Bank failures, overseas war, rising interest rates, stubborn inflation…we’re facing a litany of investment risks.

For today’s Mind Over Markets, let’s step back from the daily noise of the markets. To gain strategic perspective, I turned to my colleague Nathan Slaughter [pictured here].

Nathan Slaughter is the chief investment strategist of our premium trading services, Takeover Trader and High-Yield Investing. My questions to Nathan are in bold.

Do you think the S&P 500 will end 2023 with a gain or a loss? And by what approximate magnitudes?

We’re coming off a year in which the benchmark S&P 500 retreated nearly 20%. That’s the fourth worst decline on record.

The three biggest prior downturns all gave way to powerful recoveries the following year. In fact, that’s true of 14 out of the past 18 corrections. History tells us that back-to-back annual declines are quite rare, having only happened four times over the past century.

But I don’t rely on sheer probability. The macro picture is looking increasingly bearish. Consumer spending (the foundation of U.S. GDP) is starting to show cracks as steep borrowing costs and persistent inflation cause households to retrench.

More than 80 S&P companies have already reported negative earnings guidance, and the index overall is tracking towards a 6% drop in profits next quarter, according to FactSet.

Meanwhile, the deeply inverted yield curve (a reliable indicator of looming recession) is flashing the brightest sell signal since 1981. My hunch is that we will see more up days than down in 2023. But the red days could be more volatile than the green, dragging the index down perhaps 5% to 10% by year’s end.

The collapses of Silicon Valley Bank (SVB), Signature Bank, and Silvergate have shaken confidence in the financial system. But isn’t there a silver lining here, in the sense that these failures have provided a deflationary shock to the economy?

The jury is still out on that. It’s remarkable that a lender catering primarily to tech startups and venture capital firms survived the calamitous dotcom crash, yet couldn’t withstand this crippling rate-tightening cycle unleashed by the Fed. Not even with $200+ billion in assets.

If last year was bad for stocks, it was downright terrible for bonds, among the worst on record. And SVB had parked tens of billions into long-term Treasuries, among the hardest hit. By itself, the damage wouldn’t have been fatal. SVB could have avoided the unrealized paper losses simply by holding these bonds until maturity.

WATCH THIS VIDEO: After SVB’s Collapse, Will The Dominoes Fall?

But its clients have been facing their own liquidity issues. Deposits had slowed in recent quarters, and many customers were filling out withdrawal slips. And we’re not talking about a few hundred here or there. About 97% of the bank’s deposit base was in excess of the $250,000 FDIC insurance limit.

To meet withdrawals, the bank was forced to liquidate its bond portfolio early and sustain hefty losses. In hindsight, there were signs of stress. Shares of parent company SVB Financial (NSDQ: SIVB) had already been cut in half over the past year. And a recent attempt to raise capital flopped. But the end came quickly, leaving 40,000 customers in a financial bind.

The Fed rode to the rescue, partnering with the Treasury Department to backstop deposits and establish a new bank funding facility. Instead of dumping bonds at less than face value (like SVB did), these negotiable assets can now be pledged against a fresh infusion of Fed cash.

That should help limit the damage. Other imperiled banks, like First Republic (NYSE: FRC), have secured emergency financing from deep-pocketed national banks like JPMorgan Chase (NYSE: JPM).

These lifelines didn’t come soon enough for Signature Bank of New York, which recently closed and was seized by regulators. But once again, this particular financial institution had a unique and highly concentrated clientele composed largely of crypto investors.

To paraphrase the great Warren Buffett, you don’t see who is swimming naked until the tide goes out. Well, the banking waters have receded, and quite a few lenders have been exposed. But unlike the financial crash of 2008, these breakdowns are idiosyncratic in nature, not systemic. This disease may not prove to be too contagious

We aren’t out of the woods yet. According to the FDIC, U.S. banks are still sitting on $620 billion in aggregate unrealized losses on securities available for sale. Fortunately, most banks are well-capitalized and can absorb some portfolio losses. As for deteriorating credit quality and rising defaults among retail and commercial borrowers, that’s a whole different matter.

