Despite March’s bank-failure scare, most investment categories posted a second-consecutive quarter of gains in the January-March period. Large-company domestic stock benchmarks rose by around 5%, on average; their small-company counterparts advanced a bit less. Overseas, developed-market equities jumped nearly 9%, while the emerging-market category rose about half as much. Real-estate-related results were roughly flat, on average, while commodities were mixed: gold gained 8% and copper rose 7%, but oil dipped 6% and natural gas plummeted (again), down nearly 50%. Bond yields were notably volatile but ended the period lower (the 10-year Treasury finished at 3.49%, compared with 3.88% at yearend); credit spreads widened modestly, resulting in solidly positive returns from most fixed-income investments.
Among large-capitalization U.S. stocks, outsize gains posted by a handful of mega-cap names propelled the Consumer Cyclical, Communications Services and Technology sectors to strongly above-benchmark results; Energy, Financial Services, Health Care and Utilities lagged. The “growth” investment factor clearly dominated “value” among large-company stocks, though value posted a narrow win among small-caps.
Though the global pandemic and war in Ukraine receded somewhat from investors’ radar screens, the first three months of 2023 were anything but uneventful. Early weeks saw a continuation of the late-2022 rally: as more market participants became convinced that a combination of subsiding inflation and resilient economic growth would allow the Fed to engineer a chimeric “soft-landing,” bond yields fell and stocks enjoyed broad-based gains approaching 10%. But as economic data released in February trended hotter than hoped, wet-blanket central bankers reprised admonitions that the fight against inflation was not over; yields rose anew and stock prices wavered. In the second week of March, the situation suddenly morphed into a banking crisis accompanied by near-panic in financial markets – though, notably, the main equity-market gauges never fell below their early-January lows.
Despite the Federal Reserve’s year-long crusade to quell inflation with higher interest rates, the U.S. economy continued to show surprising resilience. Aggregate activity (GDP) expanded at a healthy annualized pace of +2.6% in the final three months of 2022 (bringing the full-year gain to a respectable +2.1%). Inventory restocking and net foreign trade augmented weaker underlying consumption and capital investment; consumer spending, accounting for some 70% of the economy, grew just +1.4%. More timely data had a stronger-than-expected tone. Monthly job creation (including January’s blockbuster 504,000 gain) averaged more than 350,000 – far above the rate needed to absorb labor-force growth; the unemployment rate ended at a minuscule 3.6%. Though manufacturing remained in the doldrums, conditions improved in the much-larger service sector, where purchasing-managers surveys showed the strongest new-order activity since late 2021. Likewise, consumer confidence (February) ticked up to its best reading since before Russia’s invasion of Ukraine, and retail sales (January) notched the strongest showing in nearly two years. Even the beleaguered housing market saw some relief as mortgage rates dipped, boosting home-builder sentiment from a late-2022 nadir; house prices nevertheless fell each month during the quarter, extending a slide that began in mid-2022.
Outside the U.S., sluggish late-2022 activity gave way to modest improvements in most regions. In the Eurozone, fourth-quarter GDP was essentially flat (though the full-year figure was a strong +3.5%). A mild winter allowed the continent to sidestep the worst impacts of weaning itself off Russian energy, with salutary effects on both sentiment and activity; purchasing-managers surveys picked up throughout the period, reaching their highest level in nearly a year. Japan, too, recorded meager growth (GDP: +0.1%) to close 2022. Hampered by severe late-stage pandemic disruptions, aggregate activity shrank in three of the past five quarters, advancing just +1.1% for the calendar year. The end of pandemic-related restrictions throughout East Asia around yearend provided a welcome boost, which began to show up in modestly improving data as the first quarter progressed. Unsurprisingly, China enjoyed a more distinct up-turn. Flat fourth-quarter GDP yielded a full-year gain of just +3.0% – massively undershooting the official target. Industrial output and retail sales both accelerated markedly during the period, while both manufacturing- and service-sector purchasing-managers surveys returned to expansion territory, the latter reaching the highest reading since 2011 in March.
Inflation news was again broadly positive, though most measures of underlying price pressures remained well above the hoped-for 2% level. With declines each month of the quarter – and eight-straight in all – the year-over-year gain in the “headline” consumer price index (CPI) receded to +6.0%, compared to a mid-2022 peak of +9.1%. Likewise, the “core” figure that strips out volatile energy and food components fell in five-straight months to +5.5% (versus a high of +6.6%); and the Fed’s preferred measure (the index of core personal-consumption expenditures) declined to +4.6% compared to a peak of +5.4%. February’s wage-growth figure (+0.2%) was the smallest gain in a year and pushed the year-over-year rate below +4% for the first time since April 2021. Elsewhere, survey results showed a decreasing percentage of businesses planning to raise prices and declining household expectations of both near- and longer-term inflation.
