Q1 2023 Market Commentary
Despite the stress in the banking system, including the failure of Silicon Valley Bank, global equity markets held up remarkably well in March and posted solid returns for the quarter. The S&P 500 index was up 3.7% in March and gained 7.5% in the first quarter. Developed international stocks (MSCI EAFE Index) did a bit better, rising 8.5% for the quarter (2.5% in March). Emerging markets stocks (MSCI EM Index) gained 4% for the quarter and rose 3% in March.
Underneath the calm market surface, there was wide dispersion in returns across sectors, market caps, and styles. Large-cap growth stocks (Russell 1000 Growth Index) gained 14.4% in the quarter, while the large-cap value stocks returned 1% (Russell 1000 Value Index). The Nasdaq Composite Index surged 17%, while the Russell 2000 Small Cap Value Index dropped 0.7%.
Fixed-income markets had a strong quarter as longer-term bond yields fell, generating price gains. Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) returned 3%, as the 10-year Treasury yield fell to 3.5% from 3.9% at year-end. Municipal bonds gained 2.3% (Morningstar National Muni Bond Category). Flexible/nontraditional bond funds gained around 3%.
Alternative strategies and nontraditional asset classes generally underperformed traditional stock and bond indexes for the quarter.
QUICK RECAP: THE SILICON VALLEY BANK FAILURE & WHY IT IS NOT LIKELY THE START OF ANOTHER FINANCIAL CRISIS
The story of the Silicon Valley Bank (SVB) failure is well known; however, we think a quick recap is worthwhile as it provides context for our investment outlook and portfolio positioning. Silicon Valley Bank was the victim of a classic “bank run” – too many depositors wanted their money back simultaneously and SVB didn’t have the cash on hand to meet customer withdrawals.
SVB had unique characteristics that made it susceptible to such a run, but don’t necessarily apply to the broader banking industry. This is one reason we do not see the failure of SVB as the beginning of a replay of the Great Financial Crisis (GFC) of 2008. The failure could have a broader impact on financial markets. SVB was particularly exposed to interest-rate risk as it held an unusually large share of its assets in long-duration bonds. As such, SVB faced extremely large unrealized losses on their bond portfolio when rates rose sharply last year as the Fed sought to choke off inflation. Unlike most banks with a diversified deposit base that includes individuals of all sizes and types of businesses in different sectors, SVB’s depositor base was comprised of start-up technology and venture capital firms; and almost its entire depositor base was above the FDIC insurance limit of $250,000 per account.
Combined, these characteristics of SVB caused some of their concentrated, large, uninsured depositors to start pulling their money from the bank. This forced SVB to raise capital (liquidity) to meet the withdrawals by selling bonds at losses, turning the unrealized losses on their balance sheet into realized losses, raising the question of not only liquidity risk for the bank but solvency/bankruptcy risk, leading to even more depositor flight, etc. Ultimately, the FDIC and Fed stepped in over the weekend of March 11 to take over the bank, guarantee all SVB deposits above $250,000, and set up a broad banking system liquidity backstop (the Bank Term Funding Program (BTFP)). The BTFP allows banks to borrow from the Fed for up to a year, based on the issued face value (par value) of their treasury and agency MBS bonds, rather than the current (lower) market value. This new facility enables banks to meet deposit withdrawals and other liquidity needs without having to sell currently underwater bonds at a loss. As we can see in the chart below, banks have taken the Fed up on its offer, and then some.
While the banking system is not out of the woods it seems these steps and subsequent actions from authorities have stemmed the risk of widespread bank-run contagion.
INVESTMENT OUTLOOK & PORTFOLIO POSITIONING
We always consider a range of macroeconomic scenarios when constructing our investment views and diversified portfolios. Our approach is particularly valuable during periods of heightened uncertainty, which we would argue is the case today given the dynamics of inflation, fed policy, and stress in the banking system.
Inflation likely peaked last year and has come down yet remains too high relative to the Fed’s 2% long-term target. February’s year-over-year core CPI inflation rate was 5.5%, while core CPE inflation – the Fed’s preferred measure – clocked in at 4.6%. Given persistently high inflation, the Fed has continued its rate hiking campaign this year, although the magnitude of rate hikes has diminished.
At its March 22 FOMC meeting, the Fed hiked its federal funds policy rate by 25 basis points (0.25%) to a range of 4.75% to 5.0%. This was the Fed’s ninth consecutive hike since March 2022, representing a total tightening of 475bps (4.75 percentage points). This is the most aggressive monetary policy tightening campaign since the Paul Volcker days in the early 1980s. It was inevitable something (in this case SVB and other poorly managed banks) would “break” given the magnitude and speed of the hikes.
The risk of a recession in the next year cannot be overlooked, however, we see many positive data points. Household and business balance sheets remain healthy and supportive of continued spending. U.S. households are still sitting on an estimated $1.4 trillion in pandemic-era savings. Employment remains robust, with a stronger-than-expected 311k new jobs in February, following the shockingly strong 504k jump in January. Real disposable income is rising as wage growth is now stronger than CPI inflation. Moreover, the U.S. and other major global economies appear to have grown in the first quarter of the year. So even if a recession does play out, these are all reasons to believe it may be relatively mild.
We believe 2023 will present us with some excellent long-term investment opportunities. While our current positioning is cautious with a modest underweight to equities, we do not rule out the possibility the U.S. economy avoids recession this year, or that the recession is mild, and stocks do not experience a precipitous drop.
The short-term future depends on the Fed and how much further they tighten (raise rates). If the Fed pauses its hiking campaign sooner than later, equities may positively respond, as lower interest rates imply higher P/E multiples. But numerous other key variables for the economy and financial markets are beyond the Fed’s or any policymaker’s control.
While the short-term outlook for equities is uncertain, we feel optimistic about the future of core bonds. Fixed-income assets and high-quality bonds are also now attractively priced with mid-single digit or better-expected returns, depending on duration and credit quality. Our research suggests that after a historically poor year for bonds in 2022, higher yields and the potential for price appreciation create an environment for a turnaround this year.