The first quarter of 2023 closed with a stark illustration of economic stress that often arises during periods of prolonged monetary tightening. It may be surprising to hear that the first interest rate hike of this cycle began only a year ago on March 16, 2022.1 Since then, we’ve seen the worst bond selloff in decades, elevated levels of inflation, and a rapid repricing of assets as the markets reflected higher discount rates and a general increase in the cost of capital.
Source: J.P. Morgan
As we go forward, all eyes remain on the trajectory of Federal Reserve policy. The pace of rate hikes over the past year triggered enough losses to drive Silicon Valley Bank and Signature Bank to insolvency. The psychology of bank runs is a vicious spiral, and healthy, solvent banks can find themselves under stress if confidence in the system weakens. The spike in rates has left US banks with $620 Billion of unrealized losses on their books at quarter-end.2 Most banks are strong enough to withstand the paper losses. Still, their finances could be squeezed for years to come. The recent drawdown in bank deposits and the decline in value of their bond portfolios impairs bank capital and may require some banks to reduce their lending capacity. A reduction in overall credit availability would restrict economic growth. However, we believe the strained financial system is well-capitalized enough to avoid systemic crises.
It is likely that the SVB collapse changes the trajectory of Fed policy to a less restrictive one. Since the crisis, the entire yield curve has shifted down, and markets are now implying a full point of rate cuts by the end of this year.3 We believe that higher interest rates will continue to cause more volatility, highlighting the criticality of risk management. On the other hand, because of previous interest rate hikes, the Fed has more policy tools to combat the next crisis.
It is difficult to predict the implications recent bank runs will have on the economy. However, to the extent recent events in the banking system impair the ability and willingness for banks to make loans, it may meaningfully constrain economic growth. Credit is the lifeblood of the U.S. economy. The impact of a credit crunch will restrict growth in a more direct fashion than rate hikes, which take time to influence aggregate demand. The potential credit crunch materially lowered interest rate expectations late in Q1.
The health of the labor market will likely influence the future path of inflation. Despite numerous headlines of layoffs in high-profile tech companies, the employment market remains relatively strong with a 3.6% unemployment rate,4 which is close to the 53-year low of 3.4% set in January of 2023.5
This is likely because many companies that benefited from low interest rates (and Covid-era economic trends) over-hired during the post-pandemic boom, and normalization of those trends makes for catchy headlines that overstate their impact on the underlying data. In other words, while layoffs in the technology sector have been well publicized, the demand for labor in segments of the economy that were most negatively impacted by the Covid-19 health crisis (travel and leisure, for example) remain very strong.
On the other side of the Fed dual mandate, inflation continues to trend downwards in line with expectations,6 and the Federal Reserve hiked 25 bps as expected in March.7
Higher than average wage growth (resulting from tight labor market conditions) continues to put pressure on inflation. The more Americans earn, the more they will spend. The good news is that we are starting to see average hourly earnings slow. Per the chart below, while we are still trending above average, the recent downward trend is encouraging, from the standpoint of inflation. We would add that companies are finding it a bit easier of late to find labor as the labor participation rate has risen back to pre-pandemic levels.
Asset Class Performance Reverses 2022 Trends
The theme for asset class performance in Q1 was resilience. In the face of shockwaves that few anticipated, risk assets proved more buoyant than many investors thought possible. Investors began the year feeling largely upbeat.
Inflation appeared to be subsiding, and many bet this would lead the Federal Reserve to switch quickly from raising interest rates to cutting them. Then economic data started coming in hot. Following a surprisingly strong labor report at the end of January, stocks and bond prices slid, hit by worries that the Fed would likely have to keep rates higher for longer.
The biggest shock of the quarter came in March when Silicon Valley Bank and Signature Bank collapsed. Bank stocks tumbled, but so did interest rate hike expectations. Markets quickly repriced an earlier end to the Fed's rate hike campaign, which supported risky asset prices as the quarter closed.
The S&P 500 finished the quarter up 7.5%, while the more value-oriented Dow Jones Industrial Average finished up just under 1.0%. The tech-heavy Nasdaq Composite jumped 21% in Q1. In a stark reversal from last year's performance, risky assets were the best place to be in Q1, with Bitcoin and technology stocks among the biggest winners while the commodity complex lagged.8
Contained Contagion, Dovish Expectations Boost Growth Stocks and Bonds
On March 8, Silicon Valley Bank and Signature Bank were both, according to public disclosures, “well capitalized,” the optimal level of health by federal regulatory standards. Days later, both failed. We’ve written about the failure of Silicon Valley Bank, and the gist of the story is the bank was caught with a severe asset/liability mismatch followed by a bank run that pushed the bank to insolvency.
