Calm Surface Concealing Turbulence Underneath
While capital markets have generated positive returns thus far in 2023, there was a significant disconnect between fundamental economic developments and the current prices investors were willing to pay for some equities. The quarter’s events hardly reflected an environment supportive of higher equity prices:
- Bank Failures
Three of the largest bank failures in history – Silicon Valley Bank, Signature Bank and Credit Suisse – sparked an inflationary liquidity response by regulators.
- Historic Interest Rate Volatility
Multiple points along the interest rate expectations curve moved up and down by 100-150 basis points through the last several weeks of the quarter.
- Continuing Historic Rate Hike Cycle
The Fed raised rates by 25 basis points twice during the quarter.
- Additional Warning Signs
Inflation remained persistent, the labor market remained tight, and many forward-looking indicators flashed even stronger recessionary signals, including shrinking corporate profits.
With each of these challenges, it’s hard to understand how the S&P 500 managed to move 7% higher during the period. However, a closer look reveals headline performance does not reflect what actually happened to the great majority of stocks. The chart below explains the story: Only two percent of the companies (10 expensive technology stocks) accounted for almost all of the index’s performance during the quarter. The remaining 490 barely broke even.
We believe the rally in these few stocks was the result of the Federal Reserve being forced to expand its balance sheet by $400 billion in just two weeks to shore up the financial system. This expansion unwound two-thirds of the Quantitative Tightening that has occurred since last year in an effort to bring down persistently high inflation and saw the Fed temporarily working against its goals.
Also contributing to the rally in these stocks was the anticipation of a meaningful change in Fed policy by some investors. This next chart would argue that this idea may be supported more by misguided hope than a realistic appraisal of market conditions. The Federal Reserve has a dual mandate to maximize employment and foster price stability, which essentially means that it needs to keep inflation under wraps. This graphic illustrates that core PCE, the Fed’s preferred measure of inflation, remains far too elevated for rational investors to expect the Fed to pivot by cutting interest rates in a material manner. The Fed’s target for inflation is 2% and it’s a long way from achieving that goal.
Historically, the Fed has had the flexibility to adjust monetary policy during periods of market stress because inflation was well contained, as you can see in the chart above. Previous episodes of dramatic interest rate cuts only occurred after significant setbacks to risk assets and/or the onset of recession. A Fed pause may be in the offing, but those who are expecting rate cuts to support markets are likely to find themselves disappointed.
Bear Market Rally
The narrow performance by this small group of technology stocks appears to be another bear-market rally within a drawn-out downtrend. Rallies of this nature often show several failed attempts at recovery before fundamentals and valuations reset to attractive points of entry. As depicted in this next chart, there were five bear-market rallies of greater than 20% between 2000 and 2002 before a durable bottom formed. It is also noteworthy that the Nasdaq declined more than 50% after the second bear market rally on the way to its eventual low point.
The chart below shows the two bear-market moves in the Nasdaq that we’ve witnessed so far during this cycle. The tendency for investors to constantly run back to the areas that worked for them in the past is a common and oft-repeated mishap. We would expect the optimism for technology stocks and growth stocks in general to fade over the coming months due to vulnerable valuation levels and a deteriorating earnings outlook.
Tighter Conditions and Weaker Growth
In our 2022 year-end edition of Capital Markets Review, we opined that the ‘era of free money’ had run its course. The banking turmoil that enveloped markets during the month of March was a consequence of the dramatic rise in interest rates that has marked the turn to this new environment. We believe that the events that have transpired throughout the first quarter of 2023 are consistent with our expectations that tighter market conditions and weaker growth are necessary to ease inflation pressures and soften the labor market.
The heightened risk concerns regarding the banking system underpin a trend towards tighter lending standards and weakening demand for loans. We would anticipate another round of ratcheted-down economic expectations, continued pressures on corporate profitability, and more concerns about the onset of recession over the coming months. Until the Fed sees a worsening of the unemployment rate and a significant decline in inflation, it’s unlikely to reverse course.
We continue to believe asset allocation will need to be dynamic rather than simply buying and holding a diversified portfolio of assets. The next several years are likely to require a highly selective approach to isolate and capture opportunities and to avoid unacceptable risks, which we believe are the strengths of our investment process.
Our search for attractive entry points to add to risk assets with a high margin of safety is continuous. Some opportunities may come sooner because of lower prices in certain sectors, while others will be deferred until markets bottom. The extreme market reactions over the past quarter reinforce the importance of protecting capital during protracted bear markets. We remain vigilant and patient.
As always, we thank you for the privilege of allowing us to guide your assets forward. Should you have any questions or observations, please don’t hesitate to contact us.