Q1 2023 Commentary
We entered 2023 with a sense of optimism. After a brutal year for markets across the board, there were emerging reasons to believe that the worst of the market volatility was behind us.
One cause for relief was the sense that inflation uncertainty was subsiding. After reaching an annualized rate of 7.5% in June, November’s core PCE inflation number (the last inflation reading we saw before year end) was less than half of that. Looking at year-over-year data, a downtrend in inflation began to emerge, reducing the fears of an inflationary spiral. Market history tells us that stocks can perform quite well in an inflationary environment, as long as that inflation rate is not accelerating.
Most-encouragingly, the moderation in inflation was not accompanied by a weakening labor market – something that many expected would be necessary to quell pricing pressures. Weekly initial jobless claims remained near 200,000, and the unemployment rate never rose above 3.7% – both near historically low levels.
Given these factors, it seemed like the Fed could be close to ending rate hikes, and that a soft-landing could be possible.
This reality led to a violent rally to begin the year. By February 2nd, the S&P 500 was up more than 9% and the Nasdaq had gained over 17%.
Despite causes for optimism, the market reaction certainly appeared overdone. The economy had not yet realized the full extent of last year’s historic rate hikes, the Fed was still raising rates to fight inflation, and stocks were once again at historically unsustainable multiples.
Markets seemed to understand that they had gotten ahead of themselves, and by March 8th the S&P 500 had slipped nearly 5% from its February high.
The next day, markets witnessed the abrupt failure of Silicon Valley Bank – the second largest bank failure in the history of the country. A few days later, Signature Bank landed in FDIC receivership, marking the third largest bank failure in the history of the country. While domestic regulators worked frantically to prevent a full blown banking crisis, issues spread globally, and just over a week later, Credit Suisse, one of only thirty banks considered to be a “Global Systemically Important Bank” (G-SIB), was forced to sell itself.
Domestically, the solution to the banking woes has been for the Fed to create a new lending facility, followed by signaling that they may be close to ending rate hikes. Markets have aided the process by forcing rates lower – a move that should take pressure off of bank balance sheets.
Traditional Time Overlay accounts took advantage of the turmoil to put more cash to use. Targeted investments brought equity allocations close to 80% by the end of the quarter. Because of broader market concerns, however, we remained more cautious in Global ETF accounts, which remain nearly two-thirds allocated to cash.
The buying opportunity was very brief. Markets have interpreted the banking crisis as a net positive, with all of the major averages closing the quarter higher than they were on the eve of Silicon Valley Bank’s collapse. The hope is that the Fed’s dovish tilt and the decline in interest rates will benefit the rest of the investment landscape, isolating the damage to the financial sector.
Though we are encouraged by the rebound, we cannot become complacent just because of a hot start to the year. It is unlikely that we have seen the last of the fallout from last year’s rate hikes, and we could see more pain from monetary tightening ahead.
The Fed may only be one meeting away from pausing rate hikes, but they have been clear in their belief that there is more work to do to suppress inflation. The steepest rate hikes are behind us, but interest rate changes can take over a year to filter through the economy, meaning that we will still be dealing with the effects of rate hikes into 2024.
Beyond headwinds from monetary policy, economic growth could be hampered by fallout from the latest banking crisis. Even if the spate of bank runs is over, the reverberations through the banking system are likely to impart some economic constraints, as financial institutions will be forced to act more prudently and are now being threatened with additional regulatory burdens.
Given the level of panic surrounding bank issues and the targeted regulatory response, it is likely that we have just about seen the worst for financial stocks. It is unlikely, however, that we see such a dramatic pullback (regional bank funds fell 40%) without some catching-down from the broader stock market. The effects of interest rate changes generally hit the financial sector first, but rarely stop there.
Though we see a reemergence of risks to equity markets, it is possible that the market recovery continues on the back of solid fundamentals.
Hopes that the Fed could manage a true “soft landing” were tossed out when banks began to fail, but the underlying economic resilience, particularly from employment data, offers the most hope that the tightening cycle could conclude with minimal damage. If stocks continue to grind higher on this optimism, we will likely be quick to reduce equity exposure, particularly in Traditional Time Overlay accounts.
Stock valuations remain the primary driver for our readiness to go to cash. The price/peak earnings multiple for the S&P 500 finished the quarter above 21. That level has never been sustainable with the exceptions of the leadup to the Trump corporate tax cuts and the latest post-COVID bubble (levels that could plausibly be revisited in a recession).
Earnings are expected to begin their rebound next quarter, but are not expected to reach a new 12 month high until the end of the year. That means that any gains from here will push our preferred valuation metric even deeper into unsustainable territory. Those valuations are difficult to justify in any environment, but are particularly tenuous in a world with interest rates above 3% and without broad corporate stimulus.
If we do face increasingly expensive markets, moving to cash remains more attractive than it has been in years, with money market yields at levels last seen in 2007.