First Quarter 2023 Market and Economic Review
Domestic Recap of Q1
The domino effect is prevalent in many economic theories, and it’s not without merit. In many situations, one economic event can trigger another and on down the line. The first quarter of 2023 exhibited many of those behaviors.
Following a rough 2022, there were several indications that the U.S. economy (and many others) was beginning to turn the corner and get a handle on its feverish inflation. Yet there were still some underlying symptoms that kept the quarter primed with volatility.
Initially, January got off to a favorable-looking start. Inflation had been on a gradual descent for a few months and the Fed eased up on the interest rate throttle. Perhaps overly optimistic as the calendar turned over to a new year, but investors began buying and the markets surged nicely for much of the month. But then, some of the dominos began to lose their balance.
In keeping with rising interest rates and the gradual decline of inflation, market analysts anticipated job growth to follow suit in January and predicted a job growth number of 187,000 new jobs with 3.6% unemployment for the month. When released in early February, the January jobs report smashed those expectations with 517,000 new jobs and 3.4% unemployment – marking the lowest unemployment rate since May 1969. Suddenly, inflation looked less ‘under control’ than initially thought and the markets retreated accordingly.
The headlines took a much more unexpected turn in March when several small banks collapsed, the largest being Silicon Valley Bank (SVB).
One of the challenges with a rapid increase in interest rates is the impact on longer-term bond pricing. For example, one major index for 20+ year treasury bonds (TLT) had a price decline of (31.41%). When a bank, like SVB, places many of their investments in these bonds, the strength of the bank comes into question. Couple that with the bank’s unique small number and large deposit customer base and a negative social media campaign, a run on the bank was quickly realized.
Unfortunately, it’s not solely the individual bank in question that gets hit in these scenarios. When such a failure makes national headlines, it creates doubt in the minds of customers of regional banks across the country. Enough doubt obviously creates major issues, but even smaller shifts in behavior can cause some customers to move portions of their deposits from the regional banks to larger institutions ‘just to be safe.’ However, regional and community banks play a significant role in on-the-ground lending to individuals and small businesses. With fewer customers and fewer deposits, these banks now have less to lend.
While not necessarily what the Fed intended, regional and community banks are simply tighter on their ability to lend which will push down purchasing demand and, subsequently, inflation.
On the Plus Side
The combination of the aforementioned falling dominos has many analysts believing that the end of the Fed’s rate hikes is drawing near. Some would certainly argue that those hikes should stop immediately. Regardless, the Fed’s recent willingness to reduce the basis point size of the last couple of hikes provides some evidence that the increases are winding down.
As is usually the case, when challenges arise in one sector (or multiple), another sector will present some opportunity. One such beneficiary in Q1 was technology stocks, even if limited to mostly the largest companies. The boost was mostly experienced because of these companies’ perceived balance sheet strength. As the markets showed more and more turbulence, large tech stocks were viewed as a bit of a safe haven because of their financial strength, size, and longevity. Also, a slowing or pause in higher interest rates is most beneficial to growth stocks.
The Global Scene
Conditions around much of the world are much like what the U.S. is encountering if not more challenging. And the causes are the same as they have been for the past year: inflation, Russia’s attack on Ukraine, China’s slow emergence from Covid restrictions.
Europe had its own run-in with banking challenges – mostly notably, the UBS acquisition of Credit Suisse which was closely directed by the Swiss government. The move was done partly to save Credit Suisse in the aftermath of bank challenges experienced in the U.S. as Credit Suisse had long been floundering in difficulties stemming back to the 2008 financial crisis.
China’s markets were mostly stable through the first quarter even though there was certainly some concern from the rest of the world as China abruptly transitioned from having the strictest Covid lockdown policies to fully lifting virtually all restrictions essentially overnight. Many health officials were worried that such a transition could lead to a new wave of infections and overwhelm China’s hospitals. And economists worried about staff shortages in China’s manufacturing plants just as those facilities were catching up to normal supply chain operations. So far, neither concern seems to have developed.
In the near term, expect more unexpected challenges within specific investment sectors. Continued volatility in the markets seems almost certain and it will be as important as ever to maintain diversity with a focus on long-term goals.
More specifically, the tightness of banks’ ability to lend will likely harm the commercial real estate market, making it possibly the next investment sector to feel the brunt of the Fed’s rate hikes. And, it’s a sector that we will be keeping a watchful eye on.
MARKET AND ECONOMIC COMMENTARY