The Federal Reserve’s heavy-handed fight against inflation was bound to break something, and this quarter, we found out what: bank balance sheets. The well-telegraphed rise in interest rates somehow caught some banks off guard, resulting in solvency fears, bank runs, bankruptcies, and bailouts. Through it all, US stocks had a strong quarter.
As we look forward to the rest of the year, the inflation and interest rate story still appears to have many chapters to be written. While the Fed has backstopped banks to stem the contagion of the recent crisis, other unintended consequences are undoubtedly possible. Yet, we entered 2023 with far more promise than a year ago when valuations were stretched for both stocks and bonds. Fear and uncertainty are admittedly high, yet historically that has been a good time to get greedy.
Dissecting Q1 2023
The Fed has moderated rate increases, with a peak in sight
Inflation is still high but slowing, and the Fed has eased its approach. There were two Fed Funds rate increases in Q1, both 25 bps. That is a significant slowdown from the meteoric pace of the past year, where 75 bps was the norm. Peak rates are now in sight. The latest average peak rate forecast by the Federal Reserve members is 5.1% in 2023, with declines to follow in subsequent years. From that estimate, it is clear that some Fed members believe we are already at the peak.
Chart 1: Peak in Sight for Inflation and Fed Funds Rates
Source: The US Federal Reserve, Bureau of Economic Analysis
Rate increases exposed poorly constructed bond portfolios
While increases have moderated, banks are still reeling from the impact that past increases had on the value of their bond and loan portfolios. The rapid rate increase hit bond values and exposed those banks with too much duration in their portfolios, triggering a crisis of confidence and bank runs. Silicon Valley Bank and Signature Bank were high-profile poster children for the mini-banking crisis. The fallout may not be done, but for now, this was a problem specific to banks that did not do well matching their asset and liability exposures.
The Fed launched its Bank Term Funding Program to avoid additional bank runs and stem contagion. The program lends to banks allowing them to use the par value of their Treasuries and other qualifying assets as collateral. The Fed’s balance sheet grew $324B in March as financial institutions successfully utilized the facility.
Chart 2: The Fed Steps in to Calm Bank Fears
Source: Federal Reserve
Stocks rose despite the barrage of dour headlines in Q1
There has been no shortage of scare stories this quarter, focusing on banking crisis contagion and the potential for recession. Despite that, the S&P 500 was up 7.5% in the first quarter and 16% from the October lows. Market recoveries can be swift and often start while the news flow is still at its worst. Investors should avoid falling into the trap of equating news and media sentiment with stock market returns.
Under the hood, the gains this year are largely a rebound in Tech. The top six companies in the S&P 500 (Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla) plus Meta accounted for over 80% of the upside in the S&P 500.
Chart 3: Stocks Defied Media Sentiment
Higher yields do not necessitate allocation changes
The sell-off in bonds in 2022 raised yields across the fixed-income space and created a margin of safety not seen in many years. Investors can now enjoy earning yield on low-risk money market funds, but wholesale allocation changes are not justified in our view. Why? Fixed income is not the only asset class looking more attractive.
The 2022 sell-off in equities created opportunities for stocks as well. We saw a dramatic increase in the long-term expected returns of equities this year compared to last year’s start. As such, a higher allocation to cash and bonds may lock in higher yields, but it locks out the higher return potential of equities. This could limit portfolio returns and introduce unnecessary risk for long-term goals. In other words, attempts to de-risk portfolios could increase the chance that your long-term investing goals are missed.
Chart 4: De-Risking Can Add Unintended Risk
Source: Factset, Example MM w/4.2% yield, JP Morgan 2023 Long-Term Capital Market Assumptions
2023 has started on the right foot
Poor returns in 2022 set up portfolios for better prospects in 2023, which played out in the first quarter. US Large Cap put in a strong performance, but Foreign Developed stocks were top of the returns table this year. Gold was also higher, continuing from a strong run in the fourth quarter. Both of these moves were a good reminder of the importance of diversification in a well-constructed portfolio.
It was also nice to see that bonds started the year in positive territory after the challenges in 2022. Commodities, the best performers last year, fell as energy prices moderated.
Chart 5: Asset Class Performance in Q1 2023
Be “fearful when others are greedy, and greedy when others are fearful.”
– Warren Buffett
The Q2 2023 Playbook
As we continue on the journey of 2023, we remain optimistic. As we said last quarter (in fact, we always say this), we are not predicting a market rebound this year. It is indeed a possibility, but that is not the source of our optimism. Instead, we take comfort in knowing that the 2022 market declines created a margin of safety for upside in both stocks and bonds that did not exist at the start of 2022.
We enter the second quarter with the luxury of high yields in our fixed-income instruments that we have not enjoyed for decades. Relatively safe money market funds earn upwards of four percent per year. The temptation in this environment is to de-risk… to allocate more of your portfolio to fixed income. For some, this may be a prudent move. For most, this is more likely to unnecessarily limit the upside of your portfolios and potentially even jeopardize your long-term savings goals.
Tactically, we are positioned to benefit from and enjoy the higher return potential that bonds offer today but remain fully invested in equities to capture their long-term return benefits. The long-term prospects for stock returns are still far greater than that of money markets and Treasuries, and we see no reason to reduce our exposure. In the words of Warren Buffett, we would much rather be “fearful when others are greedy, and greedy when others are fearful.” Right now, we see a lot of fear.
On behalf of the entire Strategic Financial Services team, I thank our incredible community of clients, associates, friends, and family for placing your trust in us. We appreciate your confidence and thoughtfulness in these unusual economic times.
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