The period’s most dramatic development was an unexpected crisis of confidence in the banking system. A textbook case of tightening monetary policy causing something to “break,” the sudden tumult resulted in the failure and seizure by the FDIC of two mid-size American banks and the narrowly averted collapse of a third (not to mention the state-engineered, over-the-weekend merger of two Swiss banking giants). The troubles in the U.S. stemmed from a combination of three factors – two being direct results of central-bank-engineered higher interest rates. First, as rates rose, depositors increasingly eschewed near-zero-yield bank deposits in favor of more competitive money-market offerings, putting pressure on the liability (funding) side of banks’ balance sheets. Meanwhile, regulatory quirks incentivized banks to invest (on the asset side) in long-term Treasury and other federally backed securities that, while eminently safe from a credit-risk perspective, still carried substantial interest-rate risk – i.e., their market values fell substantially as the Fed raised interest rates, saddling banks with billions in unrealized (‘paper’) losses. Deposit-flight was exacerbated by the dollar-limit on FDIC insurance and was concentrated among smaller (i.e., not too-big-to-fail) banks, which lost deposits at a near-record pace during the peak turmoil (in fact, the largest “systemically important” banks saw deposit inflows). The unrealized-loss problem, however, was correctly viewed as pervasive – estimates of total exposure vary, but a widely cited figure of $620 billion would represent more than a quarter of U.S. banks’ total shareholder equity (around $2.2 trillion).
Global central bankers continued their year-long fight against inflation, though signs began to appear that the end was in sight. The U.S. Federal Reserve, European Central Bank and Bank of England all hiked rates at both February and March policy-setting meetings; the Bank of Canada became the first major monetary authority to break ranks, holding rates steady in March. (Notably, the March meetings came after the spate of bank failures.) In its March post-meeting communication, the Fed noted “recent developments were likely to result in tighter credit conditions” and “weigh on [both] economic activity… and inflation.” And even though inflation was described as “elevated” compared to previously “having eased,” the allusion to future policy actions was clearly softened: February’s “ongoing [rate] increaseswill be appropriate” became “some additional policy firming may be appropriate” in March (our emphasis).
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the +7.5% S&P 500 total return?
First Quarter (January-March) 2023
+ Change in Earnings
+ Change in Valuation
= Total Return
Our read: A second-straight quarter of rising prices and falling year-ahead earnings has reversed much of last year’s improvement in valuation, raising the bar on further market gains.
Several noteworthy patterns caught our eye among the quarter’s investment results. First, precious metals and crypto-currencies (bitcoin surged more than 70%) seemed to be direct beneficiaries of the loss of confidence in banks. Meanwhile, declining bond yields and boosted liquidity fueled a re-acceleration of gains by mega-cap growth stocks, masking lackluster results elsewhere: seven iconic growth names – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – gained an average of more than 45%, while the remaining 493 names in the S&P 500 Index rose just over 2%, on average. And, amid burgeoning hype surrounding rapid developments in artificial intelligence, stocks of semi-conductor companies – eyed by some as economic bellwethers akin to transportation stocks of past eras – led market gains for the first time since late 2021.
Corporate profits reported during the period, generally covering the final three months of 2022, came in a respectable 11% above 2021’s corresponding figure; the full year saw a gain of 15%. Wall Street analysts expect earnings for the just-completed first quarter of 2023 to be approximately 7% below last year’s result; estimates for the remainder of the year continue to fall.
While the recent financial-sector turmoil seems unlikely to morph into a 2008-esque global crisis, it clearly adds to downside risks that were already non-negligible. Bond-market investors have concluded the episode marked a turning point in the rate cycle: lower yields are now seen much nearer in the future than they were just a month ago. While lower yields would support asset prices, they might not be an unalloyed good: they could reflect investors’ view that the banks’ problems have not only seen off inflation but also damaged the economy. Worse, they could indicate worries that monetary authorities, underestimating the impacts, will “stay the course,” keep rates higher for longer, and trigger a recession that is exacerbated by a fragile banking system.
