A Positive First Quarter
The year’s opening quarter provided investors a bit of relief, following last year’s disappointing returns. Most investment markets logged mild positive returns, reflecting a bounce back from oversold conditions at year-end, combined with a degree of optimism that the Fed tightening cycle is close to being done. Among S&P 500 constituents, the Technology sector was a notably strong performer, followed by the Communication Services and Consumer Discretionary sectors. Last year, those sectors were the bottom three performers in the market. Energy, following a two-year run as the best-performing market sector, was second from the bottom to start 2023. It was not a dull market, to be sure.
The Federal Reserve continued its rate hike campaign in the quarter, adding a cumulative 0.50% to the Fed Funds Rate, which is now targeted at a range of 4.75% to 5.00%. In its public pronouncements, the Fed has continued to hold its tough line against inflation, with a stated goal of returning it to a 2% annual target. The latest CPI inflation read for March indicated a trailing, 12-month inflation rate of 5.0%; less food and energy, the core rate was higher at 5.6%. Although inflation is waning from its earlier highs, it remains elevated. The current forecast from the Fed is for one additional quarter-point hike this year.
Higher Rates Hit Banks
The economy has absorbed a significant rate shock over the last thirteen months, with the full effects of rate hikes not completely apparent. A few stress cracks have appeared, though. In March, we began to see banking jitters in the financial sector, beginning with the failure of Silicon Valley Bank. SVB was a large bank catering to the technology and venture capital ecosystem of Silicon Valley. With a highly concentrated base of tech companies and their executives as core clients, SVB presented a unique set of risks from an account base undiversified by either geography or industry. In addition, 95% of its deposits were uninsured (i.e., above the FDIC account limits for coverage). In the space of a few days, SVB suffered a historic deposit flight and was shuttered by bank regulators.
The prime culprit for the bank’s failure was its poor risk management during a period of high deposit growth, complicated by sharply rising rates, which impaired the value of the bank’s securities portfolio. Bank management made bad decisions in stewarding the bank, and regulators and auditors were slow to notice the rising risks. The failure at SVB triggered wider concerns in the banking sector, and the interrelated issues of uninsured depositors, potential deposit flight, and unrealized losses among banks’ investments (brought on by higher interest rates) threatened the industry with a crisis of confidence.
Fortunately, in the weeks following the demise of SVB and another bank in similar circumstances, the sector is showing signs of stabilization. As banks have provided updates to their individual situations, and with quarterly earnings beginning to be released, investors’ worst fears of deposit flight have not been realized.
The hit to bank balance sheets from the sharp Fed rate hikes is an impact that should be obvious in hindsight. In a very simplified illustration, a bank takes in deposits, and with the money, makes loans or buys investments (primarily fixed income securities) for the bank’s investment portfolio. Deposits are a liability of the bank; they must be returned to the depositor when demanded, and a primary funding source to pay back depositors is the bank’s investment portfolio, which it can sell to meet deposit redemptions. Higher rates, however, will have impacted the value of the bank’s investments, and if it is forced to sell, it can be selling those investments at a loss, destroying bank capital.
Ironically, a reason for deposit redemptions is the higher interest rates engendered by the Fed. Investors of all stripes have begun to realize that annualized yields of nearly 5% are available in riskless Treasury bills, as compared to typically paltry yields paid by banks on their deposits. Quite clearly, the Fed is being forced to contend with banking fragility brought on by the Fed’s own interest rate policy!
Looking ahead, interest rate markets are not on the same page as Fed rhetoric, and the disconnect is noteworthy. As noted above, the Fed has told the market to expect one more 0.25% rate hike this year. The market’s forecast, on the other hand, is for a nearly 80% chance that rates will be lower than current, with an almost 50% chance for at least two quarter-point rate cuts from present levels. Put simply, the rates market doesn’t believe what the Fed is saying, and is betting on lower rates, presumably in response to a slowing economy, and possibly to much better inflation news.
Our Near-Term Outlook
We have tempered our view on the economy somewhat, but believe it continues to show remarkable resiliency in the face of higher rates from the Fed. The much-anticipated recession that seemed certain to overtake the economy continues to get pushed out in time. Some economic activity is slowing; manufacturing indices are moderating, announced layoffs continue to rise, and the consumer’s activity is increasingly uneven, but none of these factors, even taken together, appear to be tipping the economy over. The employment market, overall, remains on a good footing, and the housing sector is holding up well in the face of higher rates. We suspect that a continuing shortage of supply versus demand is helping to keep that sector reasonably firm.
Based on current forecasts, corporate earnings appear to be flat in 2023 versus 2022. So far, the recession is showing itself in earnings, but not in GDP overall. Real-time tracking of the first quarter indicates an annualized growth rate of 2.5%, a figure actually higher than its immediate prior reading. For the rest of the year, the state of inflation and the accompanying Fed’s monetary policy, as well as the potential and severity of an economic and earnings recession, will remain the primary focus. We will closely monitor the earnings season, which is just commencing, for additional clues on the path of economic conditions.