Markets delivered relatively good results in the first quarter. With stocks up approximately 7.5%, investors are perhaps looking ahead to a recovery in the economy and earnings, while shrugging off new challenges in the banking sector. These challenges may prompt a new direction for the Federal Reserve as it responds to these banking sector pressures, while also trying to reduce inflation and avoid massive unemployment.
In reviewing these overlapping themes, our general sense is that Jay Powell and the Fed will find a compromise that supports both the economy and financial conditions. But before we jump to what’s next, let’s review what triggered the bank failures last quarter, what may unfold during the balance of the year, and what we are doing to position portfolios for downside risks and upside opportunities.
What’s going on with regional banks?
During the last 12 months we’ve seen a significant rise in interest rates (from 0.25% to 5% on the Federal Funds Rate), which has led to a decline in the value of bonds—in particular, bonds that were purchased in 2020 and 2021 have been hardest hit.
Over the course of the pandemic, banks took depositor cash and bought safe, investment-grade bonds such as Treasuries at relatively low (but prevailing) interest rates. In retrospect, those were flawed bets: Surging inflation and Fed rate hikes drove bond prices down, so when depositors asked for their deposits back, banks such as Silicon Valley Bank had to sell what they believed to be “safe” investments at rock-bottom prices, thus realizing losses which impaired their capital position.
Fast forward to March 2023: Depositors started to get nervous as word spread about the falling values of bonds held by banks. Rapid depositor outflows at Silicon Valley Bank and Signature Bank triggered a government rescue to protect the remaining depositors. At the moment, it appears that withdrawals have slowed since the initial wave of outflows, and we are seeing a modest trend of deposits moving from small banks to larger banks.
What’s next for the Fed?
Inflation has spread like wildfire since the U.S. emerged from COVID-19 lockdowns. Tight supply chains, along with higher government and personal spending, initially boosted inflation during the last two years. Since last March, the Fed’s strategy to combat soaring inflation has been to pour cold water on the problem in the form of higher rates.
The regional banking crisis has added significant constraints on Fed policy. More Fed rate hikes could push inflation even lower but might also push the U.S. closer to a recession, which would certainly lead to more job losses and even more pressure on banks and the stock market.
On the other hand, the Fed could decide to pause or even cut interest rates. This policy shift would likely keep the economy, employment, and the stock market steady, but could perhaps take us back to red hot inflation. It’s a tough call, but our sense is the Fed will continue at a slow pace, likely pause during the next couple of meetings, and perhaps look to cut rates later in the year.
The economy, earnings, and positioning
Our base case is that moderating Fed policy may limit the downside brought on by troubled regional banks. However, we are also on the lookout for emerging risks that could impact markets and portfolios. A surprise bout of inflation such as an unexpected rise in gas prices or wages could add a few more rate hikes or delay a shift to Fed easing. Other risks we are watching include the possibility of more bank failures, worse than expected S&P earnings, investor complacency (as seen in the VIX or fear index), and concerns that stocks are too expensive relative to long-term averages.
While new risks can and do surprise markets in the short term, we continue to remain comfortable with stocks as a favorable asset class for generating long-term total returns. Over long periods of time, stocks generally “follow” corporate profits, so if we want to figure out where stocks are headed, we need to consider how macro themes may impact corporate profits.
At the moment, companies have high profit margins because consumers are still buying, despite elevated prices due to high inflation. However, we have observed a modest manufacturing slowdown in recent months. We’ll be keeping a close eye on this because S&P500 earnings generally follow manufacturing trends.
We expect the economy and earnings to eventually recover, though timing remains uncertain. Still, instead of attempting to “time” the market with large shifts out of and back into the market, we generally prefer a more disciplined approach which, barring any outlier risks or systemic failures in our economy, calls for staying fully invested with ownership across defensive, cyclical, and growth stocks. We also favor diversified companies with improving margins and the potential for market share gains in the event the economy slips into recession. Speaking of diversification, while a large portion of our equity holdings are in U.S. stocks, many of the companies in our portfolio are multi-national, which gives investors exposure to non-U.S. markets.
In addition to equities, we continue to take advantage of the attractive yields available in the bond market—in some cases, we have locked in yields for up to 10 years or more. New challenges demand new directions for the Fed and other market participants, and we believe that high-quality bonds can help offset near-term volatility. Should rates eventually decline, longer dated maturities will also become more valuable—for the same reason that bond values declined during the last 12 months.
As events unfold this year, we return to our core investment principles, which include a flexible yet consistent approach to uncovering opportunities, remaining ever mindful of your goals and objectives.
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®