Markets & the Economy

Economic Commentary – Q1 2023

Quarter in Review

• Despite the volatility in the financial sector related to the banking crisis, the S&P finished up 7.5% over the first 3 months led by the technology sector, up 21.8%, which benefited from lower rates and sector rotation.

• The drop in rates led to strong returns for bonds. The ten-year Treasury dropped 40 bps from the end of 2022 to a yield of 3.47%.

. Prevailing Treasury yields are signaling an end to Fed rate hikes and the beginning of rate cuts. Upcoming corporate earnings will give us a glimpse of the overall health of the economy.

The first quarter was notable for the banking crisis that led to bond market volatility and a sharp move to lower yields. Equity markets were remarkably resilient during the period and likely boosted both by lower bond yields and by the prospect of more muted Fed rate hikes owing to the emerging signs of recession. The big news, of course, was the sudden demise of Silicon Valley Bank along with two smaller U.S. banks and one European (Credit Suisse, which UBS res-cued) which had a profound impact on financial conditions (corporate bond yield spreads, bank lending conditions) and bond yields. Yields on Treasuries fell across the entire yield curve even as the Fed raised rates for the ninth consecutive time to 4.75%-5.0%. All of this led to strong gains for both markets in the first quarter.

Any time a major financial institution fails with little warning (Silicon Valley Bank was the 2nd largest bank failure in U.S. history), the market implications will be significant. This is the first financial crisis-type event since the Great Financial Crisis and it comes after the substantial increase in interest rates last year. Some of the implications from the banking turmoil may also prove to be deflationary, which could be helpful in the Fed’s battle to bring down inflation. It seems almost certain that tighter lending stand-ards will result for businesses and consumers. Credit conditions were already tightening before this crisis and are often a precursor to recessions due to the critical role played by credit in our debt-dependent economy. Another could be new regulations aimed at small-to-midsize banks, and still another could be changes to the FDIC insured deposit framework. All of this bears close watching for potential impacts on companies and industries that may not yet be apparent.

Due to the complex nature of the financial system, its role in facilitating credit creation and economic activity, and the myriad regulatory bodies involved in oversight of the in-dustry, one failure quickly leads to heightened concern. This immediate reaction in the market is a vivid reminder that trust and confidence are essential to a properly function-ing financial system. When confidence is lacking, the market quickly reverts to a “risk-off” posture which means bond yield spreads widen — causing bonds to underperform like-duration Treasuries — and a cautious tone develops until enough evidence of stabi-lization emerges.

Tighter lending standards increase the chance of a recession developing later this year. Still, the Fed took action in the midst of the turmoil by raising the Fed funds rate yet again, which demonstrates their resolve in ending the inflation problem. This decision displayed how the macroprudential* actions taken by the Fed, the FDIC, and the Treas-ury Department were deemed sufficient to handle the banking crisis, leaving monetary policy free to continue fighting inflation. The rate hike came after favorable economic data in early March: another strong jobs report with 311,000 new jobs created in Febru-ary along with solid housing starts and permits.

While equities were up nicely during the quarter, it was not a smooth ride. In January, the equity market rallied on signs of slower inflation and some enthusiasm for better-than-expected earnings reports. February brought a reversal of fortune as stronger economic data reinforced the need for further rate hikes by the Fed. During March, the banking crisis initially produced a sell-off, but the market rallied as signs emerged that the crisis may be contained.

Bond market performance during the quarter was led by the big move lower in Treasury yields in March. Risk spreads on corporate bonds moved wider, particularly for banks, which means corporate bond performance did not keep pace with like-duration Treasuries. The same was true for Agency mortgage-backed securities. In comparison, municipal bonds were the star performers, lagging Treasury returns but still posting respectable results.

Looking ahead, one of the keys to equity performance will be corporate earnings. While much of the earnings landscape remains somewhat distorted by the pandemic years, the expectation is that earnings growth will be challenging due to slowing economic momentum from higher interest rates, stubbornly high inflation, and tough comparisons from last year’s strong results. Some sectors such as Financials will also face difficult conditions from the recent crisis which has seen bank deposits declining and borrowing costs climbing. Other challenges include the war in Ukraine and the rising tension with China which threatens more export bans, and neither situation shows any signs of improving. We are becoming in-creasingly concerned about the increase in economic warfare between China and the U.S. and the ramifications for the companies caught in the crossfire. One of the market consequences could result in China reducing purchases or outright selling Treasury bond holdings, which could send interest rates markedly higher.

As for the bond market, the Fed is clearly closer to the end of its hiking cycle and sentiment is tenuous after the banking crisis. The consequences from recent developments could be considerable and will almost certainly make the Fed’s job more challenging. Prevailing Treasury yields are signaling an end to Fed rate hikes and the beginning of rate cuts, but we continue to believe the Fed will remain on hold rather than begin cutting before inflation moves below 3%. The resilience of the U.S. economy will surely be tested in the coming months, but entering any downturn from a position of strength could result in a less pronounced recession and perhaps a more rapid return to growth.

*Macroprudential policies are financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit and other vital financial services necessary for stable economic growth.

Index Definitions
The S&P 500 (S&P 500) Total Return is a market capitalization-weighted index composed of the 500 most widely held stocks whose assets and/or revenues are based in the US; it’s often used as a proxy for the U.S. stock market. TR (Total Return) indexes include daily reinvestment of dividends.
The Dow Jones Industrial Average® (DJIA), is a price-weighted measure of 30 U.S. blue-chip companies.
The Nasdaq Composite Index (Nasdaq) is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange
The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap
and current index membership.
MSCI EAFE Total Return Net is the Morgan Stanley Capital International Europe, Australia, and Far East index that is a market-capitalization-weighted index of 21 non-U.S. industrialized country indexes. The index includes net dividends reinvested minus-tax-credit calculations, but subtracts withholding taxes retained at the source for foreigners who do not benefit from a double taxation treaty.
The MSCI Emerging Markets (MSCI EM) Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.
The Bloomberg Barclays U.S. Treasury Bond Index (US Treasury) includes public obligations of the US Treasury, i.e. US government bonds. Certain Treasury bills are excluded by a maturity constraint. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded.
The Bloomberg US Credit Total Return Value Unhedged USD (US Credit) measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD (Municipal Bond Index) covers the US-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD (US Corporate High Yield) measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.