As the year began, many market commentators felt the first half of the year would be difficult for financial assets but strength would return in the second half. This was based on their outlook for a weakening economy that would pull down earnings early in the year. In fact, the economy remained surprisingly resilient in the first quarter and financial assets continued to recover from their October 2022 lows. Another first quarter surprise was the leadership. The S&P 500 was powered by the prior bull market leaders and some of 2022’s worst performers as investors returned to technology and internet stocks and moved out of 2022’s best performing sectors. Energy, healthcare, and utilities were three of the best performing sectors in 2022, but they all fell more than four percent in 2022. Late in the quarter, another unexpected event occurred when two regional banks failed following a run on their deposits. As a result, financial services stocks were the worst performing sector as SVB Financial Group and the regional banks dragged down the index.
The S&P 500 outperformed small and mid-cap indices as mega caps led the S&P 500 higher. The S&P Midcap 400 rose 3.36% while the Russell 2000 increased 2.34%. International stocks generated strong returns, but the relative performance compared to the S&P 500 was mixed. The MSCI EAFE Index rose 7.65% outperforming the S&P 500, while the MSCI Emerging Markets Index lagged the S&P 500 rising a respectable 3.54%.
The Federal Reserve raised the Federal Funds rate another 0.75% during the first quarter. The result in the Treasury markets was interesting. Rates for Treasuries maturing two years or longer fell despite the continued rise in the short end of the Treasury curve. Most of the decline occurred after the banking crisis led to a flight to safety and a growing expectation from investors that Fed rate cuts may be on the horizon. The Bloomberg USAgg Index rose 2.96%, slightly outperforming the Bloomberg US Intermediate US Govt/Credit Index which rose a respectable 2.33%. The banking turmoil was positive for gold but caused further weakness in most commodities. Furthermore, many investors and speculators were counting on a boom from China’s reopening which never materialized. Gold prices rose 7.96% and outshone stocks and bonds. Oil fell 5.72% and the CRB BLS Commodity Index dropped a modest 0.67% as the inflation trade and future growth estimates waned. The dollar weakened another 0.98% in the quarter and now sits a little more than 10.17% off its September 27th, 2022 high.
Fear of Mass Bank Failures Subsides by the end of March
Banks stocks, and specifically regional bank stocks, fell sharply in March after Silicon Valley Bank and Signature Bank failed. The index decline ended in the middle of March and has stabilized at a lower level. The initial decline was due to a fear of bank runs as depositors and investors worried that unrealized securities losses on bank balance sheets would lead to many failures. This fear has subsided as regulators have indicated that they will help prevent cascading bank failures. While the bank stocks have stabilized, they have not risen. Investors are no longer worried about bank runs, but they have reduced their assumptions for banks’ future earnings power. Additionally, the shareholders in SVB Financial Group and Signature Bank were wiped out overnight, while their bondholders will suffer significant haircuts as the FDIC rushed to protect insured and uninsured depositors. New regulations are likely coming for the banking industry. In sum, while the risk of rolling bank failures has abated, the outlook for future bank earnings is diminished.
After the GFC, regulators tried to minimize the chance of systemic credit risk taking down the banking system. In doing so, duration risk (i.e. even “safe” fixed income securities will decline in value as interest rates rise) was overlooked by many banks and regulators. The irony of the current episode is that this mess was largely caused by banks piling into “safe” securities issued or insured by the government. During the influx of deposits in 2020 and 2021, many banks without lending opportunities poured into these securities. Once inflation accelerated, the market value of these securities fell, and unrealized losses accumulated.
As with many parts of the economy and financial markets, inflation is the key. If it falls, so will interest rates and the unrealized losses will moderate over time. If it doesn’t, banking system concerns could linger.
Commercial real estate exposure is another long-term issue that bears watching at regional banks. Regional banks exposure to office loans could prove problematic in the years ahead as more people work from home and companies rationalize their office demand.
Is the bank run over, or is this a problem that will take years to clean up? Nobody knows yet, but every day that goes by with less commercial bank usage of the Federal Reserve’s balance sheet to fund deposit runoff and without another bank failure suggests that the bank run is over. We wouldn’t be surprised if a couple more failed, but a wave of bank closures appears to be off the table.
