First Quarter Market Update: More Fed Hikes and A Banking Crisis
First Quarter Equity Markets
Markets bounced back into positive territory in the first quarter of 2023 after posting difficult double-digit declines in 2022. The bellweather indexes of the S&P 500 and the Barclays Aggregate were up 7.5% and 3.0%, respectively.
We expected volatility in the markets at the beginning of this year, and markets did not disappoint! We saw the S&P 500 rise in the early part of the year, only to have all the gains erased when two regional banks collapsed. The index rebounded nicely and returned to positive territory by quarter-end.
From a sector perspective, technology stocks that fell the most in 2022 were up the most in the first quarter. Information technology posted a 21.8% return. The Nasdaq index had its best quarter since second quarter of 2020 when markets began a strong recovery from pandemic lows. Nasdaq returns were aided by Apple and Microsoft, the top two companies by weight in the index, at 14.5% each. Apple rose 28% in three months while Microsoft returned 18%. Many investors flocked to these high-quality, safe-haven stocks as Silicon Valley Bank news created anxiety in the banking system fudamentals. The “Bank of Apple” became a trade in March.
Higher risk areas like technology, communication services, and consumer discretionary were up doule-digits in the first quarter while energy and financials were the worst performing sectors of the quarter. Regional banks weighed on financials group as the quarter came to a close as investors feared the fall of Silicon Valley Bank may spread to other regional banks. The regional banking ETF (KRE), fell 28% in March as money moved out of this group of stocks.
Returns “across the pond” were strong during the quarter with Germany’s DAX index up 12.2% and France’s CAC index up 13.1%. The MSCI EAFE benchmark (Europe, Africa, and Far East) returned 8.5%, beating the S&P 500 for the quarter. Similar to the U.S., gains were made despite a banking crisis, in Europe’s case, with Credit Suisse. A weekend arranged marriage between UBS and Credit Suisse avoided a Swiss banking crisis.
Helping bouey stocks internationally was a combination of a weaker U.S. dollar which is down 8.5% from recent November highs, relative to other currencies. In addition, a mild winter created a relief rally in Europe, whose stocks were already priced well-below U.S. counterparts.
Central banks have hiked rates similar to the U.S. to combat inflation and the latest readings out of Europe showed that consumer prices in the Eurozone have cooled. Headline inflation slowed to 6.9% in March down dramatically from the 8.5% read in February.
FIRST QUARTER BOND MARKETS
The bond market was able to transition from pain in 2022 to gain in the first few months of 2023. The quarter ended with rates across the curve lower than where they started and the yield curve was still inverted (2-year treasury rate higher than 10-year treasure rate). The bond market also went on a ride that saw the 10-year treasury rate at a January low of 3.37% and then a meteoric rise is six weeks to 4.07% only to retreat again due, in part, to the bank issues. The 10-year treasury ended the quarter at 3.49%, about where it started the year, but with a lot of volatility intra-quarter.
The graph below shows three yield curves at different times. The green line is year end, the blue line is from March 31, 2023 and the black line is an upwardly sloping (normal) yield curve in 2021.
You can see the “inversion” where short-term rates are higher than longer-term rates. As we’ve said in the past, this is typically been the bond market’s inidication of an impending recession. With nine Fed Fund rates hikes and the focus on bringing down high inflation, it’s only plausible to expect some type of economic slowdown in the next 12-18 months. Whether that becomes a mild (soft landing) or deep (hard landing) recession is up for debate. We are in the camp that a soft landing can be achieved given the strength of the U.S. employment picture.
Municipal Bond Market
Municipal bonds continue to be attractive. Municipal yields were lower in the first quarter versus year-end and March saw a pretty significant price rally in munis. As a result, returns were positive across the board in municipal bonds as seen by the table below.
Total Returns of Selected Barclays Municipal Indexes
We continue to expect a much better year for fixed income after one of the worst years in 2022. Many have correctly pointed out that this is now “income” in the fixed income asset class as yield has risen providing investors with steady cash flows they have been accustomed to in the past.
FIRST QUARTER ECONOMIC PULSE
While still positive, the employment picture has weakened versus last year. Average job growth in the first quarter of 2023 was 350K versus 560K in the first quarter of 2022. The labor market is tight with an unemployment rate of 3.5% is at a 50-year low.
However, we are seeing both wage growth and job openings begin to wane in the last few monthly readings. Job openings have fallen by 1.3 million from the recent highs and now sit below the 10 million mark for the first time since May 2021 (see chart below).
Job Openings By Month
March Consumer Price Index (CPI) was up 5.0% year-over year and core CPI (ex food/energy) came in at 5.6%, slightly better than expected. Versus last month, the CPI rose only 0.1%, much better than the 0.3% expected increase. In February, CPI was up 6.0% year-over-year and core CPI came in at 5.5%. The last two month’s readings were better than January CPI which rose 6.4% year-over-year. As a reminder, the high water mark on inflation was June 2022 at 9.1%. Graphically, you can see the steady decline in the CPI reading since June, but it also shows how elevated inflation currently stands versus history.
Other important economic data points for the month are highlighted below:
- PPI – March PPI fell 0.5% after falling -0.1% in February. Goods fell 1.0% and services fell 0.3%.
