2023 First Quarter Recap and Outlook
Photo Credit: Saulo Mohana, Unsplash
Financial Markets Start 2023 Strong But End the First Quarter on a Question Mark
First-quarter economic data showed the U.S. economy entered 2023 with considerable momentum, even in light of the Federal Reserve’s interest rate hikes throughout 2022. Fourth quarter 2022 GDP data showed the U.S. economy grew at a +2.6% rate. While businesses cut back on spending and the housing market remained weak, a resilient consumer, inventory restocking, and increased government spending were primarily responsible for the growth.
Additional economic data in the charts below highlight the broad economic trends. The data shows that growth is returning to normal as the economy returns to its pre-pandemic trend, but it also shows that it has been able to handle higher interest rates. Jobs remain plentiful, with job openings significantly above the pre-pandemic trend, inflation is easing, and consumer spending remains above trend.
Financial markets turned rocky during the last month of the quarter. Three regional banks failed, and the U.S. Treasury bond market became more volatile as investors debated whether the Federal Reserve would continue to raise interest rates against an uncertain backdrop.
This quarter’s recap discusses recent bank failures, including concerns about financial stability, and provides an update on year-to-date stock and bond returns.
Q1 2023 - Positive Economic Signals
Regional Banks Fail After Sudden Withdrawal Spree
Three regional banks failed in March as the banking industry faced a crisis of confidence, and customers quickly withdrew deposits. The Deposit chart below shows deposits at U.S. commercial banks rose from $13.2 trillion at the end of 2019 to $18.1 trillion in April 2022 as businesses and individuals flooded banks with new deposits during the pandemic. More recently, deposits at commercial banks decreased in 9 of the last 12 months. The bottom chart below, which graphs the change in bank deposits from peak levels, shows total U.S. commercial bank deposits have declined -$607 billion since April 2022. The decline marks the biggest banking sector deposit outflow on record and is starting to stress bank balance sheets.
Banks maintain a portion of their assets as liquid reserves, such as government bonds and commercial paper, to meet withdrawal requests that can be quickly converted to cash. If banks exhaust their liquid reserves, they can borrow from other banks and the Federal Reserve or sell assets, such as their bond holdings. This basic process helps explain why three banks failed.
Depositors overwhelmed the banks in early March with withdrawal requests. The banks exhausted their liquid reserves, could not obtain loans from other banks or the Federal Reserve in a time-efficient manner, and were forced to sell their most liquid assets, which consisted of U.S. Treasury bonds and mortgage-backed securities. The problem for the banks is that interest rates are significantly higher than when the banks bought the bonds, and the bonds are now worth less. When the banks sold the bonds, they were forced to realize billions of dollars of losses, which drained their capital cushions and made them technically insolvent. State banking regulators and the FDIC immediately stepped in to take over the failed banks and protect depositors.
These recent bank failures have raised concerns about financial stability and drawn comparisons to 2008. However, there are important differences from 2008, including regulatory changes and insolvency causes. Banking reforms after the 2008 crisis strengthened the overall financial system, and higher capital requirements now provide banks with a more robust financial cushion. In addition, regulators now have greater authority to resolve issues in large, failed banks to avoid chaotic situations like the Lehman Brothers bankruptcy.
In terms of cause, problematic loans and complicated securities were primarily responsible for the 2008 crisis. In contrast, recent bank failures resulted from the Federal Reserve’s rapid interest rate increases, which created paper losses for banks that made loans or purchased bonds at lower interest rates.
Navigating the Volatile Interest Rate Landscape
Due to mixed messages about the strength of the U.S. economy and the Federal Reserve's plans, the Treasury market is becoming more volatile and less liquid. The U.S. economy did well in January despite rising interest rates, which suggests that the Federal Reserve may need to do more than expected to slow inflation.
During his early March congressional testimony, Federal Reserve Chair Jerome Powell spooked markets by suggesting the central bank would need to raise interest rates higher than initially thought and then keep interest rates higher for longer. The warning caused Treasury yields to rise and bond prices to trade lower. Less than one week after Powell testified, multiple regional banks collapsed, causing worries about the U.S. financial system's stability. Treasury yields reversed course and declined, causing bonds to trade higher.
The two conflicting themes have resulted in wild price swings in the usually quiet Treasury market as traders place bets on the likelihood of future rate cuts.
The chart below graphs the rolling 2-day percentage change in the 2-year U.S. Treasury yield and shows the recent spike in volatility. Taller bars indicate the 2-year Treasury yield experienced a more significant 2-day move. The chart looks like a heartbeat over the past 12 months, going up and down with occasional volatility as markets responded to new information. However, the chart's far right shows a recent spike in both directions. The 2-year yield plunged -0.87% on March 13th after two regional banks failed over the weekend, its most significant 2-day decline since the Black Monday stock market crash in October 1987. After banking regulators took over control of the banks and the Federal Reserve introduced lending programs to stabilize the banking sector, the 2-year yield surged by +0.35% on March 21st.
