Despite the stress in the banking system, including the second-largest bank failure in U.S. history (Silicon Valley Bank), global equity and bond markets held up remarkably well and posted solid returns for the quarter.
The path to positive returns was not a smooth ride.
The major stock and bond indices were directionally in sync through January and February. They surged to begin the quarter after December data showed that inflation was continuing to come down fueling speculation that the Fed was close to pausing rate hikes. In February, strong economic data reversed this sentiment and left investors questioning if inflation was in fact under control. In March things got a little crazy when stress in the banking system surfaced. Shares of the failed banks (Silvergate, Silicon Valley and Signature Bank) fell to virtually zero and investors worried about other regional banks doing the same as well the spillover effect to other sectors. Finally, once the Treasury department stepped in to guarantee the deposits of the failed banks, the S&P 500 moved back up.
2022 losers were Q1 winners
Underneath the surface of the major indices there was a wide dispersion in returns across sectors, market caps and styles. Growth stocks which drastically lagged value stocks in 2022 showed meaningful out-performance in the first quarter. This can be largely attributed to the fact that value stocks have a larger allocation to energy and financial stocks that were among the worst performing sectors, the latter because of the bank crisis in March. Additionally, growth stocks are more sensitive to interest rates so the expectation of rates declining was a tailwind as was the decline in value of the US dollar given a large share of tech’s profits come from outside the US.
Near-term road ahead is very foggy
The bumpy ride in the first quarter is likely a taste of what the rest of the year will offer. Whether stocks move higher or lower from here is dependent on how the following questions play out.
- How quickly will inflation nose-dive back to the Fed’s 2% target?
- Will the Fed take their foot off the brake and stop raising interest rates? When will they lower interest rates?
- Is there more to come from the banking crisis?
- How much of a game of chicken will Congress play with the federal debt ceiling?
We are in the camp that stocks are likely near the top levels of a trading range and will go through a rough patch until the economy eventually enters a recession-maybe later this year, maybe in 2024. Barring other shocks, the recession should be mild but will give the Fed the ability to lower rates. Whether inflation gets back to 2% is unknown, however, we think unlikely given the supply demand concerns in the commodity complex, the fiscal stimulus from the ironically named Inflation Reduction Act (IRA) and the absence of cheap labor. For now, the Treasury department has stepped in and put a thumb in the dike to contain the banking crisis. Hopefully a single digit is all it takes. We don’t see a way that Congress will allow the US to default on its debt, but the unfortunate reality is they will play political games until the last second and investors may flinch before the deal is done. In addition to the domestic risks we consistently worry about surrounding the tenuous geo-political situation.
What we are doing
The reality is there are no definitive answers to the questions above and it is not the first time that we have had to deal with each of these issues. While the windshield may be foggy now, we do know that stocks go up 75% of the time and there has never been a 5-year period where a balanced portfolio of 50% stocks and 50% bonds has been negative. Therefore, investors with a long time horizon should not worry too much about what happens in the short-term.
We are helping our clients by:
- Staying diversified based on their income needs and risk tolerance
- Managing downside risk by
- Focusing on “all-weather” companies with more resilient earnings through active managers
- Increasing exposure to bonds
- Increasing exposure to developed international stocks that present better valuations and will benefit from a falling dollar
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