While the direct impact to portfolios was de minimis, there are significant implications to how this affects the macro landscape. As mentioned above, the expected trajectory of interest rate policy became more dovish as the entire yield curve shifted lower.9 On March 13th, in response to the SVB crisis, the 2-year Treasury Yield had its largest one-day drop since 1987.10 Lower interest rate expectations in turn created a market tailwind that helped boost asset prices.
This historic drop in rates (and rate expectations) and looming recession fears set the stage for growth outperformance versus value. Recall that secular growth stocks tend to benefit from lower interest rate expectations. Per the chart below, the Russell 1000 Growth Index outperformed its Value counterpart by a wide margin in Q1—another reminder of how style positioning can influence relative equity portfolio performance. It should be noted that growth stocks are once again expensive relative to history while value stocks trade below historical averages.
Meanwhile, rapidly changing Fed interest rate policy expectations contributed to volatile swings in the bond market. The chart below depicts key drivers of the considerable interest rate swings in Q1. Following a largely better than expected start to the year and persistently high inflation data, rate expectations increased sharply alongside hawkish Fed rhetoric. The recent decline in rates (and corresponding rally in bonds) was primarily driven by recent bank turmoil and potential negative economic ramifications, creating the dynamic where a contained banking crisis ultimately boosted stock and bond prices.
Navigating Choppy Waters with Thoughtful Asset Allocation
We close Q1 2023 with cautious optimism but acknowledge that we are likely not yet out of the woods. After such a dramatic monetary tightening campaign (that began just over a year ago), it’s unlikely we’ve seen the end of elevated volatility as various risks ranging from valuation to recession loom on the horizon.
In our assessment, risks around sentiment, fundamentals, and geopolitics remain elevated. For example, it is the same dovish attitude that drove strong performance in Q1 that leaves us susceptible to downside volatility if the market's attitude toward rates needs to shift higher. We also see risks in equity earnings growth expectations, which have not yet fully priced in economic slowdown and recession.[i] The coming debt ceiling debate is likely to get ugly and cause downside market volatility. Finally, the geopolitical landscape is getting less market-friendly by the month.
We have mentioned in the past that the Federal Reserve needed to hike interest rates for the good of the economy. As a result, the Fed now has the means to ease policy when faced with the next economic downturn. We believe this creates a natural stabilizing force in the marketplace but remain cognizant that the known unknowns and unknown unknowns are elevated during tightening cycles.
Thus, while we're happy to see markets provide healthy returns in Q1, we emphasize the importance of thoughtful asset allocation and risk management considering the sources of uncertainty mentioned above. The good news is that investment-grade bonds offer both higher yields and more diversification potential. We expect safe credit such as
U.S. Treasuries to help protect portfolios in times of recessionary price declines in risk assets, and it's essential to recognize their role as the ballast of your portfolio. In other words, at current interest rate levels, we believe that owning assets which benefit from lower rates can offset equity risk, and both stocks and bonds have contributed to performance YTD.
As always, we appreciate your continued partnership, and encourage you to reach out with any questions or feedback. We are happy to discuss the current market climate and trends with you.
[1] https://www.cnbc.com/2022/03/16/federal-reserve-meeting.html
[2] https://www.bloomberg.com/graphics/2023-svb-exposed-risks-banks/?sref=Qo...
[3] https://www.ft.com/content/1b003656-79fd-4e6a-bc48-9928728ec451
[4] https://www.bls.gov/news.release/pdf/empsit.pdf
[5] https://www.bloomberg.com/news/articles/2023-02-03/us-job-gains-post-sur...
[6] https://www.cnbc.com/2023/03/14/cpi-inflation-february-2023-.html
[7] https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322...
[8] Source: Bloomberg
[9] Source: Bloomberg
[10] https://www.marketwatch.com/story/treasury-yields-plunge-as-svb-fallout-...
[11] Source: Factset. 2023 and 2024 earnings growth are projected to be materially higher than 2022.