Quarterly Commentary

1Q 2023

The first quarter was a rollercoaster ride – alternately exhilarating and frightening. While both stocks and bonds managed to generate positive results, there were notable performance differences within each asset class. The volatility is not all that surprising – in just twelve months the Federal Reserve raised short-term rates from zero to almost 5%, a blistering pace by historical standards.

Reviewing Q1:

Hoping for a pivot - January through February 3 – Anticipating a pause from the Fed, investors buy beaten-down stocks with enthusiasm. Small stocks up 13%, large up 5%.

Blowout job numbers and Fed hawkishness – Feb 3 through March 8 – The Labor Department reports an acceleration of US job growth, and the unemployment rate is 3.4%. Investors fear the Fed will not be pivoting anytime soon, which seems to be all but confirmed later in the month when notes from the latest Fed meeting emphasize resolve to quash inflation with high interest rates. The yield on two-year Treasury bonds briefly surpasses 5%, more than a full percentage point higher than the yield on ten-year Treasuries.  The inverted yield curve is widely believed to signal an imminent recession. Stocks retreat.

Bank stress and bank runs – March 8 through 31 – Something breaks. The Fed’s tightening actions claim a victim, Silicon Valley Bank. Regulators close down SVB and another poorly managed bank. Fear spreads through the financial system. After years of costly missteps, Credit Suisse is forced into the hands of UBS. Anticipating that a slower economy will force the Fed to pause, and fleeing “risky” assets, investors flock to treasuries, sending the yield on the 2-year below 4%. Small cap stocks are abandoned (down 4% over the last three weeks of March) for large caps (up 3%), particularly large tech stocks (up 15%) that had taken a drubbing in 2022. Mid-sized bank stocks fall 25%.

Where things stand: 

  • Inflation – The Fed says it will hold rates high for an extended period to ensure inflation comes down and stays down, while investors are betting on interest rate cuts in 2023. We think inflation is cooling and will continue to do so, absent another shock, but are less confident that the Fed will pivot quickly. In a departure from the past decade, the Fed does not appear to have the market’s back (yet).
  • Recession – Bonds are generally viewed as more attuned to underlying economic health than stocks. The yield curve inversion is now nine months old – bonds are warning that a recession lies ahead, still. In our view, a deep economic slump is less likely in the short-term with the current employment situation (i.e. nearly everyone who wants a job, has one). Corporate profits are coming down, regardless of whether we technically enter a recession, and the degree of this correction warrants our attention.
  • Banks –The run on Silicon Valley Bank was over in just a few hours, thanks to social media and digital transactions. Could this happen again? Yes, but it is less likely at other banks given differences in their business models and risk mitigation policies, as well as actions regulators have taken since SVB and Signature Bank collapsed. However, like SVB and Signature, many banks have large unrealized losses on fixed rate bonds they purchased and loans they made when interest rates were low and deposits were flooding in. For those that were more prudent, this will be a profitability, not a liquidity, issue. If you throw in tighter regulation and higher deposit insurance premiums, bank earnings (especially those of small and mid-sized regionals) will likely suffer, especially until the Fed begins to lower short-term rates and the yield curve returns to its normal upward sloping shape.
  • Commercial real estate (CRE) – CRE has been tabbed as the next problem area, as higher interest rates and potentially lower rental income crimp valuations. Office properties have been declining since last summer as corporate tenants scale back their needs, largely in response to a higher proportion of employees working from home. CRE relies on leverage, and banks have historically been the largest lender – about one-third of small bank assets are CRE loans. A few high-profile defaults raise the specter of office landlords handing bank lenders the keys to a slew of underwater properties. While this is undoubtedly a concern, markets have been adjusting for months, even years, by refinancing or redeveloping underutilized properties and this will continue. We believe that better risk management, including lower loan-to-value ratios, combined with a better economic backdrop (compared to the Great Financial Crisis) will prevent anything like a 2008 event in CRE.

What’s next:

Human nature tends to fixate on what is going wrong today, and not on what could go right tomorrow. This is reinforced in the media and by politicians (of all stripes) that sell fear. While we strive to understand the very real risks that are present in today’s economy and markets, we also recognize that rarely do all the things we worry about come to pass and that there are reasons for optimism. Among them, near full employment, rapid technological innovation (mostly good!), and accelerating investment in clean energy.

We cannot pinpoint the bottom for any sector or stock, so we endeavor to identify when the risk-reward becomes sufficiently compelling that we're willing to ride out any near-term volatility in anticipation of reaping long-term rewards. We can’t say when this ride will end, but eventually it will, and by then we will be preparing for the next one.