Recession Risk Rises
Banking problems should slow the economy down. Banks are an important source of credit to business and individuals. Many banks will need to improve their capital ratios and be more selective in lending and investing. The willingness of banks to loan has fallen dramatically and this will cause economic growth to slow. It remains to be seen whether the tightening in lending standards will be severe enough to cause economic output to contract and employment to decline.
The consensus is that a mild recession is inevitable later this year or in early 2024. There are certainly a number of reliable indicators pointing in that direction. The yield curve is inverted, the Conference Board Leading Economic Index peaked in December 2021 and has fallen since then, and money supply has contracted. NPP agrees that a recession is likely and that it will be mild. However, there are several reasons why a recession may yet be avoided. Key industries have already experienced recessionary conditions. Housing starts peaked in the middle of 2022 and appear to have bottomed. Apartment rents have stopped rising in most indices not reported by the government. The Bloomberg Commodity Index is 14.51% off its May 4th, 2022 high and the cost to ship freight containers from Shanghai to Los Angeles has fallen 85.71% according to the Shanghai Shipping Exchange. The main reason it is possible, if not probable, that a recession is avoided is that the labor market remains strong. There are still more jobs available than job seekers according to the JOLTS data reported by the Bureau of Labor Statistics. Despite the massive layoffs appearing in the headlines, jobs are still plentiful if less so than a few months ago.
NPP does not think a quick, shallow recession should concern investors. Our biggest concern is the risk that a severe recession breaks out. Inflation needs to come down. It has, but nobody knows if it will stop at a tolerable level. There is a long-held adage that when the Fed raises interest rates, something breaks. The Fed’s policies have contributed to the problems on bank balance sheets. Commercial real estate loans, and specifically office loans, could turn sour quickly if the economy weakens. The Fed’s interest rate hikes work with a lag. NPP doubts that all the effects have been felt. If Fed policy were to lead to excessive labor market stress, then a deep recession is on the table. We don’t think this will happen, but it is a risk.
Fixed Income Volatility Remains, Equity Volatility Normalizes
While stocks and bonds produced positive returns, the road was choppy. Equities get most of the headlines, but as in 2022, bonds were where the action was. Despite improving performance in bonds, bond market volatility remains elevated near a ten-year high. The ICE BofA Move Index which is a measure of Treasury market volatility closed the quarter at 135.93, while the ten-year closing average is around 71. Meanwhile, the VIX Index measure of stock volatility closed at 18.70, barely above its ten-year closing average of about 18.
Many market bears believe there must be a VIX spike before the S&P 500 bottoms. We do not want to dismiss this possibility. Maybe markets haven’t bottomed and one more spike in equity volatility is necessary before the bear market ends. However, the ICE BofA Move Index reached a level on March 15, 2023, that exceeded its COVID high. The only time the Index has been higher during the last fifty years was during the GFC. Equity strategists might be looking for a volatility spike in the wrong place.
Regardless of whether the equity market bottom is in, and NPP believes it is, volatility must subside before a new bull market can begin in full. We think it will, but investors must be patient. The issue of the debt ceiling looms, and markets must get past that. There must be increased confidence that more banks will not fail. Moreover, inflation needs to show clear signs that it is trending down. If time passes with the banking system intact while inflation moderates, financial market volatility should subside. It will take months, not days, for investors to become comfortable that the economic backdrop has improved.
NPP Thinks Financial Markets Will Remain Volatile but Positive
Asset markets generated positive returns in the first quarter despite volatile markets, a rising Fed Funds rate and a brief run on the banks that required policymakers to take supportive measures. In other words, equity markets are holding up well in the face of bad news. This is typically a good sign for future returns. NPP thinks markets will be volatile in the immediate future but remains positive on a long-term basis. Equities should grind higher even with a mild recession that has been predicted for more than a year. Bond yields have fallen somewhat despite or due in part to Fed tightening but remain attractive in what is probably still a slow growth world. Equities are unlikely to turn on a dime. Stocks V-bottomed in 2018 and 2020, but the 2022 bottom (assuming it was one) has been more protracted. This will likely continue to be the case. NPP’s bottom line, we remain cautiously optimistic on equities and fixed income for the rest of 2023.