Market Commentary April 2023

Q1 Volatility – Surprising, but Not Shocking

The first quarter of the new year has provided plenty of material for the financial news networks. It’s always jarring to wake up and hear about a crisis first thing in the morning.

But as anyone who’s been alive longer than 10 years probably recognizes, the law of averages practically guarantees annual disruptions to the global financial and geopolitical landscape.

We’ve never seen an “In Memoriam” montage at the end of the Oscars where nobody died. We’ve also never seen a year in economic news without at least a temporary panic or shock. Nevertheless, 15 years after the Great Financial Crisis, it’s never pleasant to hear about bank failures. The only “run” anyone wants to see in proximity to Wall Street is the New York City Marathon.

2023’s market performance thus far has been almost a mirror image of the 2022 results. This is a common outcome following extreme market conditions as sectors become oversold or overbought.

Economists and market analysts have been talking about the prospect of something “breaking” for the last six months, given the rapid increase in interest rates (the opposite of stimulus). With the Silicon Valley Bank (SVB) news and ensuing commotion, it would appear something finally broke.

On March 13, we discussed the recent events surrounding SVB in an email to clients. Since then, panic around the banking system has subsided, but uncertainty remains.

In our view, the primary impact of banking woes will not be a financial system contagion or collapse. It’s more likely that tighter lending standards due to either increased regulation or decreased risk appetite among banks will act as yet another headwind to economic growth.

FDIC Insurance – Is Your Money Safe?

If you hold less than $250,000 per owner in a bank account registration, then you don’t need to stress about the safety of your deposit, regardless of where you bank.

If you hold substantially more than $250,000 at a regional bank, it’s worth considering splitting deposits at multiple banks or looking at a larger institution while uncertainty remains around the smaller (and less scrutinized by regulators) banking institutions.

As with all bank panics or “runs,” they tend to be self-fulfilling. If nobody is worried, then there is no reason to worry. The media landscape all but guarantees that any whisper of trouble at a bank will result in stress due to immediate, heavy withdrawals.

This trend will eventually pass, but we think the FDIC will need to modernize its insurance guarantees, a topic we’re sure to hear much more about in the coming months. (Find answers to commonly asked questions here: FDIC FAQ.)

With the Benefit of Hindsight

In our year-end commentary posted around the first of the year, we said that there was “a good chance that the first half of 2023 will continue to be choppy for stocks” and added that “we wouldn’t rule out another test of the lows seen in October of 2022.” We haven’t changed our thinking on either account. Below is the list of “unknowns” we mentioned at that time, along with what we learned in the first quarter.

Outcome of the Russia-Ukraine War: Little has changed other than death tolls and the ramping up of U.S. military aid. China’s increasing show of support for Putin has raised eyebrows. However, analysts feel President Xi’s recent meeting with Russian leadership proves China is looking for cheap energy and a chance to play peacemaker, not to provide weapons to Putin, a very positive development.

China’s COVID-19 Response: China has reversed course on lockdowns, and economic activity has picked up, albeit slowly – a reason to suspect that current low oil prices may not last long.

Corporate Profit Outlook: Earnings reports reflecting fourth quarter results remained healthy, but forecasts continued to guide lower for the coming year.

The Fed’s Policy: After the March banking crisis, it seems more likely that the Fed may soon stop increasing rates. The interest rate market currently indicates a nearly 50/50 chance of a pause in increases for the June meeting.

Inflation Status: The year-over-year inflation rate has dropped from 7.1% for November to 6.0% in the latest release for February, while the trailing three-month annualized figure has dropped to 4.0%. Chairman Jerome Powell has been adamant that 2% is the target for the year-over-year number. Will he consider the lag effect of rate increases and the impact on prices or keep hiking until we get a consumer price index at 2%? We’re hopeful he’ll consider the former and avoid a hard landing.

Spring and Summer Headlines?

We can now add banking problems to the list above as an unknown for the coming months. In our view, the biggest story is the impact banking/lending activity may have on the Fed’s ability to stay the course in their inflation fight. Regional banking exposure to commercial real estate, especially office buildings, is another factor we’ll be keeping an eye on.

The debt ceiling debate will be sure to top headlines by May. What was to be a summer of ‘23 issue got pushed forward after the banking crisis required unexpected government cash infusions. While we’re hopeful that cooler heads will prevail as in the past, members of Congress will use the opportunity to negotiate for their own agendas, and this may result in market volatility as the deadline approaches. There seems to be an appetite among some lawmakers to take the faith and credit of the United States Treasury right to the brink of default to score a legislative win.

Absent a short-term dramatic drop in the inflation numbers, the Fed will be in an even tougher spot than they were last year in terms of threading the needle. As we said last quarter, “Patience will be tested in a major way.” Incidentally, the data we watch suggests a downside surprise on inflation is definitely possible in the coming weeks.

When Is This Recession Hitting?

The 2023 recession may be the most predicted recession in history. Contrarian thinking would suggest that if so many people are sure it’s coming, then it may never arrive. If this is what conditions look like when everyone has tightened their belts and braced for impact, then maybe this economy is in better shape than we realize.

We’ve written about the mechanics of recessions multiple times in the past year, and it’s important to note that if there is a period during 2023 that is defined by the National Bureau of Economic Research as an official recession, we won’t know it until sometime in 2024. We still think the odds of an official recession call by the NBER is anything but certain until the labor market weakens or corporate profits drop considerably.

Several things remain unusual and downright odd about this particular business cycle.

For one, it’s been very difficult to pinpoint where we are in the cycle, especially because of the state of the labor market. Typically, as we approach contraction or recession, unemployment is on the rise. Today, unemployment remains at record lows, and wage growth has been a concern to policymakers who fear rising prices of goods and services may follow. For better or for worse, that trend may be cooling finally, as seen below.

Why do things feel different this time? It’s simple. Coming out of the COVID-19 lockdowns, fiscal and monetary stimulus from Washington was extreme. Unlike any previous period in history, we forced an unprecedented amount of liquidity into the financial system. The effects of this policy are yet to be fully realized or understood. The transition to normalcy has been and will continue to be awkward for some time to come.

What We’re Doing

Because of the many underlying deflationary (opposite of inflationary) pressures in the economy, we still feel that 2024 will look very different from 2022-2023.

Interest rate increases should be nearing an end, with rate cuts on the horizon for late this year or early next year. That should signal the start of a new growth cycle, a cycle the market will see coming before it gets here. Keep in mind that this means the market may look good before the economy really gets roaring. Below, you can see the potential picture from Morningstar’s point of view.

We can’t possibly predict the future of rates or inflation, but we think the thesis above is at least directionally correct.

We’ve maintained less exposure to longer-maturity bonds that perform poorly in rising-rate environments and expect to overweight those positions as the year progresses. We’ve remained focused on the U.S. and have continued to slightly overweight technology, and we’ve been rewarded for it this year. We’re also underweight in small-cap stocks and may continue to be for some time because that’s where much of the regional banking exposure lies (small companies are represented by the Russell 2000 index below). Bank exposure notwithstanding, small caps do offer a compelling value compared to their big brothers in the large-cap sector, and we will be monitoring for opportunities.

In keeping with our core long-term investment philosophies, we are not trying to make heroic predictions with any of our models. However, we remain vigilant and will make adjustments as conditions dictate.

We welcome your questions at any time and, as always, appreciate the trust you put in our advisory team.

Sincerely,

Chris Proctor, CIMA^®
Chief Investment Officer