Video Update: The Bankrupt Financing the Bankrupt

More than a third of our nation’s gross domestic product (GDP) runs through regional banks.

In today’s video update, Chief Analyst Adam Galas explains one of the most absurd banking transactions he’s ever seen – essentially, the bankrupt regionals leading the bankrupt regionals.

What does this transaction mean for your Fortress Portfolio?

Click below to watch the video to find out.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today we’re talking about how the banking crisis might actually make inflation worse.

So what’s the latest on the banking crisis?

Well, Silicon Valley Bank (SVB) is being acquired by First Citizens Bank (FIZN) at about a 26% discount for its assets.

Now, that’s great news because First Citizens Bank is a regional bank that is buying a bankrupt regional bank.

Now, why does this matter? Well, because according to the Federal Reserve, small and medium sized regional banks generate 38% of all loans in our economy. They generate 67% of commercial real estate loans, 48% of consumer loans, 37% of mortgages, 28% of commercial loans, 27% of credit cards, and 15% of auto loans. In other words, if they stop lending, that’s a significant credit crunch.

Now, we have seen continued outflows from regional banks. For example, in the first week of the crisis JPMorgan estimated that about $550 billion went from regional banks to the big banks. In the last week, the outflow has dropped to 100 billion. 80% less, but still rather high.

Fortunately, it looks like since March 16, the flows had fallen even more. So the situation appears to be stabilizing.

That’s partially thanks to what’s happening with First Republic Bank (FRC)— which to remind you – is the 15th biggest bank in the country. Slightly bigger than Silicon Valley. So if it fails, that’s going to make for some very scary headlines indeed.

Well, JPMorgan (JPM), BlackRock (BLK) and Warren Buffett are all working with the government on a bailout package for First Republic, specifically trying to get someone to buy them.

Rumors are that someone like Royal Bank of Canada (RBC) might be interested.

In addition, the government is discussing expanding the Fed’s new bank term lending facility, which so far has lent out $54 billion to banks.

Now, overall, the Fed has lent about $400 billion over the last two weeks to the banking sector. This is not actually quantitative easing (QE) or money printing because when these loans are repaid, the Fed will simply destroy it.

So it’s a temporary money printing, unlike the regular money printing that lasts forever that we’ve been so used to for the last 15 years.

Now, what does this actually mean for the economy? Well, Goldman Sachs (GS) estimates that the regional banking crisis will cause credit to dry up and effectively have similar repercussions to the Fed hiking interest rates an extra 25 or 50 basis points.

Apollo Management (APO) thinks it could be as high as 1.5%, a significant tightening of financial conditions.

What does that actually mean for the economy? Goldman thinks it’s going to be mild, a 0.25% decline in this year’s GDP.

Well, a reduction of 0.25%, would mean that we could potentially still avoid a recession. J.P. Morgan thinks it might knock 1% off growth this year, enough to push us into a modest recession lasting about six months.

Now, is there actually any evidence of this? Well, that is where the St Louis Fed Financial Stress index comes in, which consists of 18 metrics.

Right now it’s telling us that everything from yield curves to credit spreads and loan losses went from -0.3% below average financial stress to 1.6% last week. Now, that indicates average levels of financial stress consistent with previous recessions.

So if we are headed for a recession within potentially the next four months, according to economic data and the bond market, meaning potentially by July, how is this bad for inflation?

Recessions generally cause inflation to fall, and that is expected to happen this time as well. However, the stagflation hell scenario that UBS and Société Générale of France have been warning about has actually increased.

And here’s why. Let’s consider the 1970s stagflation. What did the Fed do back then?

Well, when the economy started to struggle with from higher interest rates, the Fed did what everyone wants today, they pivoted. They did so in 1967, in 1972 and again in 1977 under Arthur Burns so-called stop-go policy. Now, this was a policy that was absolutely crazy.

The Fed would hike rates 50 points in one meeting and literally cut back by 75 in next meeting. If you think the Fed’s credibility is weak today, back then, Arthur Burns and the Fed had zero credibility. To give you an example, Paul Volcker in his autobiography talks about a meeting with business executives in 1980 when he announced that he was hiking rates to 20% and promised all those present that inflation would come down.

Well, one executive said that he had just signed a three-year contract with his union for 15% annual wage growth, and mentioned that he was very happy about did not believe that the Fed could ever beat inflation.

Well, of course, we know the end of the story. We did beat inflation under Paul Volker and had 40 years of falling inflation because as a result. With consistency and enough strength, you can, in fact, beat it.

Well, this is the scenario that Stockton and UBS are warning about today. Recently inflation peaked at 9.1% and has come down to 6%. But core inflation is stuck at 5% and expected to remain there for about the next two months.

Well, the problem is that even if we get a mild recession, inflation might come down to only about 3% or 4%.

