Quarterly Newsletter

Evidence began accumulating midway through the first quarter that the way out of our confusing strong-labor, sticky-inflation, rising-rate economic cycle was unlikely to be straightforward or swift. This recognition took the wind out of the optimism that had produced strong stock returns in the last quarter of 2022 and in January. The S&P 500® Index dipped -2.4% in February, and by mid-March another drop of a similar amount put the year-to-date return near zero.

The initial optimism of 2023 saw bond yields rise early in the quarter as the 10-year Treasury yield broke 4%. The sentiment shift hit the bond market in March as a flight to safety pushed the 10-year yield back below 3.5%. Unemployment reports in February showed a drop to 3.4%, the lowest rate in 53 years, while the reports for monthly core Personal Consumption Expenditures (PCE) inflation over the previous year edged up from 4.6% in December to 4.7% in January. Adding to the concerns was the upward revision for GDP for the fourth quarter and what appears to be solid GDP expansion so far this year. Consumer spending remained strong in January, though we see growing indications that this spree might be on a shaky foundation as consumer savings diminished and credit card debt increased. This trend is less concerning than in other bear markets since employment remains robust, a key element in sustaining the vital consumer spending segment of the economy. Another crack in what had been a resilient-looking economy was the collapse of Silicon Valley Bank in March, demonstrating the kinds of pressure the rapid rise in Fed Funds rates have put on financial institutions, particularly smaller banks. This particular case should not invoke memories of the 2008 financial crisis, as this appears to be an idiosyncratic issue with how one regional bank handled a massive influx of deposits from mostly venture capital-backed firms. Since the financial crisis, stress tests and banking policies have put larger institutions on much more solid ground.

Federal Reserve Chairman Powell and his governors have been broadcasting their intent to keep raising rates and to maintain them for “some time.” The wishful thinking has seen these statements as positioning needed to keep expectations and financial markets dampened. However, the recognition that underlying inflation may be showing stubborn persistence has convinced more investors that perhaps we should take them at their word. One result has been a reckoning that upcoming raises in the Fed Funds Rate may actually be more aggressive than previously anticipated. By early March the Fed futures trading indicated an increased possibility of a half-point bump coming at the Fed’s next meeting rather than just another quarter point. At the same time, the economic trends revealed during the quarter have diminished hope that the Fed may pivot before the end of 2023.

Another interesting development during the quarter was a reversal of year-over-year M2 money supply expansion, the first decline since 1981. This is a sign that the Fed’s tightening policies are finally gaining traction. However, even with December’s M2 contraction, the total M2 money supply is still up 39% compared to pre-pandemic levels.

The average bear market has historically lasted around 300 days, a threshold we surpassed in the first quarter of 2023. But as mentioned earlier, not much about this current cycle is ordinary, suggesting the unique circumstances of emerging from an unprecedented pandemic. With the stock market hovering about -20% off its record high hit back in early January 2022, we are close to the historic average bear market stock decline. Should inflation trends improve, we could see the Fed on the sidelines for the latter parts of 2023, possibly setting the stage for a more buoyant market in the second half of the year.

While we are clearly closing in on the end point of rate hikes, it appears the consensus has concluded we can anticipate higher rates for longer. The likelihood of sustained high rates will likely demand continued patience from investors as the lagging effects of rate increases slowly reverberate through the economy. We are already seeing corporate earnings predictions for the calendar year dropping and it wouldn’t be a surprise to see this trend continue. As we’ve stated in the past much of what we are experiencing is unprecedented, including the steepest Fed Funds increases in history. This creates uncertainty. Uncertainty, along with shifts in inflation readings or other key indicators, could create additional sentiment swings and more volatility. In the past, bond investments have helped investors through rocky stock markets, and with investment-grade corporate bond yields rising to the 5% level, investors could once again gain some support from their fixed income allocation as we find ourselves marking the first time since 2008 that bond yields are on parity with the earnings yield on stocks.