During the first few months of 2023, investors remained laser-focused on the persistent interconnected themes of inflation, the Federal Reserve’s (Fed) ongoing aggressive policy response to thwart it, and the impact this policy might have on the economy.  

Minor anecdotal and statistical evidence provided glimmers of hope that the Fed would be successful, and inflation would soon be moderating without the economy falling into a serious recession. This optimistic soft-landing theme provided a strong boost to both stocks and bonds in January. 

However, this hopeful outlook faded in February as strong employment, and rising wage and inflation numbers led to renewed fears the Fed would need to raise rates more aggressively, leading to a potential hard landing for the economy and markets. Bond yields surged, and the sudden change in short-term interest rates, along with the impact the rate hikes had on bond prices, appears to have been a key catalyst that exposed problems in the banking system. 

Another banking crisis – an echo, not a replay

In March, the fear of a possible crash landing became more likely with the sudden collapse of three domestic banks and the fire sale of a major international bank, Credit Suisse. This wind shear problem of financial system instability now injects even more turbulence that the Fed and investors must navigate going forward.

Fortunately, concerns over the banking system are being swiftly addressed by various government regulators and banking industry leaders. Although challenges persist for a few weaker regional banks, this problem does not appear to be systemic in nature. The current crisis was triggered by realized and unrealized loss positions on treasury and mortgage-backed securities at a few regional banks caused by the sharp and swift increase in interest rates and what appears to be poor risk management.

That being said, the banking industry is unusual in that it can be severely impacted by basic human emotion and behavior; that is, confidence and trust. Currently, the market is showing very little confidence or trust in financial institutions. This will continue to have a dampening effect on the economy and markets in the 2^nd quarter, if not beyond.

A key impact of the banking troubles likely will be tightening credit standards, resulting in fewer loans to businesses and consumers. Banks already were tightening credit before the bank failures and likely will tighten further now, which would impact the economy.

Potential recession remains on the horizon

Market consensus expectations of a recession have thus far failed to materialize. Labor markets have been surprisingly strong, providing the fuel for continued consumer spending – especially on services. However, many indicators continue to suggest that economic weakness is imminent. These include a historically inverted yield curve, declining money supply, a moribund housing market, sharply falling leading indicators, and now the potential for credit conditions to tighten further in response to challenges in the banking industry. 

Fed policy remains, as always, a major factor influencing economic activity and market returns. Prior to the recent banking issues, the Fed was intent on maintaining its restrictive monetary policy stance until inflation moved materially lower. 

Problems in the banking sector now complicate this strategy. However, even in the midst of ongoing banking problems, the Fed still raised rates by 0.25% and indicated rates could rise another 0.25% at its next meeting. The bond market is now looking well past current Fed policy and is pricing in an eventual policy reversal that will lead to short term rates dropping by more than 1.0% over the next year.

It appears likely that the economy will be somewhat stagnant and may potentially fall into a modest recession. If so, we expect that inflation will continue its gradual deceleration to lower levels. However, it seems overly optimistic for inflation to fall from approximately 5% currently to the Fed’s stated goal of 2% over the next year. Given persistent core inflation, it seems likely that bond yields, which have already fallen sharply due to the banking crisis, may fall only moderately further outside of recession or renewed bank concerns, resulting in rate cuts. 

A view of 2023 – A volatile path to muted returns

The economic uncertainty and volatile investment environment that characterized the 1st quarter seem to be trends that will prevail through much of 2023. The multiple challenges of transitioning to a post pandemic environment, continuing inflationary pressures, restrictive monetary policy, geo-political angst, and now a banking crisis, will all present strong headwinds for the market. Consequently, market returns are expected to be modest at best over the course of the year.

Fixed income market

Money markets continue to offer yields of 4.0 – 4.5%, which is an attractive return for a turbulent environment. Having an explicit allocation to cash is now sensible after years of 0% returns. This area of the market is simple and safe, both of which are nice characteristics in a challenging environment.

The yield on 2-year and 10-year U.S. Treasury Bonds recently declined more than 1.25% and 0.60%, respectively, in just two weeks (before rebounding somewhat). Treasury yields again are decidedly lower than the current rate of inflation. It is important to the Fed that it remain resolute in fighting inflation and that investors are confident in this conviction. Thus, it seems unlikely that the Fed would reverse policy and begin cutting rates later this year.

However, that prospect may change if we see further negative surprises from the banking industry or a rapid slowdown in the economy, which is a significant risk for later this year. After a substantial decline in bond yields, returns on high quality treasury bonds are expected to be positive. 

High-quality corporate bond yields currently average about 5%, which is approximately 1.5% higher than treasury bond yields.

Higher risk areas of the fixed income markets now trade at yields that are substantially higher, a reflection of increasing economic risk. Current yields of 8% to 12% in the higher risk areas of the fixed income market rival or exceed expected equity market returns. Therefore, in the current uncertain economic and market environment, investing in this area should be viewed as an alternative not to higher quality fixed income investments, but closer to investments in the equity market, given the higher risk of widening spreads and higher default rate. 

Equity market

Market turmoil and sharply lower interest rates have upended what had been an emerging trend of value and small cap stocks outperforming large cap growth stocks. Mega cap technology stocks, which had significantly lagged the broader market, have recovered strongly as investors migrate back to high quality, low capital intensity, and less cyclical stocks.

In the near term, this trend favoring large cap growth equities may persist. From a longer-term standpoint, smaller capitalization and value equities remain historically cheaper relative to larger capitalization growth equities. However, these sectors of the equity market perform better when the economy transitions from contraction back to expansion.  

Regardless of equity style or size characteristics, quality factors, such as reliable earnings and strong balance sheets, will be critical issues in equity performance as the year progresses. Fourth quarter 2022 earnings announcements collectively for the market were uninspiring, with the energy sector being a standout performer.  

All eyes will be on 1^st quarter corporate profit results in the coming weeks. Earnings estimates still seem rather optimistic given the potential for economic deceleration. However, the stock market, especially the large cap growth sector, has received a boost from the sharp decline in interest rates. Still, the overall price/earnings ratio (P/E) for the market remains somewhat high relative to historic averages.   

International and emerging market equities had been performing well until the surprising banking turbulence dramatically changed expectations for non-U.S. markets. European markets have a much larger weighting in banking than the U.S., and the collapse of Credit Suisse added to an already cloudy environment caused by the war in Ukraine. Like small cap and value U.S. stocks, international stocks will need to see clearer economic skies to truly regain their performance footing.

Looking ahead – a bumpy flight path

Risks abound in the current environment, and investors should be prepared for continued market volatility over the coming quarters. In the near term, quality large cap growth stocks should continue to outperform other equity market sectors. Longer term, valuation for small, midcap and value equities are historically attractive, and investors should maintain exposure to these sectors in anticipation of a cyclical recovery.

What is needed to get more aggressive across fixed income credit and equities? More attractive overall valuations along with clear evidence that inflation is retreating, an easing of Fed monetary policy, stability in the banking and financial system, and a stable economy poised for expansion.

Before making a change in your investment portfolio, you may wish to consult with a financial professional to determine how that may align with your long-term goals and objectives.