Edward R. Murrow, the famous broadcast journalist, reportedly said, “Anyone who isn’t confused really doesn’t understand the situation.” That may be an appropriate summary of the financial markets in the first quarter of 2023. We will do our best to break it down and try to make some sense of it all.
Two competing headlines
Bad news: On Friday, March 10, a run on Silicon Valley Bank (SVB) caused regulators to seize the bank with lightning speed. It was the second largest bank failure in US history. It was quickly followed by the third largest bank failure in US history, Signature Bank, on Sunday, March 12. To stem the risk of immediate contagion, US regulators created a backstop for uninsured deposits at SVB and Signature. A few days later in Europe, the Swiss bank Credit Suisse Group AG, reportedly on the verge of failure, was saved by banking rival UBS Group AG in a takeover orchestrated by the Swiss government.
Good news: Yet despite significant uncertainty in the banking sector, financial markets proved to be more resilient than many thought possible.
- US Equities as measured by the S&P 500 Index were up 7.5% in the first quarter of 2023. Technology stocks represented by the NASDAQ index performed the best of all asset categories, returning 17.0%.
- International equities in the developed nations performed better than the S&P 500, returning 8.6%. Emerging market economies returned 4.0%.
- Bonds, which had a historically bad 2022 in the face of the Federal Reserve increasing interest rates at the fastest rate in history, returned 3%.
The popular misquote attributed to the author Mark Twain seems appropriate for the financial markets; “The reports of my death are greatly exaggerated.” Despite a near-death experience in 2022 and some severe scares in banking to begin the year, the financial markets rose like a Phoenix from the ashes to fight another day in the first quarter of 2023.
Two sides of the coin
There are two sides to the coin of higher interest rates. On the one-hand, banks that heavily invested in long-term 30-year US treasuries without hedging got into trouble when the Fed increased the Fed funds rate by 4.75% (475 basis points) over the past 12-months (March to March). The reason for their trouble is that the value of bonds decrease as yields rise. No one is going to pay the same price to buy a US backed government bond paying 1% as they are going to pay for a bond paying 5%, all other things being equal. (For example, a 10-year bond purchased one year ago at an interest rate of 1.5% with 9 years left to maturity would be worth approximately 22% less today).
In a 5% interest rate environment, if the 30-year bonds paying ~1% that a bank holds have to be sold (for example, because bank depositors demand their money now), the bank must sell those ~1% bonds at a steep loss. In an over-simplistic summary, that is what happened with SVB. On Wednesday, March 8, SVB reported a realized loss of $2B because they had to sell some of their long-dated bonds. SVBs institutional depositors created a depression-era style run on the bank with $42 billion in withdrawal requests on Thursday, March 9. On Friday, March 10, the Federal Deposit Insurance Corporation closed SVB.
Treasury and Federal Reserve officials fretted over the potential of a massive bank run when markets opened on Monday, March 13. They decided to backstop the bank with deposit guarantees and a new lending facility to help contain the crisis and prevent contagion. The politics will be debated, but the contagion seems to have been largely held in check.
What is the other side of the coin regarding higher interest rates? For most of the last number of years, the acronym TINA (There Is No Alternative) applied to investing in the equity markets. Of course, there is always an alternative, but TINA caught on because “no-risk” investments were paying basically zero. Therefore, many felt they had to turn to riskier public equity markets to get any amount of return.
Now that “risk-free” alternatives paying 5% are available (like short-term CDs or treasuries), many are considering them as alternatives to “risky” stocks and bonds. Disregarding that earning ~5% in a ~6% inflationary environment creates a real return (yield minus inflation) of -1%, many see the safe harbor of these risk-free options as better than the unknown of the public markets in stock and bonds. To be clear, there is risk in the public equity and bond markets. At the same time, we all realize there is truth in the adage “no risk, no return.” So, let’s take a look at what the risk assets have done in 2023.
First quarter performance
Volatility remained high, but market returns were solid across the board in the first quarter of 2023.