Policymakers were determined to quash inflation by tightening until something broke. Well, something just broke, triggering government intervention on a scale we haven’t seen in 15 years. To avoid throwing fuel on the fire, the Fed may feel compelled to take a wait-and-see approach for the time being.

When do you think the Federal Reserve will finally pause its interest rate hikes?

Not long ago, hawkish comments from Fed Chief Powell had driven the odds of another half-point rate hike at the upcoming March meeting up to 75%.

Then came the banking failures. Suddenly, traders were anticipating multiple rate cuts by the end of the year, a 180-degree reversal from tightening to loosening. But the crisis seems to have been averted, and the new Bank Term Funding Program (BTFP) has restored confidence.

So the rate cut scenario seems to be out the window now. Most are wagering on a small quarter-point uptick, and there is a 15%-30% chance that rates remain unchanged.

History has shown that if inflation isn’t fully eradicated, it can return with a vengeance, much like a bacterial infection if the full dose of antibiotics isn’t administered. The Fed isn’t letting up yet, particularly with the labor market running red hot and the consumer price index (CPI) still showing 6% growth, which is triple its 2% comfort zone.

What are your favorite types of high-yielding assets right now?

We are still in an inflationary environment. Over the past year or two, I have repositioned my portfolio to reduce sensitivity to rate hikes and seek out securities that are immune or even benefit from this climate. That bias hasn’t run its course just yet.

I expect a strong year from companies like Blackstone Mortgage (NSDQ: BXMT), a hybrid lender/investor that originates mortgage loans for hotel resorts, apartment complexes and other commercial properties. Most of the firm’s liabilities are fixed, while 98% of its loans are variable. So borrowers are paying considerably more than they did a year ago.

And we’re not done. Every additional percentage point increase in rates adds another $0.05 per share in quarterly earnings. As it stands, distributable earnings per share have risen sequentially in each of the past four quarters, supporting the lofty 12% yield with a comfortable coverage ratio of 140%.

I have also gravitated towards the preferred stock of Gladstone (NSDQ: LANDO), which rents farms to experienced operators. Farmland (and crop prices) has appreciated faster than inflation, an effective hedge for investors.

Do you think bonds are starting to show greater appeal right now? If so, what specific types of bond investments do you recommend under these conditions?

Absolutely. I have avoided bonds the past few years, which is unusual for an advisory that specializes in income. The risk/reward was simply too asymmetrical. That hesitation paid off in last year’s collapse. But after eight straight rate hikes, the investment calculus has changed.

My first issue of 2023, entitled Why Now is the Time to Buy Bonds, laid out a bullish argument for this group. It wasn’t that long ago that reaching for a 4% or better fixed-income yield meant settling for riskier junk bonds. Now, the average investment-grade corporate bond payout stands at 5.2%, while yields on those same lower-rated junk bonds have shot up past 8%.

According to Morningstar, credit spreads for junk bonds over comparable Treasuries have widened by 134 basis points to 4.37%. That’s more than adequate compensation for the higher risk, especially considering default rates remain benign.

The bond segment of my portfolio has gone from near zero to around 10% of assets and will likely continue to climb.

Which sectors do you think will outperform in 2023?

I remain a fan of real estate investment trusts (REITs), from lodging to industrial warehouse to multi-family residential.

Given my overall neutral to slightly bearish outlook for the market, I also recommend businesses with transparent and predictable cash flows, including midstream energy and infrastructure.

Which sectors will underperform this year?

Certain pockets of the tech sector remain overvalued, with prone balance sheets. The implosion of SVB could also have ongoing repercussions.

Elsewhere, consumer discretionary may struggle as spending softens, although there will always be exceptions. I recently bought outdoor retailers like Camping World (NYSE: CWH) and Marine Products (NYSE: MPX).

Thanks for your time.

PS: In this volatile and risky market, where can you still find solid growth opportunities? We can sum it up with a single word: takeovers.

Even the whisper of a “mega-merger” can hand investors enormous returns. My colleague Nathan Slaughter just pinpointed a potential takeover deal that could dwarf them all.

Want to get in on Nathan’s next big trade? Click here for details.

John Persinos is the editorial director of Investing Daily.

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