Two-Day Change in 2-Year Treasury Yield
What is causing the volatility? Investors now fear the Federal Reserve faces a challenging set of choices. The central bank must find a way to control inflation while doing as little damage as possible to the U.S. economy. One factor complicating the central bank’s task and contributing to interest rate volatility is the lag effect of monetary policy – it is difficult to model how 2022’s interest rate hikes already have and will impact the economy. As a result, there is little consensus inside the Federal Reserve on the path of monetary policy. In its Summary of Economic Projections, the central bank predicts what will happen with key economic indicators and hints about monetary policy’s future direction. The projections for interest rates cover a wide range.
Projections for interest rates at the end of 2024 range from 3.4% to 5.6%, while the 2025 projection range is 2.4% to 5.6%. With even the Federal Reserve uncertain about policy, interest rates could remain volatile in the coming quarters.
Equity Market Recap – A Reversal in Performance Trends During the First Quarter of 2023
Stocks traded higher in January before giving up some of their gains in February and March. The S&P 500 Index of large-cap stocks ended the first quarter up +7.4%, outperforming the Russell 2000 Index’s +2.7% return. Most of the S&P 500’s relative outperformance occurred in March as investors de-risked their portfolios following the bank failures. There was also a sizable shift in factor performance during the first quarter. The Russell 1000 Growth Index gained +14.3%, outperforming the Russell 1000 Value Index’s +0.9% return. Like the S&P 500, the Growth Factor’s relative outperformance occurred in March after the bank failures. Growth stocks tend to be higher-quality businesses with more robust fundamentals, and recent bank failures may have motivated investors to rotate into higher-quality companies. Regardless of the cause, Growth’s outperformance is a significant change from 2022, when the Federal Reserve’s interest rate increases weighed on expensive stock valuations.
The Growth vs. Value performance reversal also shows up in first-quarter sector returns, with Growth-style sectors outperforming. Figure 4 is a scatterplot that compares each sector’s 2022 return (vertical y-axis) against its first quarter 2023 return (horizontal x-axis). The worst-performing sectors in 2022 are the top-performing sectors in 2023, while 2022’s top-performing sectors are broadly underperforming at the start of 2023. Beyond the year-to-date performance reversal, there was no apparent preference for defensive or cyclical sectors.
US Sector Price Returns (2022 vs Year-to-Date 2023)
Turning to global markets, international stocks posted positive returns during the first quarter. The MSCI EAFE Index of developed market stocks gained +9.0%, outperforming the MSCI Emerging Market Index’s +4.1% return. Europe was the top-performing international region and boosted developed markets’ performance. After Russia cut off most of its natural gas supply, the region avoided a major energy crisis by having unusually warm weather and working to find other sources of natural gas. Short-term gas prices have dropped from record highs, preventing severe shortages and rationing, but utility bills are still high. In Asia, all eyes remain on China as it reopens after relaxing its COVID-Zero restrictions. The reopening is expected to boost China’s economy and potentially the global economy, but it is unclear how strong or lasting the growth will be.
Bond Market Recap – Riskier Bonds Underperform Due to Concerns About Refinancing Risk
Bonds traded in both directions during the first quarter, initially trading higher in anticipation of the end of the tightening cycle before trading back lower as the Federal Reserve hinted at higher interest rates for longer. Corporate investment grade bonds ended the first quarter with a +4.6% total return, outperforming corporate high-yield yield’s +3.7% total return. Like equities, investment grade’s outperformance primarily occurred in March after bank failures raised concerns about increased default risk.
Tighter bank lending standards are becoming a concern in the credit markets. For perspective, banks aggressively tightened lending standards during the last 12 months in anticipation of the Federal Reserve’s interest rate hikes slowing economic growth. With recent bank failures causing banks to question the stability of checking deposits, there is a risk that banks will adopt a more cautious approach to lending and reduce the total amount of credit they offer. The decreased credit supply and access could have a domino effect, impacting the economy and financial markets over time. Borrowers, especially high-yield issuers, could stop paying their debts if refinancing their coming-due loans becomes hard and expensive. Credit markets will watch for signs of refinancing stress in the coming months.
Second Quarter Outlook – Back to the Fundamentals
The outlook is indecisive as the financial markets close out in the first quarter of 2023. Some investors believe the Federal Reserve’s actions will slow economic growth and tip the U.S. economy into a recession. This group points to recent bank failures as a warning sign that higher interest rates will have a negative impact. In contrast, some investors believe the U.S. economy is strong enough to withstand the Fed’s actions. This group points to the first-quarter economic data as a sign of strength and the banking regulators’ actions to indicate the U.S. financial system is functioning as intended.
The back-and-forth will likely continue until some of the market’s most pressing questions are answered.
Key questions include:
The direction of Federal Reserve policy
The stability of the U.S. banking sector
Inflation’s stickiness
Corporate earnings growth
The strength of the U.S. economy
Our team will monitor the answers to these questions in the coming months to help guide investment portfolio positioning. The first-quarter earnings season is scheduled to start in mid-April.
Developing and sticking to a financial plan is important to achieving your financial goals. As mentioned, the current investing environment requires a long-term outlook. Trend changes are frequent, fast, and driven by fluctuating market headlines, and keeping up with the day-to-day whims of the market can be emotionally taxing.
Please feel free to reach out to our team if you have any questions or concerns about your financial plan or situation.
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