Q1 2023 US Market Review & Outlook

The markets started the year off on a positive note, with stock and bond prices moving higher despite encountering an unexpected shock in the banking sector. Stocks surged out of the gate in January, hoping that inflationary pressures would subside and the Federal Reserve (The Fed) could stop their rate increases. Economic data in February came in hotter than expected, which dashed hopes that the Fed would pause its rate cycle and pressured stocks in the middle of the quarter. The Fed raised rates twice by 0.25% at each meeting. Both bonds and stocks rallied in the weeks after Silicon Valley Bank and Signature Bank collapsed to end the quarter higher.

The Fed has raised interest rates by 4.75% over the past year. This has been their most aggressive policy move to fight inflation since the early 1980s. With this much tightening in the interest rate markets, it is not surprising that something broke in the financial markets. It was a surprise that there was a run on bank deposits which caused the collapse of two regional banks. Silicon Valley Bank (SVB) and Signature Bank both saw deposits rapidly leave the bank, which caused them to collapse with some unique underlying circumstances in each case. The Fed and US Treasury stepped in to ensure that other banks could meet their funding needs and prevent the current situation from spreading further. This has worked so far, with things stabilizing by the end of March. The issues in the banking sector did mark a peak in the two-year and ten-year treasury bond yields. Rates topped out at 5% on the two-year and 4.08% on the ten-year in early March and closed the quarter a 4.1% and 3.55%, respectively.

The clear winners in the quarter were found in tech and growth stocks. These groups’ performance came from two opposing moves in the quarter. In January, shares of companies that performed the worst in 2022 surged for the first month. Many of these companies were down between 98% and 80% last year. Optimism that higher interest rates may be ending sooner, the end of tax loss selling, and investors hoping for a bounce lifted this group. After the Fed meeting in February where they pledged to keep rates higher for longer, there was a leadership change. The mega-cap tech stocks took over and lead the market higher. Apple (+27.06), Microsoft (+20.52), Alphabet (+17.16), and NVIDIA (+90.10%) had extraordinary gains this quarter. This shift was a flight to safety because these companies have strong balance sheets. The sector leaders for the first three months were tech (+21.35%), communication service (+20.80%), and consumer discretionary (+15.78%). The laggers were financials (-5.99%), energy (-5.30%), and health care (-4.70%).

Investment Strategy

Your portfolio is fully invested but we have maintained our conservative tilt in stocks. We still have a healthy growth allocation in our stock basket, which did well. This quarter we took advantage of higher interest rates and moved most of your cash holdings into money market funds.

We continue to be patient and are waiting for several items on our checklist to be met before we shift away from our conservative tilt to a more aggressive stance. Here is a summary of our updated checklist.

Valuations get cheap: We have set a target valuation range based on our expectations for earnings over the next 12 months. This range is currently around 3,650 and 3,550 on the S&P 500.
Interest rates start to decline: 10-year bond rates pull back to around 3.25% or below.
A spike in stock market volatility: Monitor VIX Index above 30.
Manufacturing surveys bottom: The ISM survey of manufacturing purchasing managers is one of the best coincident indicators of a bottom in the stock market. When it has reached its lows, stocks have usually seen their market lows within a month or two.
The Fed changes its stance: The Fed is focused on slowing inflation by using restrictive monetary policy. Once the Fed stops raising rates and signals they are confident inflation is no longer a risk, it will be reviewed as a positive for investors.
The economy starts to recover: This is the most unlikely of our indicators in the next year. If the economy bounces back or avoids recession altogether, markets should bounce.

Outlook

The rest of the year continues to be a challenging environment to forecast. There is divergent information that is pointing toward both a recession as well as a soft landing.

Recession risk remains elevated. but it is not guaranteed that we will see one in the next 12 months. Some reliable economic indicators continue to flash that a recession is on the horizon. The Leading Economic Indicators Index has contracted to levels seen in the previous eight recessions. The yield curve continues to be inverted and has been since last fall. This is when short-term rates are higher than long-term rates. This has served as an early warning signal in previous recessions. In March, the difference between the ten-year treasury and the two-year treasury tightened by 0.5%. This re-steepening of the yield curve typically occurs when a recession is near.

While some information towards an economic slowdown, the job market is still in great shape. Despite the headlines of large layoffs, unemployment remains at record low levels and wage growth is solid. As long as the US consumer has a job, they will continue to spend and consumer spending is about 70% of US economic activity.

The secondary effects of this year’s bank failures are just beginning to impact the economy. It is expected that lending standards will tighten as banks react and get more conservative in the wake of March’s banking issues. At the moment, there are no additional signs that another bank could collapse but it is too early to signal an all-clear. Banks shifting to a more conservative lending position will be a headwind for economic growth and have an impact on small businesses and smaller public companies’ ability to borrow.

The Fed continues to be an essential factor in how the rest of the year evolves. Market expectations are pointing towards one more rate increase before the summer and possible rate cuts in the second half of 2023. The Fed is signally a different message. In speeches, Fed leadership has talked about keeping rates evaluated until they feel inflation is truly under control. However, the only thing the Fed hates more than inflation is a banking crisis. It may have to prioritize ensuring the banking system and financial markets run smoothly over fighting inflation. One positive is that once the Fed does stop increasing rates, it has historically been a great environment for stocks. The average 12 month returns are around 19% after the Fed pivot.

We recommend being patient and taking advantage of what the market is offering investors. Bonds and cash look attractive in the near term. Expected returns in bonds and cash are their highest in well over a decade. We anticipate that there will be more volatility on the stock side of your portfolio and we’ll have the opportunity to buy stocks at better prices later this year. We are using our checklist as our guide to help navigate the road ahead.

Andrew Comstock, CFAApril 7, 2023