“When my information changes, I alter my conclusions. What do you do, sir?” — John Maynard Keynes, British Economist (1883-1946)cncartoons029020 965

First Quarter Recap

Financial markets rose in the first three months of 2023 with equities and fixed income improving despite a volatile environment. Most global indices joined the rally although commodities were mixed. Copper rose higher while oil fell for the period. Similarly, gold rose while the U.S. dollar drifted lowe

The first quarter was confronted with shifting narratives.

  • Early January featured a continuation of a soft economy consensus from the old year, with reports showing general weakness. Bond and stock prices rallied, hoping for an imminent Fed pivot where rate hikes would soon end, and the US central bank would begin cutting interest rates.
  • By February, stronger employment and inflation reports changed that narrative to a “no landing” or reheating story, which lasted for another month.
  • In March, fears of a banking crisis were sparked by the sudden failures of SVB Financial (the parent of Silicon Valley Bank) and the closure of Signature Bank. The FDIC had to quell the predicament by promising to insure all depositors of the failed institutions with accounts over the $250,000 limit.
  • In Europe, long-ailing Credit Suisse was taken over by UBS in a merger engineered by the SNB, the Swiss central bank.

Implications of the Regional Banking Crisis

Fortunately, the systemically important money center banks were not involved in this event compared to the Great Financial Crisis of 2008.

However, regional banks do account for 30% of all loans in the US, with their presence in mortgage lending and commercial real estate even larger. By quarter’s end, it is likely that regional banks will begin restricting credit by tightening lending standards for borrowers. It is still too early to quantify the impact of reduced lending to the economy, though most estimate the hit to be around 0.5-1.0% of real GDP (Gross Domestic Product).

The Effect on Fed Policy

The economy is still growing at a moderate rate but slowing pace. Inflation continues to normalize although service inflation, as well as housing costs and wages, remains sticky. Recently, the Fed has shown a slow tightening bias, citing an ongoing shortage of workers. The effects of regional banking problems may also lead the Federal Open Market Committee (FOMC) to pause or even halt the interest rate hiking process.

At this point, it is our belief that a pivot — or the beginning of a rate lowering cycle — is possible sometime in 2024 and not this year. Having lost a lot of public credibility by staying with the theme of “transitory” inflation in 2021, Fed Chair Jerome Powell is determined to bring down inflation much closer to 2%. Perhaps haunting him is the memory of the late 1970s, when then Fed Chair Paul Volcker stopped restrictive monetary policy too soon and had to raise rates sharply after just a few months, causing a deep recession.

Differing Messages from the Stock and Bond Markets

Fixed income markets have displayed unusual volatility this year. Overall, yields have moved lower, with the curve (difference between short and longer maturities) deeply inverted, with three-month and two-year Treasury yields considerably higher than the ten-year yields. This normally indicates a recession or at least a significant slowdown in the economy to a stall-speed pace. Another predictor of future economic growth, the index of Leading Economic Indicators (LEI) has been in negative territory for some time.

On the other hand, equities have rallied on the prospect of an imminent Fed pivot but seem to ignore the main reason for a pivot – significant economic weakness. A steep falloff in GDP growth would also impact corporate earnings, causing stock prices to swoon. The only way to avoid this is a soft-landing scenario. Although possible, we view it as an outside chance at best.

Investment Implications Going Forward

In our view, the Fed is close to ending its interest rate increases. If that occurs, stock market leadership will migrate back to growth after favoring value strategies over the last 18 months. As a result:

  • We have started to add to higher growth equities, especially those that are not too dependent on the economic cycle
  • Our bond market strategy will gradually rotate to longer fixed income bonds from short-term maturities
  • We have added to international equities, focusing on emerging markets which feature positive demographics due to our belief that the US dollar has peaked, at least for the for next year or two

Numerous cross currents due to the pandemic and its aftermath still reverberate throughout the economy manifesting a great deal of the market uncertainty and volatility being experienced. We think that a well-diversified portfolio featuring quality and liquidity will offer the best opportunity to build and preserve wealth over time, especially when the situation improves.