1st Quarter 2023 Market Commentary
By David J. Haas, CFP®
April 18, 2023
The beginning of 2022 was very tough for investments, but if you remember, the 4th quarter was better with the S&P 500 index up 7.6%. I have to call 2023 choppy so far. The S&P 500 was up 8.98% by February 2, dropped to a quarter low on March 13th, where it was only up 0.77% for the year, and then has come roaring back to end up 7.5% as of March 31st. Fixed income, which did so horribly last year, has performed better this year so far, although also in a choppy way. As of March 31, the Bloomberg US Aggregate bond index is up 2.96%.
Why is the market so choppy and what is the likely outlook for the rest of the year? The market is being driven by the following themes:
- Inflation and whether it will moderate by the end of the year.
- The Federal Reserve Bank and whether they will continue to raise interest rates.
- Stability of the banking system.
- Is the US going into a recession and how deep will it be?
The stock and bond markets are affected by these themes, and no one has the answers. Until there is more clarity, I expect continued choppiness. I will share my own opinions on these points.
Inflation – Inflation can be caused by the mismatch between supply and demand. If there is more demand than supply, prices tend to rise until one of two things happen: the higher prices cause more supply to come online, or demand drops to match the supply. There were two causes of our current inflation situation. The pandemic has caused supply drop in goods because of disruption in factory production and transportation. There is a general shortage of labor in the US because many workers have permanently left the economy for various reasons both related to the pandemic and unrelated to the pandemic. At the same time the stimulus money from the Federal Reserve (ultra-low rates) and the Federal government (various stimulus programs) created excess demand for both goods and services. Inflation can become a self-fulfilling prophecy when employees demand rising wages to compensate them for higher prices and higher wages cause prices to rise further.
The Federal Reserve Bank has been raising interest rates to lower demand. Unfortunately, the tool they use to lower demand makes everyone poorer in a blunt way. They want the American public to stop demanding so much. That means they must make us feel poorer. The federal government has stopped the excess stimulus, but they are not prepared to cut spending. Since a lot of their expenditures are aid for the poor and defense spending, it becomes difficult for them to cut. The Fed is left to do all the work.
The Fed would like rising rates to cause a drop in demand which will cause companies to moderate their hiring, cooling the demand for labor. Rates have risen from 0.25% to 5% in a year. That is 1900%!!! Warren Buffett says that when the tide goes out, you can see who has been swimming naked. In this context, you can see who was relying on ultra cheap money to fund their operations. The rapid rise in rates has caused instability in the banking system and is hurting start-ups which rely on debt financing.
Stability in the banking system – The business of banks is fundamentally to take in short-term deposits and lend out with long-term loans. Think about mortgages. Banks will take your savings account and loan out the money to someone else in a 30-year mortgage. Banks intermediate by converting a short-term asset into a long-term liability. Do you think that sounds risky? Definitely. When banks do this with many customers the risk is reduced, but if all the customers ask for their money at the same time, the bank won’t have the cash and will be forced to fold. Just rewatch It’s a wonderful life to understand a bank run. The FDIC was created to give people confidence that their deposits are safe so bank runs wouldn’t happen. But they deliberately only protect small depositors. Larger ones are supposed to be on their own.
The problem with Silicon Valley Bank was that they had many large depositors, whose deposits were not insured and easily moved electronically. Their loans were mainly to those same depositors and not very diversified. At the same time, they held bonds which would have been very safe if held to maturity, but because the interest rates of the bonds were lower than the prevailing rate (Fed has raised rates), the current value of the bonds were lower than the value at maturity. It’s all OK unless there’s a bank run. Because the large depositors were uninsured, they heard rumors about the stability of the bank and rushed to move their deposits out. Classic bank run.
Is the banking system safe? Mostly yes. Most banks have more diversified depositors and loans than SVB. The FDIC and bank regulators have proven that they will protect the public. But will banks be under some pressure? Possibly. Some of their loans may go bad. Real estate loans for retail and office properties may not be able to be refinanced at higher rates, causing them to go bad. Existing loans have lower rates and demand for new loans is poor. Long-term rates are lower than short-term rates right now (called a yield curve inversion) which means banks may have lent long-term at lower rates than they must currently pay depositors. This will cause a profit problem, even if the bank is fundamentally sound. This will work itself out in the longer run, but there could be additional headlines in the short term.
Is the US going into a recession? The technical definition of a recession is two consecutive quarters of negative Gross Domestic Product (GDP) growth. While many recessions bring high unemployment and bankruptcies, that is not always the case. The Fed is trying to slow the economy to lower inflation while avoiding a recession. This is very difficult to do, and the Fed is likely to get it wrong. They continue to raise rates, looking to moderate inflation, but higher rates have a lagging effect on the economy. It takes a while for higher rates to have the effect the Fed wants. Still, we have a robust labor market with unemployment at 3.5%. Even if we do enter a technical recession, employers are reluctant to fire employees they have had a tough time hiring and the service sector still has a robust demand for employees. I expect that any recession which occurs will not be accompanied by high unemployment which means consumer spending is not going to drop off a cliff. On the other hand, moderating demand and companies keeping workers will probably mean company earnings will be under pressure this year. We call this an earnings recession.
How will all this affect the stock and bond market? I expect the Fed might be done raising rates (although they could raise them one more time in May). The earnings recession will mean stocks are going to continue to be under pressure this year, but after last year’s decline, that does not mean they will drop a lot. It means a choppy, rocky road for stocks. Investors like to look to the future, so any hint that the Fed is going to lower rates will probably drive the market higher. I think that’s likelier towards the end of the year as the Fed will want to see inflation drop significantly. Meanwhile, the bond market will act normally this year with the benefit of higher rates paying investors an income. I am still recommending shorter duration bond funds, but it will make sense to switch to longer duration mid-year as the Fed’s intentions become clearer and the yield curve inversion moderates.
The information in this discussion is the opinion of the author and there are no guarantees on the accuracy or completeness of the data. Markets move for a variety of reasons and the author is likely to be wrong in one or more areas. Investing involves risk and your portfolio should be designed for your timeframe and risk tolerance. You should consult your financial advisor before making any investment decisions.