And then if the Fed cuts rates and stimulates the economy, the economy starts to reaccelerate and inflation starts to rise again, but not from 1%, but from 3 to 4. And remember, the Fed’s not going to be cutting to zero as the market seems to think it might.

The bond market saying the Fed is going to cut from 5% down to 3%, but then they might have to start hiking again and this time they might not stop until six or 7% or even higher.

And that is essentially how we can get into a wage price spiral, because right now everyone expects inflation to be around 2-2.5% , at least according to the bond market and surveys of economists as well as consumers. But if inflation stays high for several more years, well, guess what? Those expectations start to rise. Suddenly consumers say I need 4%, 5%, 6% wage growth every year just to keep up.

That’s what we’re seeing in Europe right now, where core inflation just hit a record high and inflation hit 10.4% in the United Kingdom. So what happens in a stagflation scenario? Well, the last time it happened in the 1970s, we had 7% average inflation for the decade, 15% peak inflation in 1980. 20% interest rates, 16% mortgage rates.

In 1970, we had about a 40% market crash, followed by a 54% market crash in 1974. We had two severe recessions, 9% unemployment, and the Dow Jones, not counting dividends, was flat for 16 years. So what is the actual scenario that we are potentially facing today if the Fed blinks?

Well, according to Sachin and UBS, inflation on a headline level could fall to around 3% in the coming recession and then start climbing again, possibly peaking around 11,5% by the end of 2027.

By which point the Fed will have to really go full Volcker on it and push us into a severe recession. That would still take until about 2032 for inflation to come down to around 2.5% percent.

That essentially means a lost decade for financial markets and our portfolios. And this is why the Fed cannot blink. They have to kill inflation, shoot it in the head, set the corpse on fire, and then launch those ashes into the sun.

You cannot mess around with inflation this high, not in a highly indebted world with the government deficits expected to be $2 trillion for the next decade.

So how is your Fortress Portfolio able to protect you from both the coming recession and potential stagflation? It starts with long duration bonds. Historically, the single best blue-chip asset that you can own for crashing markets and black SWAN events.

For example, while in 2022 long bonds did fall 40%, the worst bond bear market in U.S. history.

In 2008, when the U.S. was in the Great financial crisis and the S&P fell 37%, long bonds went up 55%. In the pandemic, bonds were up 20% while the market was down 34%. During the Great Recession itself, bonds were up 24%.

But at one point in the darkest days of the panic, they were up 75%.

And during the tech crash, they were up 150% while the market was cut in half.

Basically, long bonds average about 37% gains in bear markets, almost the mirror image of stocks.

But what about after the recession, and potential rising inflation? This is where managed futures such as PIMCO’s Managed Futures Fund come in, I selected it for this reason as a part of the Fortress Portfolio.

During the the stagflation of the 1970s, well managed futures went up 630%, 22% annually, including tripling after the OPEC oil embargo of 1973 and doubling after the Iranian revolution of 1979.

Now, PIMCO is a five-star rated fund from Morningstar with brilliant managers who know how to go long, short commodities, stocks, bonds and currencies. In fact, they use a thousand different futures contracts for the best diversification and the lowest long-term volatility.

Now, managed futures average around a 30% gain in bear markets, not just instead inflationary times. Because remember, in a bear market, commodities tend to fall. Bonds tend to rally. Stocks tend to fall as well. And basically, managed futures know which way the trends are going and how to position themselves. That’s why they’re great at what’s called crisis Alpha, just like bonds.

This is why the 33% hedging bucket in Fortress Portfolio, which consists of PIMCO’s long Bond ETF and Long and Managed Futures ETF, is such an optimal blue-chip strategy. It’s also why your Fortress Portfolio as a whole, historically falls 50% less than the S&P during bear markets. And remember, that is still with a 6 to 7% yielding portfolio that’s expected to deliver about 10 to 11% market like returns—but with far lower volatility.

So what about this specific recession that we have coming? Well, Toronto-Dominion (TD) thinks that the 30 year treasury which is what’s going to drive PIMCO’s long bond ETF, should fall to between 1.5% and 2.5%. That means a potential 31% to 57% gain for that long bond ETF, while the S&P is likely to fall 15 to 30%.

And of course, what about the stagflation scenario?

Well, that’s where PIMCO’s Managed Futures Fund comes in, it will help hedge the portfolio, minimize volatility, and protect us in case of a bear market coming in 2027 or 2028.

I want to remind you to please send us your questions and comments here so I can respond to them in these videos as well as our monthly issues.

Just remember, I’m legally not allowed to give personalized investment advice.

Thank you for joining us for this weekly update.

I hope you join us next week when we’ll look at the latest inflation report and how it predicts what the Fed is likely to do as well as what the economic outlook is for the next few months, and what that means for the stock market and your Fortress Portfolio in the coming months.

Wishing you safe investing and a wonderful week. This is Adam Galas signing off.