2023 First Quarter Investment Market Report

Heading into this year after a tumultuous 2022, all indications suggested more turmoil was ahead in 2023, and the first quarter certainly met that expectation! Inflation and its implications for the future course of interest rates are still baffling the markets and creating strongly diverging opinions on the appropriate next steps for the Federal Reserve. The stock market came roaring into the New Year, with the S&P 500 climbing ~9% early in the quarter, only to retrace most of its gains in February. March ended with a strong rally after a bank scare, allowing the S&P 500 to post a strong quarter up 7.5%, with the tech-heavy NASDAQ enjoying a strong bounce back from a dismal 2022, although it is still down substantially from year-ago levels.

After one of the worst prolonged bond market declines in history last year, the first quarter saw a roller coaster for interest rates as bond prices saw similar volatility to stocks. When inflation is the headline, the stock and bond markets both tremble at signs of higher inflation and feel relief from signs of lower inflation, which is why additional diversification strategies have been a high internal focus and priority at Montis this year. The quarter was punctuated by a historically rapid rally in U.S. Treasuries when fear over a new bank crisis briefly gripped the markets in March. On the bright side, we at least saw diversification functioning in a more expected fashion during the short-lived panic of the banking turmoil as bonds rallied to offset the declines in stocks.

International markets echoed the U.S. markets for the quarter, experiencing similar volatility, but ultimately finishing the quarter on a strong note. These markets are still trading at significant discounts to U.S. markets from a valuation perspective, which we believe is a long-term opportunity, although near-term we expect the same macro drivers of volatility to dominate the headlines and drive returns.

A Banking Crisis?

A few weeks ago, most Americans had never heard of Silicon Valley Bank (SVB), but over the course of 48 hours it experienced the fastest “bank run” in history with $43 billion of withdrawals in a single day, collapsed essentially overnight despite having $16 billion of equity on its balance sheet, and set off a wave of panic that the banking system was on the verge of another 2008-style crisis.

With the domino effect of 2008 still scarring investors, it will likely take a while for the market to trust that contagion is not threatening more banks. Fortunately, the Federal Reserve acted quickly to reassure depositors at all banks by creating a lending facility for banks that essentially guarantees access to unlimited liquidity to prevent another run on any U.S. bank. In addition, SVB was an unfortunate combination of extremely poor risk management of their investment portfolio after a flood of deposits that saw the bank triple in 18 months, magnified by a failure to understand the risks of a very concentrated client base whose deposits were mostly above FDIC insurance limits and were likely to all need to draw on their deposits at the same time. These two issues were compounded by bad luck in the form of a vocal and high-profile depositor with ties to many depositors who expressed doubts about the bank’s safety. Regulators had already been working with the bank to remediate the first two issues, but once depositors lose faith in their bank, it is virtually impossible to survive the ensuing “run on the bank.” A second bank, Signature Bank, was also closed by regulators, but their issues appear acutely derived from a significant presence in the collapsing world of cryptocurrencies than any systemic bank concerns.

Given the reassurance created by the Federal Reserve, investor confidence in the banking system should gradually return, especially since the bank whose deposit base most closely resembles SVB, First Republic, got a huge vote of confidence from a consortium of U.S. banks that jointly deposited $30 billion of their own cash at the bank.

The Fed and Inflation

The Fed’s tug-of-war with inflation will likely still be making headlines in 2024, and the first quarter provided little illumination as to which side is winning. Fortunately, markets remain confident that the Fed will eventually succeed in getting inflation back down to its target of 2%, which is reflected in the chart below in that 10-year U.S. Treasuries are only yielding 3.5%, which includes any inflation premium on top of the real return.

U.S. Treasury yield curve

Par yield, constant maturity, at three dates

Outlook

The first quarter ended with the markets seeming to face even more questions than at the beginning of the year. Last year was all about Inflation, rate hikes by the Federal Reserve, and whether the U.S. economy would be tipped into recession by higher interest rates. Those three questions still dominate headlines, and they have been joined by questions regarding fallout from the banking turmoil, an upcoming political battle over the U.S. debt ceiling, concerns over commercial real estate in a post-pandemic world where demand for office space has plummeted, and whether all these questions combine to push us into a now long-anticipated recession.

With all that in mind, we continue to focus with clients on improving portfolio diversification for the purpose of smoothing out potential ‘bumps in the road’ ahead. Seeking improved diversification and recognizing that market leadership may change in the next bull market, we have been discussing the risks posed by the concentration of technology exposure in the U.S. large cap market and how owning the market’s favorite individual technology stocks can amplify those risks. Continued volatility seems very likely, but good defense through diversification can make a big difference over the long-term for investors.