Though the quick return of calm to financial markets was cause for optimism, we think it’s too soon to say if recent bank troubles will be as consequential as they were dramatic. We are marginally reassured that the crisis was spurred by a well understood and easily modeled problem: interest-rate risk. But we are simultaneously worried that such an obvious risk was so disastrously under-appreciated by bank managers, grown complacent during 15 years of “low and lower” interest rates, as well as by regulators, haunted by the specter of 2008, when the bogeymen were exotic derivative-instrument and counter-party risks. The pervasiveness of under-water bond holdings combined with the kick-the-can nature of the response suggests this will be a slow-boil issue that afflicts the banking sector for some time. Investor focus is likely to center on smaller institutions, whose large exposure to the soon-to-be-troubled commercial real-estate sector – think over-built shopping centers, low-occupancy city-center offices – could be the next shoe to drop. In our view, investors have been right to question the future profitability (though generally not the solvency) of a wide array of financial-service entities.
Unprofitable banks often become un-lending banks, curtailing the supply of credit that fuels economic growth. Federal Reserve loan-officer surveys conducted before the recent bank failures already signaled tightening lending standards; a further restriction in the availability of credit in response to the crisis could be the straw that tips the economy into recession – or exacerbates an already-inevitable downturn. As we have previously noted, an array of forward-looking indicators (e.g., inverted yield curve, weak industrial-orders data, slumping consumer sentiment, cratering real-estate activity) have flagged substantial risk of recession. While acknowledging healthy consumer-sector finances as a saluary offset, most Wall Street and business economists continue to expect at least a mild downturn; even the Fed’s latest (post-crisis) forecast called for essentially zero growth for the remainder of 2023 and an anemic +1.2% expansion in 2024.
A yawning gulf has emerged between official expressions regarding future monetary policy and market-implied investor expectations. Projections (‘dot plots’) released after the March meeting indicated Fed bankers (still) expected short-term interest rates to end the year slightly above the current level (which is officially expressed as a range of 4.75% to 5%) and to fall by less than a percentage point during 2024; notably, the end-2024 figure was moved marginally higher compared to February. Meanwhile, in the wake of the banking crisis, bond investors slashed their future-rate views: a transformed short-end of the Treasury yield curve implied multiple quarter-point rate cuts this year followed by more in 2024, with overnight rates falling below 4% by late-2023 and below 3% a year later. How this disconnect is resolved seems sure to greatly influence financial-market performance in the period ahead: over the past 15 months, falling yields (and dovish Fed utterances) have ignited numerous rallies while rising rates (and hawkish commentary) have repeatedly stymied market advances.
Even if investors can put the bank crisis in the rear-view mirror and “look through” growing recession risks, we see ample cause to remain cautious. Despite its vaunted post-pandemic “reopening,” China is beset with economic/demographic challenges and ideological/geo-political distractions that may cause it to focus on stability and resilience – even at the expense of growth. The end of the (first?) Cold War and the global integration that followed are universally credited as a powerful tailwind that propelled markets higher for a generation; we find it difficult to cheer on the apparent return of great-power rivalry and an accelerating trend of “geo-fragmentation.” And don’t even get us started on the myriad work/life disruptions (or are they existential perils?) presented by “generative artificial intelligence.” Let’s just say: we remain cautiously optimistic it won’t make us all redundant before our next quarterly reporting cycle. Throw in the global climate-change/energy-transition challenge and it becomes unsurprising that worrisome terms like “poly-crisis” and “radical uncertainty” are steadily climbing the Google-search rankings.
Given heightened risk of an economic downturn in the near term and less picayune concerns complicating matters down the road, we think investors may be too complacent. Back-to-back quarters of rising stock prices and declining forward earnings have undone much of the improvement in valuation seen in the first nine months of 2022 (as we write, the S&P 500 index was priced at nearly 19 times year-ahead expected earnings – which we suspect have further to fall; this measure intermittently fell below 16 in mid-2022). Meanwhile, yields on high-quality, intermediate-maturity bonds – though off the highs reached before the bank crisis – remain near the most attractive levels in fifteen years. As a result, the so-called equity-risk premium – a measure of the relative attractiveness of stocks vis a vis bonds – recently fell near a two-decade low. A return of this gauge to a more normal reading would require a meaningful decline in either stock prices or bond yields – both developments that would favor a (temporary) defensive investment posture. Cognizant that achieving superior investment results requires the timely embrace of (a prudent degree of) risk, we look forward to periods of rising uncertainty and ebbing complacency – we suspect the next may not be far off – that afford opportunities to add to equity holdings at more attractive valuations. In the meantime, we will continue to collect 4%-plus yields on “uninvested” portfolio balances.
Thank you for the confidence you continue to place in the Oarsman Capital team. Please call or email any of us if we can be of assistance in the weeks ahead.
Alan Purintun, CFA Benjamin J. Kebbekus Robert W. Phelps, CFA