Thayer 1Q23 Commentary/Key Questions
What drove financial markets in the first quarter of 2023?
The opening quarter of the year finished with gains for both stocks and bonds, on the heels of significant losses in 2022. The inclusive all-country world index (ACWI) and S&P 500 index gained 7.4% and 7.5%, respectively, while the AGG bond index rose by 3.2%. The quarter in fact comprised three distinct phases for both main asset classes. The year opened with a strong first five weeks on improved valuations and continuation of benign inflation readings; stocks were up around 9% through February 2nd. But the January employment report the following day, with a heady 517,000 new jobs added, kicked off a series of “hotter” inflation indicators, implying a longer series of needed Federal Reserve policy rate hikes. The next five weeks saw much of the earlier gains given back. Then, from March 10th, the final three weeks then were dominated a new headline: the downfall of Silicon Valley Bank and concerns about deposit flight. Interestingly, market indices resumed gains. The final phase upturn suggested that markets were happier with the prospect of a Fed pause to gauge the impact of possible bank retrenchment than they were concerned about the threat of a broad banking crisis. Looking more closely, the S&P’s 3% closing kick was driven entirely by the large technology and communication names, with the two sectors up about 8% (carrying the tech heavy NASDAQ to a 16.8% quarterly jump) while the financial sector shed about 8%. Other banking-sensitive areas, including real estate, energy and industrials, also saw late quarter losses. Meanwhile, bonds also turned positive during an unusually volatile stretch; the two-year Treasury yield dropped a full one percent, from 5.06% to 4.06%, in March’s final weeks.
What are the significance and implications of the emergent banking issues?
Fortunately, actual bank failures so far have been few, most notably Silicon Valley Bank and Credit Suisse, each with fairly specific sets of frailties exacerbated by poor management. The vast majority of SVB’s deposits – 94%, or twice the percentage for US large banks as a group — were above the $250,000 FDIC insurance threshold, held by wealthy tech entrepreneurs who enjoyed their affinity with each other and discounted the risks, until a need for funds and a Twitter-driven run provided the death knell. Credit Suisse was cursed by a revolving door leadership, admitted tax evasion on the part of one CEO, and a $5.5 billion 2021 loss tied to the hedge fund Archegos. However, this does not mean an absence of broader threats. As noted in earlier commentary, banks hold several trillion dollars of Treasury bonds, with unrealized losses in the hundreds of billions. Moreover, we’ve seen policy confusion, including from Treasury Secretary Janet Yellen, about whether the emergency backstopping of the SVB depositors (costing the FDIC rainy day fund some $20 billion) would apply to all banks. Uncertainty is the great market enemy, and it seems likely that general unease and new constraints on lending will undermine what was already a tenuous economic picture.
How are changing operating conditions affecting Fed policy?
The impacts from Chair Jerome Powell’s historically aggressive policy rate hikes — 475 basis points, or 4.75%, over the nine meetings since March 2022 — are just now beginning to be seen, the bond losses and SVB’s fall among them. The rate hikes were meant to cool inflation by making borrowing more prohibitive and tamping down demand. Indeed, there have been softening trends in housing (existing home sales dropping steadily over the past year, for example), autos and other rate-sensitive areas. But to the extent that banks tighten their lending practices in SVB’s wake, these actions might do Powell’s work for him, necessitating fewer rate hikes. Betting odds seem to be oscillating around 50% that the Fed will take a pause at the next meeting in early May. Alternatively, a hike of another .25% might be their last in this cycle. While improved, inflation continues to be stubborn, however. The Fed’s favored Personal Consumption Expenditures (PCE) index, at a 4.6% annual rate most recently, is notably better than 18 months ago, but still well above the 2% target. Longer-cycled rental rates, now in a decline phase, arguably have yet to really hit composites such as CPI and PCE, so we may see greater strides towards 2% ahead. On the other hand, an OPEC production cut announcement has pushed oil prices back up to where they started the year, which could counter the cooling effect.
What are the key policy and political issues as we head into mid-year? A number of issues bear watching, including China, Russia, AI, and the banking travails, to name a few. The debt ceiling standoff, arguably the most pressing issue, has no clear resolution. The Republican House leadership demands, centering around budgetary spending cuts, are not clearly defined or agreed upon within the party; leader Kevin McCarthy is attempting to pull together a proposal. So far, President Biden has refused to negotiate, taking the position that the debt ceiling is a routine uber-partisan procedure, most recently done three times under President Trump without incident. This will heat up in the next two months; a flirtation with a first-ever US debt default and attendant market dislocation clearly serve no ones’ interest. Electoral jockeying and pre-positioning for the 2024 presidential race will also begin to grab headlines as the first round of debates approach this summer. While a President Biden re-election bid has been assumed so far, with not a glimmer of an alternative, Biden, now 80, seems to have delayed an announcement, moving from spring to possibly fall. The GOP field has expanded with Nikki Haley and most recently Asa Hutchinson, both making clear a need for new leadership, while former President Trump, even post-indictment, remains the front runner. We’re just getting started.
How healthy is the fundamental economic and corporate picture, and what are market implications?
After a 2.7% gain in the fourth quarter, GDP growth seemingly has held up in the early months of 2023. While recent job opening and hiring figures have cooled a bit (continuing through the March employment picture just reported), consumers remain well-employed, have become better paid, and continue to hold upwards of a trillion COVID relief dollars. That said, the COVID money will be worked off over the course of the year. And it remains to be seen how much the new banking headwinds will be felt throughout the economy, smaller and mid-sized businesses in particular. Overall, slower economic growth seems likely as the year progresses, and a recession — more than likely shallow — remains possible. Corporate performance will of course be a key support for equity valuations, and upcoming reports and guidance will be closely watched. At current forecasts for next-twelve-month earnings, this S&P trades at just under 18 times, which is about average by historical standards. While economic uncertainty might keep a damper on returns, any visibility into renewed growth, and possibly a more benign monetary environment, at both the Fed and broader banking levels, could support stocks. In most of the portfolio strategies, we are adding equity exposure both here and overseas. Non-US stocks bring diversification, and as measured by the EAFE index currently trade about 55% cheaper than the US on a price to book basis.
David Miller | Miller CPA, LLC & Chris Wilmerding | Thayer Partners, LLC
Thayer Partners LLC is a registered investment advisor. Information in this message is for the intended recipient[s] only. Please visit our website www.thayerpartnersllc.com for important disclosures.