In some ways, the first quarter of 2023 was a continuation of the fourth quarter of 2022. Equities rallied, outperforming bonds. Non-U.S. developed equities once again led all assets with the best returns. Maybe there’s some value in geographic diversification again.
Asset class returns: Let’s pretend 2022 didn’t happen
Among U.S. large cap, growth stocks, particularly in the tech sector, had a very strong quarter, leading value stocks by a wide margin.
When you consider that we witnessed two of the largest bank failures in U.S. history during the first quarter, these results are rather remarkable. Fortunately, the fallout from the regional banking crisis has been limited to the financial sector thus far.
Bonds, particularly long duration, performed quite nicely in the first quarter. Even treasury inflation-protected securities (TIPS) generated positive returns after suffering a disappointing 2022. And cash (with a Q1 2023 return of 1.1%) nearly matched its 2022 gains in three short months. It’s good to see cash and bonds generating positive returns again – conservative investors can sleep a little easier now.
Treasury rates observations: Pause or pivot, will something break?
The tightening of monetary policy continues but is moderating and may be over. Yields in shorter-term treasuries rose with Fed hikes, but longer-dated securities decreased. Lower treasury rates decreased discount rates, which increased pension liability values.
On the asset side of the ledger, return-seeking assets have generally helped improve funded status in 2023. Gains in the growth portfolio and declining yields increased asset values. Thus, the higher the allocation to return-seeking assets, the better the improvement in funding ratios.
The first quarter of 2023 also showed how difficult timing interest rates can be. LDI hedging programs should pay attention to key rate durations given curve inversion. Completion portfolios may help address this issue by providing exposure to key rate durations.
Where do markets go from here?
We always like to preface this section with a word of caution. We don’t know where markets are headed ― does anyone? The best that we can do is identify a set of data points that are going to give us clues about the direction of markets.
Corporate earnings
The first thing to watch is earnings. We highlighted this last quarter. In the long run, stock prices follow earnings, but in the short term, price multiples (what the market is willing to pay for a dollar of earnings) often have a significant impact on equity returns.
For 2021 and 2022, the Standard and Poor’s (S&P) earnings per share came down a bit as inflation accelerated last year. For 2023 and 2024, analysts have lowered their estimates slightly, but not as much as one would think if we’re headed into a recession. That means if we do experience a recession, earnings will likely decline even further than analysts are currently estimating. Stock prices will likely follow ― unless of course, price multiples continue to expand.
The Fed
A year ago, FOMC members thought the Fed funds would peak at 2.75%. Every three months, though, that estimate increased. Now, the Fed is signaling they’re about done raising rates and that sometime next year, they’re likely to cut rates to 4.25% or 4.50%. Given how much their opinions have changed quarter-to-quarter, we’re not sure how much faith to put into the most recent estimates. The Fed Funds Futures, where market participants predict the Fed’s next moves, is signaling a rate cut this year – maybe as soon as September. Yet, most of the investment managers we speak with think that’s too soon and that the Fed will hold rates here until 2024.
Why is this important? Because we want to know what’s priced into the markets. If markets are pricing in a rate cut that doesn’t happen, then prices will need to adjust.
Inflation
Inflation is another piece of this puzzle. No doubt you’ve seen that inflation is coming down. For most of the last decade, we had 2% inflation; then COVID hit and, as a result of governmental actions and other factors, inflation skyrocketed from below 2% to nearly 7% in less than 24 months.
The odds are against inflation falling as fast as it rose. Once price increases start working their way through the economy, from the raw commodity inputs through the prices we pay at the gas station and the supermarket and into wages, it becomes difficult to slow that train down. Consider the experience of the 1970s: in February 1975, inflation hit 11.8%. Two years later (1977) it was 6.2%. Two years after that (1979) it climbed back to 9.1%. It then took four years to fall under 4%.
The regional banking crisis: all clear?
Turning to the regional banking crisis for a moment, from an equity market perspective the damage appears to be contained within financials. Silicon Valley and Signature Banks, the argument goes, were one-offs, idiosyncratic situations where concentrated depositor bases and mismanagement led to disaster. Also, the Fed was very quick to backstop all regional banks in a way that was, dare we say it, unprecedented. While financials, regional banks in particular, have been the worst segment of the equity market this year, that hasn’t held back the tech sector from posting strong gains.
Keeping an open mind
So those are some of the critical data points we’re watching, and again, we’re keeping our minds open to the possibility of other unknown unknowns.