Markets were volatile as big swings in expectations around Federal Reserve (Fed) policy dominated stock and bond returns for the quarter.
After a strong January, markets were whipsawed in February and March, first impacted by data showing persistent inflation and a hot jobs market, which led to expectations for more Fed tightening and higher rates. That narrative changed as higher rates created credit concerns and banking stress, which manifested later in the quarter.
Quarter in Review
Despite turmoil in the banking sector and elevated rate volatility, the broad stock indexes ended the quarter higher with the Dow Jones Industrial Average (DJIA), the S&P 500 and the NASDAQ composite up 0.9%, 7.5% and 17%, respectively. Bonds also ended higher in price, lower in yield, with the Bloomberg US Aggregate Bond index posting a 2.96% return.
A stock rally early in Q1 fueled by hopes of a Fed pause proved short-lived, with hotter-than-expected inflation and strong payroll data.
Inflation, Jobs, and the Banking System
The Fed’s preferred measure of price inflation, the personal consumption expenditure (PCE) index climbed in January and came in ahead of Wall Street expectations. Though down from its peak in June of 2022, the 4.7% year-over-year read was still notably above the Fed’s longer-run objective of 2%.
The January jobs report also exceeded expectations with nonfarm payrolls increasing by 517,000, far higher than the 187,000 the market had estimated. The unemployment rate fell to 3.4% versus the estimate for 3.6%, the lowest jobless level since May 1969.
Following these two reports, Federal Reserve Chairman Jerome Powell rocked markets with his semiannual testimony before the Senate Banking Committee March 7, 2023, when he stated that the Fed would likely need to raise interest rates more than expected due to strong data and was prepared to move in larger steps if the totality of incoming information suggested tougher measures would be needed to control inflation.
Interest Rates and the Banking System
This sent bond yields surging higher, as stocks moved lower. Within days, these higher rates were causing problems and signs appeared that there may be cracks in the banking system.
Silicon Valley Bank (SVB)
Within days of Powell’s remarks and the subsequent spike in interest rates, SVB announced that it was realizing losses in its hold-to-maturity investments and would be raising capital to cover the losses. It was noted in SVB’s company filings that the bank was funded by a high number of uninsured deposits and had a heavily concentrated investor base of technology, life sciences, and health care start-ups and venture capital funds.
Once these depositors became concerned about the safety of the deposits, it spurred a modern-day run on the bank. Regulators swooped in and placed the bank in receivership once it became clear that the bank was no longer solvent.
This led to widespread concern about deposits leaving other regional banks. Soon thereafter, Signature Bank was also placed into receivership. Market volatility was seen through US regional bank stocks on the news.
Regulators in the United States quickly stepped in to make all depositors whole at both SVB and Signature Bank. They added a new funding facility, the Bank Term Funding Program (BTFP) available to all banks to safeguard deposits. A Fed press release covered the details for this program.
Outside the United States, long-struggling Credit Suisse, one of the largest global banks, was forced into a bailout merger with Union Bank of Switzerland by Swiss regulators. This bailout, along with the Fed’s quick response in the United States, eased concerns of global contagion.
Rotation by Investors
The pain in the banking sector led to gains in other investments considered to be safer havens, like bonds, gold, and large cap technology stocks. Large cap technology stocks, which had been battered in 2022, drove the market indexes higher in Q1, as lower rates and the perceived safety of large cap tech—big balance sheets with little need for financing—sent the NASDAQ Composite 17% higher.
Financials were a big detractor in Q1. Energy, health care, and real estate also underperformed.
In fixed income, interest rate sensitive bonds led the rally as bond yields fell sharply. However, the catalyst for the drop in bond yields was the regional bank crisis, which spurred fears of a credit crunch that could hurt lower-quality bond issuers. Investors will likely be monitoring the credit quality of their bond holdings more closely as a result.
The Fed began tightening monetary policy in March of 2022. Since then, the federal funds rate has risen from zero to a range of 4.75% to 5%, the fastest tightening of policy since the early 1980s.
At its March meeting, despite the banking turmoil, the Fed increased rates an additional 25 basis points (bps). It did however update the language in the released statement, removing “it anticipates ongoing increases” and replacing it with “anticipates that some additional monetary policy may be appropriate.”
During the press conference, Chair Jerome Powell noted that the current issues among regional banks may result in tightening credit conditions that could have the same effect as one or more interest-rate hikes. This statement suggests some room for a pause or restraint on the part of the Fed.
The two counterforces between fighting inflation and maintaining financial stability make the Fed’s job more complicated going forward.
The market is anticipating that the Fed is nearly done with the tightening cycle—pricing in the potential for one more 25 bps hike in May and the potential for cuts toward the end of the year. However, volatility in the rates markets remains high and expectations continue to fluctuate with each new data point.
Fixed Income Markets
The banking turmoil caused significant swings in rates during the quarter. In early March, rates had moved up after coming around to the Fed’s higher for longer guidance. That hawkish outlook changed quickly after the collapse of SVB, and the Fed funds market quickly began pricing rate cuts.
Short-duration US treasuries yielded in excess of 5% early in the quarter as it looked like the Fed was set to keep going with rate hikes. Investors, enticed by these higher yields, flocked to short term treasuries.
Though there’s appeal to capturing these higher short-term rates, extending duration will reduce reinvestment risk, making a balanced approach appropriate.
Outside the US
Eurozone shares showed strong gains in the first quarter, despite volatility in the banking sector. Similar to the United States, gains were led by information technology, consumer discretionary and communication services, with real estate and energy lagging.
Despite the problems with Credit Suisse, the eurozone financials sector posted gains for the quarter overall as markets largely saw the situation as contained. The real estate sector saw significant weakness amid worries over higher financing costs and weaker occupancy rates.
The European Central Bank (ECB) raised interest rates by 50 bps in both February and March. Eurozone inflation has declined but is still significantly higher than in the United States.
Emerging markets posted positive returns over the quarter but lagged the MSCI World Index. The start of the year brought renewed optimism about emerging markets given the reopening of China’s economy. However, February and March saw US-China tensions reescalate following a Chinese high-altitude surveillance balloon in US airspace being shot down.
Though this incident dampened enthusiasm, China still led the index as optimism about the reopening an apparent easing of regulatory pressure on the internet sector were positive for Chinese stocks.
While financial markets showed gains during the last month and quarter, the economy showed signs of slowing. Labor market indicators, including job openings and hiring, slowed toward the end of the quarter and some measures of consumer and business confidence declined.
Manufacturing surveys stayed in recessionary territory, while the service sector softened from previously strong levels. While a recession isn’t likely in the immediate future, the probability of a shallow recession in coming quarters has increased.
Despite the headwinds from slower growth and the possibility of a recession, there’s potential good news ahead. With inflation dropping—and likely to drop further as the economy slows—the Fed will have less incentive to raise rates further, and the drop in longer-term rates reflects that. Lower interest rates are typically supportive for stock and bond values.
What This Means
While continued market volatility seems likely in the short term, the economic slowdown and adjustment in interest rates could put the markets in a better place in the longer term.
While it’s impossible to predict what will happen to markets in the short term, the broader economy isn’t always reflected in the market. Equity markets are considered a forward-looking mechanism while gross domestic product (GDP) is backward looking.
Markets have historically done well following a peak in inflation, the conclusion of a Fed tightening cycle, and a trough in consumer confidence. Often the market bottoms before the economy, which is why it’s important to stay the course and stick to a long-term plan.
As always, client portfolios should be viewed through a long-term lens, considering your time horizon, objectives, and risk tolerance.
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If you have any questions about the market review or Investment Management, please contact your Moss Adams advisor.