The first quarter of 2023 is already behind us and what a change from our last note. Year to date the S&P is up 7.5%, the Nasdaq is up 17%, and MSCI EAFE is up 6.7%. Growth outpaced value as fear of missing out took over after 2022’s losses. Yet despite the gangbuster start to 2023, nothing has significantly changed in equity valuations to explain the bounce. Inflation remains high, the Fed continues to raise rates, albeit at a slower pace. The banking system has shown signs of cracks as banks with higher risk profiles have felt significant pressure after the regional bank failures in March. Yet even in the face of two bank failures, the Fed raised rates 25 basis points in March, signaling the fight against inflation is not over. Inflation continues to be a global problem as almost all international banks are raising rates in tandem with the Fed (inflation in the UK is still over 10%). Employment remains a positive: the unemployment rate continues to fall and labor participation continues to climb.
The biggest news of the quarter was the failure of Silicon Valley Bank and Signature Bank in March. While these banks had higher risk profiles than most, the Fed’s aggressive rate hikes have made longer term “safe” bond investments lose value and have caused unrealized losses on banks’ balance sheets. These losses became realized when SVB and Signature had to sell them to meet liquidity demands. However, the US Government stepped in quickly to limit the risk of contagion to the banking industry, which appears to have stabilized the situation. This news offers signs the Fed rate increases are starting to cause breaks in the economy. Credit has been tightening throughout the quarter as loans become harder to obtain and high rates make them less attractive. Any banking issues bring risk management under the microscope, and credit standards become stricter as banks worry about audits and regulation. Subsequently it becomes harder and more expensive for both businesses and consumers to obtain loans. This, along with higher interest rates, should continue to decrease demand for credit and slow spending, which in turn slows inflation. The Fed and the market finally have evidence the tightening campaign is working.
Concern around regional bank failures would naturally cause clients to wonder about exposure in their own portfolios. It’s important to remember that proper diversification reduces the risk of a small sector, such as regional banks, from having a large impact on your total portfolio. As of February 28, Silicon Valley Bank (SIVB) represented just 0.04% of the Russell 3000, and regional banks represented approximately 1.70%. Factoring in international and emerging market holdings, exposure to US-based regional banks was even smaller. Adding exposure to fixed income, the percentage becomes smaller still. This is an excellent example of why diversification is key to long term success.
Last quarter we talked about discouraging unreasonable pessimism and encouraging reasonable expectations. It appears unreasonable pessimism wasn’t a problem in Q1, almost the opposite. However, we can’t help but question the fundamentals behind the market’s bounce. Growth stocks continue to be historically overvalued, with the latest market move making them even less appealing. While Growth stocks would benefit from lower interest rates, the Fed and central banks around the globe are raising rates and inflation is still high enough to keep them on track. The most recent data shows inflation may have peaked, but it’s hard to imagine it will move to the Fed’s target of 2% as quickly as the market is anticipating without a painful contraction. While seeing positive returns in the market is refreshing after last year, we have concerns around sustainability. Inflation is proving to be stickier than expected. Consumers, the heart of the economy, continue to feel the pressure of higher expenses, higher interest rates, and wages that haven’t kept up with inflation. A healthy job market and leftover stimulus money have kept consumers spending, but stimulus is behind us and the job market is showing cracks, as layoffs tick up and job openings tick down. Tax refunds are down, another headwind for consumer spending. All banks, regardless of size or quality, appear to be tightening lending standards and risk controls. The commercial real estate market is beginning to show signs of stress as office vacancies and higher rates take a toll. The Prime Rate currently stands at 8% while the S&P 500 still trades at more than 18x earnings. Volatility persists across all segments of the market. In short, the list of economic liabilities continues to outweigh the assets.
Since our last writing, we continue to favor caution and safety in our portfolios. We maintain an overweight to Large Cap Value in equities, added exposure to International Developed markets, while remaining underweight Emerging Markets, Small Cap, and Mid Cap equities, as well as Large Cap Growth. In Fixed Income, we continue to favor high quality, short duration securities. We think 2023 will continue to be volatile but believe planning, proper asset allocation, and diversification are keys to success.
Heather A. Voight, AIF® | Portfolio Manager
Previous market commentaries:
2022 Fourth Quarter Market Commentary 2022 Third Quarter Market Commentary 2022 Second Quarter Market Commentary
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