign stocks.  

Bond markets continued to recover, as interest rates fell for bonds.  The only rates that did not experience a meaningful decline were the shortest dated, where the Federal Reserve and other central banks have the most influence.  Despite a few notable bank runs, and emergency stopgap measures from the regulators, the Fed continued with increases to the Fed Funds Rate.  The market for creditworthy borrowers seems to have held up, albeit the cost of borrowing is higher today.  

The Banking System

In prior quarters, we struggled to come up with something new to say, as the market environment and concerns were generally inflation related.  This past quarter saw the emergence of a whole new concern, the health and soundness of the banking system.  

As we write this, 3 larger banks in the US have failed:  Silicon Valley Bank, Signature Bank, and First Republic.  These banks had different business models but some version of the same problem.  All three banks had a large percentage of uninsured deposits and losses on assets that were purchased in a much lower interest rate environment.  As depositors lost confidence, these banks experienced runs and could not sell assets at prices that kept the institution solvent.  In Europe, Credit Suisse experienced a similar loss of confidence and was pushed into the arms of a competitor by the Swiss government.  

The market for equities and interest rates has gyrated in response but generally held up as policymakers have responded with lending programs to sure up confidence in the system.  As a result, the bank runs have slowed to a pace more akin to a walk, at least for now.  Conventional wisdom from the 2008 financial crisis was that capital was king for banks and the banking system.  Today it seems that capital without confidence is insufficient.  

A year ago, the consensus was that higher rates were good for banks.  The view was that banks could earn more on their assets, and while their cost of funding may go up, it would go up more slowly than what they could earn.  However, the pace of interest rate increases has been sharp, and banks learned that the speed at which their deposit costs rise may not be stable.  As depositors look to earn more on their cash, banks must offer more attractive rates to hold onto their deposits or risk losing them.  This creates pressure on earnings and decreases a bank’s appetite to lend, at least as long as the higher short-term interest rate regime holds.  

For regional and smaller banks, it’s a tough environment.  As we go forward, it seems reasonable to expect more bank failures along the way.  While the failures may be among banks that individually are less systemic in nature, enough non-systemic failures could be considered systemic when viewed in aggregate.  

Larger, systemically important banks have something of an implied deposit backstop, similar in nature to the implied backstop Fannie Mae and Freddie Mac mortgages had prior to the 2008 financial crisis.  The current set-up seems to be a situation where the biggest banks are poised to get even bigger, an example of this is JP Morgan’s recent acquisition of the failed First Republic.  We think that from a public policy perspective it may not be an ideal situation, but it is unclear what, if anything, could alter it.  

What We Think

The market has improved this year, but the breadth of the improvement has not been all that wide in the US.  Small and mid-size US companies, as a group, have lagged larger companies in the market.  The same is true for publicly traded Real Estate Investment Trusts.  To the extent these are in a portfolio, they have been a drag.  As a group, we think the valuations are reasonable in the context of a longer time horizon.  

Across the market, the more growth-oriented sectors have fared better than more value-oriented sectors.  We think definitions of growth and value are in the eye of the beholder, but recognize that the market increasingly classifies, groups, and trades companies according to these definitions.  

We are in the midst of earnings season.  There’s some gamesmanship with companies and analyst estimates, but in general, companies have reported results that appear acceptable however visibility on the outlook going forward seems lower than normal.  The market seems very different than the one from two years ago. Today companies seem to be getting rewarded for reducing or managing the growth of their costs instead of pursuing growth at any cost.  We think a period of belt-tightening is prudent.  It will be interesting to see how lean corporate America can get.

The market and Fed continue to be at odds with one another in terms of their respective forecasts for rates.  We believe the Fed to be sincere in their projection and think it is wise to take them at their word unless something changes.  A banking crisis could be that change, depending on how it evolves from here, but they appear to be holding firm with their forecast and rhetoric.

What are we doing?

In our portfolios, we continue to apply our investment process and adhere to a long-term philosophy.  To the extent a position needs to be sold, we may not have something we purchase immediately and will hold cash equivalents, but we do intend to find opportunities to put the proceeds to work for the long-term.  To the extent we have cash equivalents in the portfolio, we seek to have it in vehicles with market interest rates.  We have also sought to keep excess cash in similar vehicles.  

As a reminder, we have always believed that less tends to be more when it comes to trading activity.  That said, we consider many potential positions and scenarios but contemplate more potential changes than we make.  We anticipate having a relatively normal level of activity, but how much depends on how markets evolve, the opportunity set, and expectations relative to asset prices.  

Concluding Thoughts

The first quarter was surprisingly good for markets.  Whether that continues, holds, or reverses remains to be seen.  Short-term predictions are hard and the prevailing market narratives have a way of shifting unpredictably.  The economy seems to be slowing, but the market and economy are not one and the same.  To the extent strength continues, we may have cash and equivalents build some.  If, and when, there are sell-offs, we expect to find opportunities to put excess cash to work for the long-term.    

We appreciate the trust and confidence our clients have in us. If you have any questions or concerns, please feel free to contact us.  We would welcome speaking with you.

Sincerely,

Gary C. Ribe, CFA, CFP®

Chief Investment Officer, Managing Partner

gary@accretivewealthpartners.com

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