2023 1st Quarter Market Commentary
Top Headline for Q1: Silicon Valley Bank
Financial headlines in Q1 were filled with news of a potential banking crisis as Silicon Valley Bank (“SVB”), our nation’s 16th largest bank, was taken over by the Federal Deposit Insurance Corporation (“FDIC”). SVB’s failure was particularly striking in how quickly it occurred. On Wednesday, March 8th, SVB was perceived to be healthy, and by Friday, March 10th, its doors had been closed permanently. The speed of the failure highlighted a new normal for modern banking where advancements in mobile banking tools allow for capital to flow freely between financial institutions. In fact, it is estimated that over $150 billion in deposits were withdrawn from SVB in under 48 hours. The SVB failure was followed by the failure of Signature Bank with rumors of more to come. It was a rough quarter for the banking sector as evidenced by the regional bank ETF, KRE, which fell nearly 25%.
Despite the banking turmoil caused by SVB, the first quarter was a strong one for risk assets. With the Fed now projected to pause in raising rates following the May meeting, the equity market and other rate-sensitive assets were positive. Most notably, “long duration” U.S. equity assets were up the most with the technology sector rising over 20% during the quarter.
General Market Update
US Equities: The S&P 500 Index was up 7% during the quarter, while the Nasdaq Composite was up 16.8%, and the Russell 2000 Index climbed 2.3%. Being market cap weighted, the S&P 500 and Nasdaq Composite both enjoyed significant outperformance from their top two holdings, Apple and Microsoft. The two companies represent a whopping 13% of the S&P 500 Index, and 23.8% of the Nasdaq Composite. During the first quarter, Apple was +27.1% while Microsoft was +20.5%. This is noteworthy given how “top heavy” these two indices are. The divergence between the S&P 500 and Nasdaq as compared to the Russell 2000 was quite striking. The surge in the Nasdaq can be attributed to its technology exposure while the small cap Russell 2000, with its heavy exposure to regional banks, was held down by a broad collapse in bank stocks.
International and Emerging Market Equities: International equity markets continue to rise following a strong 4th quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 8% in Q1, and the Schwab Emerging Markets ETF (SCHE) was up 3.6%. Inflation continues to be a substantial problem in Europe along with indications of social unrest. It’s unclear of the exact long-term implications of these developments but inflation could hinder corporate profits, and we’re watching for further developments. China continues to bolster emerging market indices as its “re-opening” provided an economic jolt, which is coupled with a government that has backed off from its previous policy of suppressing activities of large technology companies.
Fixed Income and Credit: As we all know by now, 2022 was a horrible year for bond investors. During the 1st quarter, however, the market participants concluded that May would be the final increase in rates and that rate reductions were coming later in 2023. Long term rates, as measured by the U.S. 10-Year Treasury bond peaked at over 4% in October 2022 before beginning a downward trend that continued through Q1 and finished at 3.49% on March 31. The change in expectations pushed most bond prices higher with long-term bonds being the biggest winners (e.g., VCLT was up 6.1% and VGLT was up 6.8%).
Commodities, Precious Metals, Inflation: Q1 marked a very interesting moment for real assets. Gold, to very little fanfare, approached its highest price in history. New “highs” for assets tend to mark “breakouts” where assets subsequently move to substantially higher levels. It was particularly noteworthy that Gold achieved this level during a period of falling inflation expectations. Gold, and precious metals more generally, will be interesting assets to watch throughout 2023. Commodities generally fell during the quarter as many of these assets continue to move back toward long-term averages after spiking following COVID.
A Look Ahead
Market participants very clearly moved into a “bullish” stance during Q1. Futures markets indicate that participants expect May to be the last increase in the Federal Funds Rate and, more importantly, that the Federal Funds Rate will be lowered over 100 basis points before the end of 2023. This shift in sentiment runs counter to the Fed’s recent commentary in which they suggest that the Federal Funds Rate will need to be held at current levels throughout 2023 (i.e., NO reduction). The tension between market expectations and Fed actions will likely lead to volatility in both equities and bonds as the true path of rates reveals itself.
It is also noteworthy that corporate earnings are expected to fall, and a recession is predicted. At this stage, the equity market may have some asymmetric risk to the downside given the direction of earnings and the perhaps overly aggressive assumption that the Federal Funds Rate will be coming down. If the Fed holds firm at current rate levels, earnings deteriorate, and/or the banking crisis worsens, we could see a sharp market reaction to the downside. We will be watching this closely.
Longer term rates have likely stabilized for now. At this point, it will take some extremely negative news on the inflation front to test the October high in yield and low in bond prices. As a result, we favor continuing to add some duration to bond portfolios for income-seeking investors with a long-term horizon.
