By Daniel McGarvey, Portfolio Analyst
Market and Economy Overview
Despite some heightened volatility from stress in the financial sector, stocks and bonds had a positive first quarter of 2023. The S&P 500 returned 7.5% and the Bloomberg Aggregate Bond Index rose 3%. The 10 Year Treasury Rate fell from 3.88% to 3.49%, with rates dropping across the board as the yield curve became less inverted.
After a year of inflation dominating headlines, in March, attention switched to the stability of the banking sector with the collapse of banks like Silicon Valley Bank, Signature Bank and Credit Suisse.
These banks failed largely due to their own poor risk management, which was then punished by asset losses from rate hikes.
In Silicon Valley’s case, the government protected uninsured deposits in an effort to avoid more bank runs and systemic cracks, and at this point, it appears that contagion has been avoided.
However, many banks are still sitting on large securities losses (see chart below for FDIC-insured institutions as of year-end) and are struggling to retain depositors as they compete with higher rates offered by treasuries, money market funds and other high-yielding solutions.
These factors could lead to more consolidation in the industry, but a crisis like what we saw in 2008 is unlikely. Additionally, regulators are exploring ways to tighten capital and liquidity requirements.
The banking stress complicates matters for a Federal Reserve that has now raised interest rates to 4.75-5%. Inflation is still a concern, and the Fed is keen to avoid the mistake of cutting rates too early and allowing inflation to roar back. On the other hand, continued tightening adds more pressure to company balance sheets and introduces more risk to vulnerable sectors like commercial real estate.
Market expectations of when the Fed will start loosening have been changing drastically, and as of the end of March, there is about a 55% chance that it will issue a hike once more in May. However, the 2 Year Treasury Rate, which tends to lead the Fed, is now well below the Fed Funds Rate. The Fed also appears to have reversed course on quantitative tightening, given that in March, it quickly unwound most of the tightening that had gone on over the last year. It is unclear if this trend will continue, but it seems to conflict with rate hiking.
As Jerome Powell mentioned after the last rate hike, it’s possible that the banking troubles will do some of the Fed’s job for it. A major disinflationary factor that he failed to mention, however, is the rapid drop in the money supply. After a historic surge in the first two years of COVID, the money supply has since dropped at the fastest pace seen in our lifetimes.
The drop, which has coincided with bank deposit flight, is likely dragging down inflation (see chart below).
Unfortunately, the concern is that the inflation reduction will come at the expense of slowed economic growth and declining profits. A recession, even if mild and widely anticipated, seems increasingly likely in the next year or two.
An interesting development in light of recent negative headlines has been the outperformance of growth stocks, especially at the top of the market. The technology sector has been embraced as somewhat of a defensive haven amidst the drawdown in financials, although we’ve seen similar price action in prior bear markets that did not last. The result of this outperformance is that the top five names once again make up over 23% of the S&P’s market cap, leading to concentration risk.
Developed international stocks also fared better than domestic stocks in the first quarter, and the U.S. dollar continued to weaken from its highs last fall. The Ukrainian invasion has dragged on without significant advancement, although both sides appear to be gearing up for increased fighting in the spring. Another concerning trend has been the strengthening of ties between nations like Russia, China and Saudi Arabia. These ties will likely lead the U.S. to increase reliance on internal production over time, especially in the energy sector.
In the world of real estate, housing activity has rebounded in recent months but is still depressed due to rising rates and reduced affordability. Commercial real estate is experiencing heightened pressure due to high rates and lower building values as well, but the sector also stands to lose from potential bank weakness. Some banks engaged in commercial real estate lending, especially regional banks, may need to get more restrictive with lending terms, leading to reduced liquidity and access to capital. Factors like these add to our belief that the Fed may not tighten much further.
In Washington, D.C., there has been almost no progress made on addressing the debt ceiling conundrum. Negotiations are at a standstill as the summer deadline approaches, although Republicans are now considering a proposal to cut spending by the amount of the debt ceiling increase. They would like to cut items like student loan forgiveness and unspent COVID funds, but the details will likely change as the date nears. Despite the frustrating lack of certainty or willingness to negotiate, a deal of some sort will likely come through to avoid default.
Investment Allocation
Despite events in the banking sector, our allocation preferences have largely remained the same. We continue to favor value over growth throughout the cap spectrum, especially with an emphasis on high-quality dividend growers. As mentioned above, we are wary of the market’s top-heaviness and think that valuations look more attractive in some smaller asset classes that have been neglected for years.
International and emerging market stocks continue to trade at desirable valuations, but there are still headwinds given the ongoing threat of war and geopolitical tension. As such, we maintain our positive long-term view and cautious near-term view.
After the drop in yields in March, we are continuing to keep fixed-income duration shorter than the benchmark. We also prefer higher-quality bonds as we begin seeing signs of tightening credit conditions. That being said, fixed income in general is more attractive than it has been for many years. Even with heightened rate volatility, we can lock in some palatable yields.
We are also still in favor of holding alternative asset classes that can offer diversification and uncorrelated sources of return in times of uncertainty.
*Charts provided by the FDIC and Strategas Research Partners, LLC.
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
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Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.