During the first quarter of 2023, inflation remained higher than comfortable for the Federal Reserve (the Fed); we experienced the second largest bank failure in U.S. history; war continued in Europe; U.S. and China tensions increased; and the stock market went … up? While market performance may be a surprise, given the headwinds we are facing, it is important to remember we are recovering from a year that saw significant pullbacks in both equities and fixed income.
To be clear, it has been an impressive start to 2023. The S&P 500 was up 7.03% and the tech-heavy NASDAQ was up 17.67%. There have been amazing recoveries in individual stocks in the first quarter with Tesla (up 68.42%), NVIDIA (up 90.10%) and Meta (up 76.12%), to name a few. Again, these were some of the biggest losers of 2022. Foreign stocks have had a good start to the year as well, with the EAFE up 8.47%. Fixed income has also participated in the recovery with Barclays AGG gaining almost 3%. Finally, cash and cash equivalents (Government Treasuries, CDs, Money Market Funds) have finally become an asset class worthy of discussion. If properly positioned, cash equivalents are currently yielding 4%-5% annually.
So, what are the reasons behind this recovery? First, we are coming from a low point, so it is not surprising to see the market bounce upwards to start the year. Second, while the inflation rate is above the long-term goal, it is improving. In June 2022, the annual inflation rate peaked at 9.1%; the most recent reading in April was 5%. This was the lowest reading since May 2021. This has led to the hope that the Fed is close to the end of raising interest rates. Finally, the rally might be a little deceiving. While it is great to see a 7.03% increase in the S&P 500, that gain has been concentrated in around 20 stocks. The top 20 stocks have accounted for almost 90% of the gains so far in 2023. The hope that the Fed will cease making interest rate hikes has also helped fixed income. That hope has decreased the pressure on the value of existing fixed income holdings and given rise to yields we haven’t seen in over a decade.
I feel like a broken record, but the coming months could be volatile for the markets. We have a looming debt ceiling situation (yes, again). Sometime in early June, the U.S. Treasury is scheduled to run out of money to pay the bills unless Congress authorizes the Treasury to issue new debt. Without doing so, the U.S. will begin defaulting on our outstanding debt. While the general consensus is that Congress will end up raising the debt ceiling (since we have already spent the money), there will likely be a fight over spending cuts in exchange for raising the debt ceiling. In the past, there has been a lot of volatility in the markets leading up to this deadline, but the stock market has quickly moved on to trading based on the current economic outlook.
Another issue worth following is the ongoing conflict between China and Taiwan. Recently, China has been running military exercises in the South China Sea near Taiwan. The United States Navy sent the USS Milius (DDG-69) within 12 nautical miles of the Spratly Islands, which is a distance internationally recognized as the limit of a nation’s territorial waters. China, along with several other nations, claims sovereignty over these islands. As of now, this seems to be a lot of posturing but, as evidenced by Russia at the beginning of 2022, posturing can quickly turn into something else.
Lastly, I feel it is important to touch on the stressors placed upon the U.S. banking system in early March. Bank failures are more common than many might realize. Between 2013 and 2022, there were 122 bank failures in the Unites States. These bank failures all occurred after the Great Financial Crisis (GFC) of the previous decade, which saw almost 400 failures. What made the failures of 2023 worthy of headline news was the size of the failures: Silicon Valley Bank (SVB) and Signature Bank were the second and third largest bank failures in U.S. history. For the most part, the failures were not due to poor performance of loans on their books but due to an old-fashioned run on the banks. Especially in the case of SVB, they had taken in massive amounts of money between 2020 and 2022 and used it to purchase longer dated bonds. As interest rates increased, those investments became worth significantly less than what they paid for them. Once this news came to light, depositors took their money out and did so quickly. The venture capitalist community in the Bay area, SVB’s target client base, is a close-knit community of depositors and the worry spread quickly. SVB had over $42 billion, or almost 1/3 of their total deposits, withdrawn from the bank in 10 hours. Regulators closed the bank the next day. This created a short-term fear in the banking system and caused a flood of customers to leave smaller banks for the safety of the larger banks, although those bank runs seem to have slown down.
While there could be more bank failures, the concern over widespread failures seems to be decreasing. The Fed stepped up quickly (even working over a weekend) to offer additional liquidity to banks if they suffer significant deposit outflows. The stress is much different than during the GFC, as during that time, banks were holding a plethora of bad loans on their books. Today most banks hold U.S. Treasuries that eventually will pay full value at maturity even if currently worth less than what they paid.
As is always the question, where do we go from here? As I have highlighted above, the key word going forward is volatility. The debt ceiling debate, the Fed ‘s upcoming decision in May on the fed funds rate, and geopolitical events could all create headwinds in the short term. However, if we can navigate to the other side of the debt ceiling debate and avoid a recession (or keep it to a short, mild recession), it could set up a positive environment for equity investing in the latter half of 2023. Fixed income is in a good spot with higher interest payments leading to more income and, if rates are cut in the future, the possibility of capital appreciation. With so many uncertainties, we continue to recommend a diversified portfolio determined by your cash needs in the coming years. We think holding cash is beneficial, not only to take advantage of opportunities, but also because cash equivalents (money markets, treasury bills, CDs) are paying above 4%. It has been a while since we have seen those types of returns on cash. Please reach out to us if you would like to discuss your investment strategy in more detail.
– Will Bowen, Relationship Manager
The views and opinions expressed are of Persium Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. Persium Advisors is an investment advisor firm located in Atlanta, GA.
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