Table 1: Key Index Returns
|Dow Jones Industrial Average
|S&P 500 Index
|MSCI World ex-USA**
|MSCI Emerging Markets**
|Bloomberg US Agg Total Return
Source: Invesco Markets Review At-a-Glance March 31, 2023
**in US dollars
March 16, 2023 marked the one-year anniversary of the Federal Reserve’s (“Fed”) first rate hike of the current cycle. The Fed was probably on track to boost the Fed funds rate by 50 basis points (to between 5.00%- 5.25%) at its March meeting prior to the SVB failure. Although inflation remains high, the Fed chose to defer to banking stability and opted for a cosmetic hike of 25 basis points.
It gives the appearance that inflation remains the Feds priority while focusing on the banking system. It also puts the Fed in a difficult position as it hopes to tackle two conflicting goals: fighting inflation with rate hikes, which would put added stress on banks, or concentrating on financial stability.
Inflation hasn’t been squashed but problems with SVB have not spread to other banks. The crisis eased as the month came to a close and most of the assets of the failed banks were purchased. Fears have waned, helping the public securities markets rally, and the first quarter ended on a favorable note.
What is next?
The recent banking turmoil might do the Fed’s job for it as tighter lending standards slow economic growth. But, at this time, no one knows by how much.
At the same time, core inflation has remained stubbornly high. In recent days, sentiment has shifted on rates, but sentiment is ever shifting. How the Fed reacts with additional rate increases this year will influence US economic performance.
After growing at its fastest pace in nearly two years in January, personal consumption expenditures, which make up two-thirds of US Gross Domestic Product (GDP), slowed in February. Private sector hiring appears to be stalling with private payrolls increasing 145,000 in March vs 261,000 in February. Layoffs, especially in the Technology sector, have surged this year. (First Trust, Talking Points, 4/23).
As economic growth slows, we can expect layoffs to expand to other sectors. Employment is the often-missed aspect of the Fed’s dual mandate. It is possible that the Fed will only stop increasing rates when layoffs start moving from the Tech sector to Main Street, bringing the unemployment rate higher.
So are investors front-running the Fed? Or are they too optimistic about future rate increases? Looking ahead, a significant rise in the jobless rate would probably force the Fed to cut rates, or at least stop increasing them. However, a drop in corporate profits could negate any benefits from falling rates.
In what could be seen as a signal of corporate strength, stock buybacks and dividend distributions were robust in 2022. In a report released on 3/21/23, S&P Dow Jones Indices reported that the companies that comprise the S&P 500 index repurchased a record $923 billion of their shares and distributed a record $565 billion in dividend payments in the 2022 calendar year. (First Trust, Talking Points, 4/23). In January 2023, companies announced a record $132 billion in share repurchase plans. (First Trust, Talking Points, 2/23). Generally, that indicates these companies believe in themselves as a great investment.
If all of this seems somewhat convoluted, Edward R Murrow might conclude we are beginning to understand the situation. The Fed is in a difficult position. On one hand, continued rate hikes are likely to usher in a recession and potentially more bank failures. At the same time, inflation remains well above their 2.0% inflation target.
What is an investor to do?
The ultimate question may be, “what is an investor to do?” Our answer may seem overly simplistic, but it is this: stay disciplined to your goals.
If you are investing with a long-term perspective, and, importantly, have an emergency fund to ride out short-term volatility, Integrity advises staying the course. However, if your investment horizon has changed, discuss this with your financial advisor. If you wish to move some additional funds into your cash management strategy due to the higher yields on “risk-free” opportunities, Integrity can help you with that. However, Integrity ultimately believes a well-diversified, long-term investment strategy that matches one’s risk tolerance is an investor’s best opportunity for success. All of us at Integrity Wealth Advisors sincerely desire to help you chart a path through challenging market conditions. I hope you have found this summary to be a beneficial overview of what is going on in the financial world we find ourselves. If we can be of further assistance, please reach out and set up an appointment with me or one of my Integrity colleagues. We believe you will be glad you did.