Reflecting on an Eventful 1st Quarter

The first quarter featured some good news and bad, with economic headlines primarily devoted to struggles within the banking industry. We’re here to discuss what happened in Q1, what it means for you and what to expect going forward.

Equity and Bond Markets

The equity market year-to-date is up about 7%, following a disappointing 2022 where it ended the year down 19%. Historical patterns show that bad market years are often followed by good ones, and 2023 is off to a strong start so far. While U.S. equities are doing well, international markets have performed even better. For instance, Europe (excluding the U.K.) is up about 12% year-to-date.

In terms of bonds, rates have risen significantly, as evidenced by U.S. Treasuries yielding about 3.8% now versus 1.5% over the past 10 years. Investors can earn pretty good risk-adjusted returns for basically any fixed-income asset class, including municipals, investment-grade corporates, asset-backed securities, emerging market debt and U.S. high yield, among others.

Last year saw a lot of negative headlines about the supposed death of the traditional 60/40 portfolio (60% equities and 40% fixed income). But data so far this year reveals that a 60/40 portfolio would be generating a solid 6% return.

Banking Crisis

In the banking sector, it seems like the immediate crisis has been contained thanks largely to quick government action to address the Silicon Valley Bank and Signature Bank failures. That said, regional banks have seen significant flight due to concerns over deposit safety, and many will face margin pressures and earning problems moving forward. After paying basically zero interest on deposits for more than a decade, banks now operate in a much different interest-rate environment. There will probably be stress on their loans, and the recovery could last several years.

If you have more than $250,000 at an individual financial institution, which is the FDIC-protected limit, we would suggest taking a hard look at alternatives that are very liquid, low risk and offer notably higher yields. For example, money market funds can earn more than 3% right now.

Going forward, the major implications of the banking crisis will be tighter credit markets and slower growth. When banks become pressured, they tend to take less risk. A bank that’s worried about depositors leaving will want more cash on hand and less tied up in loans. From a practical standpoint, that means borrowers with marginal credit profiles might not get approved for loans that they could have received six months ago.

On a national scale, less-accessible financing means that factories and plants won’t get built and people won’t be hired. The cost of financing is also higher now, so even if you do get approved for a loan, you might not be as likely to take it.

It’s hard to overstate how critical regional bank lending is to small businesses across the country. Many depositors have transferred money from regional banks to large banks such as JPMorgan and Bank of America that are perceived as “too-big-to-fail.”

However, banks like those typically aren’t going to underwrite a new 10-person company in Kansas, for instance. So it’s pivotal to our national economy for regional banks to maintain some profitability and ability to lend, because small businesses are key job and growth generators.

Interest Rates

Turning to interest rates, is the Federal Reserve finished with raising them? Probably not. Prior to the banking crisis, there were widespread expectations of a 50-basis-point rate hike in March followed by another 50-basis-point hike in May. The crisis then raised questions about whether there would be a hike at all in March. The Fed took a moderate approach by implementing a 25-basis-point increase, and it remains to be seen what will happen in May.

The March inflation report proved encouraging, noting just a 0.1% increase from February and a 5.0% year-over-year rise. However, the Fed has been adamant about wanting to bring inflation down to 2% year-over-year. With recent data indicating that the unemployment rate remains very low at 3.5%, there’s still a lot of strength in the economy. Under the circumstances, it seems likely the Fed will again raise rates in May, and perhaps later this year as well.

We can at least be reasonably confident that inflation peaked last fall at 8%. But the positive inflation numbers for March don’t necessarily mean we’ll see a steadily declining rate until the Fed’s 2% target is reached. There could still be unexpected spikes, and we may not dip below the 4%-5% range for several more months.

Impending Recession?

Another concern on everybody’s mind is whether we’ll soon head into a recession, which has been deemed imminent by some economic analysts for more than a year now. While a recession is bound to happen eventually due to the nature of market cycles, when remains a moving target.

The greater question is whether a recession has already been priced into markets. Right now, we think markets look pretty fair. Valuations are not cheap on the equity side, but not nearly as expensive as a year ago. We’ll learn a lot from company earnings forecasts in the next few weeks. Q1 earnings season will probably show a 5%-10% overall decrease for the S&P 500. What management teams project for the second half of 2023 should offer a good read on the underlying strength of the corporate economy.

While there’s still a lot of pressure on the economy in some ways, we feel it’s pretty balanced by strong positive inertia in the form of low unemployment numbers and solid GDP growth. A recession will occur at some point but the timing could hinge on whether a real credit crunch develops for small businesses, so that situation will need to be monitored.

Looking Ahead

Amid the current economic environment, with the market still 15% off its all-time highs, how should investors proceed? History would suggest that staying invested in a good, diversified portfolio will enable you to do pretty well over time. Furthermore, highly astute and successful investors like Warren Buffett might say that down markets are a great time to be invested because you can reap the rewards when markets climb again.

So if you can accept that the next market move might be another 10% down, but the long-term trend is likely to be a much higher increase, relative valuation is pretty attractive right now. And fair valuations over the long term have historically been very good return-generators for equity investors.

With this in mind, we would encourage you to remain invested because trying to time the market is a fool’s errand. Now could also be a good time to speak with your advisor and revisit your strategy — ensuring that your current allocations are consistent with your goals and expectations, and helping you feel confident about the plan.

If you’d like to learn more or have any questions about economic issues, please contact us.

Sources

• FactSet
• Standard & Poor’s
• P. Morgan Asset Management
• Federal Reserve
• MSCI
• Bloomberg
• S. Treasury
• Ibbotson/Strategas
• Robert Shiller
• Yale University
• BLS
• S&P 500 Index