- PCE – Fed’s favorite inflation gauge, core PCE rose +0.6% in January and up +4.7% y-o-y. Economists were looking for +4.3%. This is the highest one-month increase since the worst month in 2022 and contrary to trends in CPI.
- Retail Sales – fell 0.4% in February after a 3.2% gain in January.
- Consumer Confidence – rose to 104.2 in March from February’s 103.4 reading, but was negative versus last year.
- US Leading Economic Indicators – the Conference Board LEI fell again by 0.3% in February to 110.0, after declining by 0.3% in January. The LEI is down 3.6% over the six-month period between August 2022 and February 2023—a steeper rate of decline than its 3.0% contraction over the previous six months.
- PMI Composite – registered 52.3 in March, up from 50.1 in February. The latest index reading was the highest for almost a year, and signalled a solid expansion in private sector activity.
- Housing Starts – fell in February by 18.4% seasonally adjusted versus a year ago to an annual rate of 1.45M homes.
As you can see from the data points above, there are both positive and negative data points, but in aggregate the economic indicators are pointing to a shrinking economy, which is not a surprise given the nine rate hikes over the past year. Activity was strong enough in the first quarter that GDP will likely be positive, but that may be the best GDP quarterly report of the year.
FEDERAL RESERVE MAKES TWO MORE HIKES IN 2023
At the February and March FOMC meetings, the Fed raised the Fed Fund rate by 0.25% each time bringing the rate to 5.0% from 0.25% just a year ago. The Fed cited that inflation remains elevated this year in the 3.5-3.6% range overall and price stability is still the Fed’s main concern. The Fed forecasts GDP growth in the U.S. of just 0.4% this year and 1.2% in 2024, well below the median long-run growth rate. The Fed sees more downside risks to GDP growth than upside.
Additionally, the Fed also provided liquidty support late in the quarter to banks to truncate any worry or run on bank deposits that could have resulted from the SVB collapse, but luckily did not. The banking crisis will likely result in tighter credit conditions by regional banks, which may also aid in bringing inflation down (and hurting economic activity due to restrained lending). In summary, the Chairman said at his last press conference that the process of getting inflation back to 2.0% will be a long road and will likely be bumpy. The “bumpy” comment is why we believe market volatility is still here to stay.
SANDY COVE ADVISOR ASSET ALLOCATION SHIFTS
During the first quarter, Sandy Cove Advisors made two tactical allocation shifts. These changes were designed to take advantage of what we expect to be better return dynamics in two areas: longer duration bonds and international equities.
EXTENDED DURATION IN FIXED INCOME
We expect that the Fed is close to ending its 15+ month tightening cycle. There may or may not be one more hike in May (data dependent), but we believe we are in the 9th inning and that pressure on bond prices is largely done. Finally, after a decade of low rates, we’re getting paid to own duration. With that in mind, we wanted to move out the yield curve from our current stance today which is entirely focused on the short-term area with bonds maturing in about 1.5 years, on average in our portfolios. At the end of the quarter, we added back to intermediate bond allocation from 0% previously, to about a 40% allocation of fixed income today. This extends the maturity of bonds from 1.5 years to about 3.6 years in our clients’ portfolios.
ADDED BACK TO INTERNATIONAL EQUITIES
Multiple times in 2022 we reduced our weighting in foreign country equities. Ukraine invasion, an energy crisis in Europe, double-digit inflation in the Eurozone were some of the major reasons we moved from a 30% weighting in international equities in an all equity portfolio in 2021 to a 15% weighting at the end of 2022. As 2023 progressed, we got good news of a warmer winter and leaders dedicated to raising rates to bring down inflation. In addition, the U.S. dollar weakened from high levels making international stocks more attractive on a macro level. We have decided to reduce our underweight and moved an all equity portfolio to a 20% international weight from 15% previously.
ON TO SECOND QUARTER
We have an April break with no Fed meeting. The next one occurs on May 3rd, but markets will react to economic data nonetheless, so we expect another volatile quarter in both stocks and bonds as they respond to changes in prices, employment, production, and setiment to name a few. Markets were keen to focus on inflation data for the previous 12 months, but now that we are seeing declines in that gauge, the market seems to be shifting focus to ression possibilities for the economy and how that would look.
We are encouraged by the slowing inflation figures and a still resilient labor market (and consumer). We do not see overly strong data points, as of now, to assume a hard landing recession is imminent. As we’ve mentioned before, markets are discouting mechanisms and we believe 2022’s declines were factoring in the economic slowdown in 2023. When the Fed does pause/pivot/change course, that should be good news to risk assets and we believe that event is within 3-6 months from now which is why we expect to see a better second half of 2023 for both stocks and bonds. Clearly, changes in the economy (additional bank failures, as example), may shift our current thinking of a soft landing, or mild recession.
Lastly, you have heard us talking about getting a better return on cash for months and the fact that a money market fund can provide over a 4.0% return is pretty remarkable. It illustrates how much money is on the sidelines and not invested in stocks or bonds. This is actually a strong indicator of how well equities can perform in the next three years as the two graphs below illustrate.
If you would like to have further discussions with our team, one-on-one, please do not hesitate to contact us.