Market Insights: First Quarter Wrap-up

Market Update 

The equity markets ended the first quarter of 2023 with a solid gain as hopes for an economic “soft landing” and the U.S. Federal Reserve (Fed) signaling that their historic rate hike campaign is coming to an end, helped offset two rate increases and the largest bank failures since the financial crisis of 2007-2008. 

Markets started 2023 with strong gains in January, which were primarily driven by a continued decline in widely followed inflation indicators. That decline in price pressures was coupled with surprisingly resilient economic data, especially in the labor market. Those forces combined to increase investors’ hopes that the Fed could deliver an economic soft landing, whereby the economy slows - but avoids a painful recession - while inflation moves close to the Fed’s target. Additionally, corporate earnings for the fourth quarter of 2022, which were reported in January, were “better than feared” and the resilient nature of corporate America contributed to the growing hope that both an economic and earnings recession could be avoided. The S&P 500 Index posted strong gains in the month of January, rising more than 6%, while the S&P/TSX Composite increased over 7%. 

In February, however, growing optimism for an economic soft landing was delivered a setback as economic data implied a still very tight labor market, while the decline in inflation stalled. The January jobs report, released in early February, showed a massive gain in jobs, implying that the labor market will remain extremely tight (something the Fed believes is contributing to inflation). Later in the month, widely followed inflation metrics such as CPI and the Core PCE Price Index showed minimal further price declines, implying that the drop in inflation that had powered the gains in stocks was ending. The strong economic data and a leveling off of inflation metrics led investors to price in higher interest rates in the coming months, and that weighed on both stocks and bonds in February. The S&P 500 Index and S&P/TSX Composite both fell back well over 2%. 

The final month of the first quarter began with investors still focused on inflation and potential interest rate hikes, but the sudden failure of Silicon Valley Bank, at the time the 16th largest bank in the United States, shifted investor focus to a potentially growing banking crisis. Signature Bank of New York failed just days later, and concerns about a regional banking crisis surged. In response, the Federal Reserve and the Treasury Department created new lending programs aimed at shoring up regional banks and preventing bank runs, but concerns about the health of the financial system persisted and those fears weighed on markets through the middle of March. However, while the Federal Reserve hiked interest rates again at the March meeting, policy makers signaled that they are very close to ending the current rate hike campaign. That admission, combined with no additional large bank failures and Fed backing, eased concerns about a growing banking crisis, and the S&P 500 was able to rally during the final two weeks of March to finish the month up over 3%. However, a pullback in financials and energy weighed down the S&P/TSX Composite, which ended March with a small decline. 

One important aspect of the U.S. stock market to highlight in the first quarter is the rebound in large cap technology companies. While the S&P 500 Index advanced 7.5% on a total return basis, that same index on an equal-weighted basis was only up 2.9%, while the Dow Jones Industrial Average only managed a very modest 0.9% gain. The bounce in oversold tech companies was so pronounced that Microsoft and Apple alone, which make up over 13% of the S&P 500, comprised about 40% of the overall market’s return. In fact, the entire market cap gains for the S&P 500 came from the top 15 companies, most of which are tech, while the remaining part of the index actually declined slightly. Therefore, mega caps masked an otherwise underwhelming quarter, with the average stock investor experiencing lower returns than the market-weighted benchmark. 

Internationally, foreign equity markets largely traded in line with the S&P 500 with strong positive returns, with economic data in Europe betting better than expected. Emerging markets underperformed developed markets, thanks to still-elevated geopolitical stress, as U.S.-China tensions rose following the Chinese spy balloon affair. 

Fixed incomes markets in general enjoyed a strong first quarter as long-term interest rates dropped significantly in March. However, keep in mind that this is on the back of the worst year (2022) in history for fixed income markets, which are still in negative territory over the last three years. 

The strongest investment in the first quarter was gold, up 8%, with investors looking for safety and forecasting declining real interest rates. As of writing, the price of gold is less than 2% away from its all-time high of $2069.40 USD set in 2020, according to Forbes. 

In sum, markets were impressively resilient in the first quarter as a looming end to rate hikes, further declines in inflation and quick and effective actions by government officials in response to regional bank failures helped shore up confidence in the banking system. Stocks and bonds both logged modest gains in Q1, despite the threat of a regional banking crisis and still-elevated market volatility.  

Milestone Strategy & Outlook 

Markets begin the new quarter facing multiple sources of uncertainty including the path of inflation, future economic growth, the number of remaining Fed rate hikes, and whether the regional banking crisis is truly contained. Yet despite all this uncertainty, markets have proven resilient over the past six months since hitting their lows in October of 2022. So, while headwinds remain in place and markets will likely stay volatile, there remains a path for future positive returns.   

Starting with the U.S. regional banking crisis, despite comparisons in the financial media between what happened in March and the 2007-2008 financial crisis, there are very important differences between the two periods and U.S. regulators have already demonstrated their commitment to ensuring they do not experience a repeat of those difficult days. As we begin the new quarter, there is reason for hope this crisis has been contained. Regulators and government officials have proven they are ready to use current tools (or create new ones) to prevent a broader spread of the regional banking crisis, and that’s an important, and positive, difference from 2008. In addition, the losses incurred by these badly mismanaged regional banks were in very liquid U.S. Treasuries, whereas 2008 was caused by issues in much more complex and illiquid mortgage securities, and exotic derivative and credit default swaps.  

We do not see these same issues at all with the larger U.S. banks, and certainly not here in Canada, where our banking system is dominated by a few large banks, opposed to hundreds of regional banks, and stronger regulations. It is important to note that bank failures in the U.S. are not an uncommon affair, as America has endured over 560 bank failures since only 2001. Meanwhile, in Canada, over that same period there have been zero. In fact, the last material bank failure in Canada was 100 years ago! This was when the Home Bank of Canada collapsed under the weight of bad loans and mismanagement and sparked major new bank regulations by Ottawa in 1923. The point of this history lesson is to rest assured that there are no parallels between the current U.S. regional banking issues and Canadian banks. 

Looking past the regional bank crisis, inflation remains a major longer-term influence on the markets and the economy, and whether inflation resumes its decline this quarter will be very important for investors and the markets. More specifically, the decline in inflation somewhat stalled in February and March, but if the decline in inflation resumes in the second quarter that will likely provide a powerful tailwind for both stocks and bonds. 

Regarding economic growth, markets rallied on the hope of an economic soft landing earlier in the first quarter, and while the regional banking crisis complicates that optimistic outlook, it is still possible. To that point, employment, consumer spending and economic growth more broadly have remained impressively resilient, so while we should all expect some slowing in the economy this quarter, a recession is by no means guaranteed. If the economy achieves a soft landing, that will be a material positive for risk assets. 

Finally, after one of the most intense interest rate hike campaigns in history, the Fed has signaled that it is close to being done with rate increases, and that will remove a material headwind on the economy. If that expectation for a looming end to rate hikes does not change, it’ll increase the chances that the economy can achieve the desired soft landing.  

To be sure, this remains a volatile time in the markets. Investors are facing the highest interest rates in a very long time, some of the worst geopolitical tensions in years, such as those between Ukraine & Russia, and China & the U.S., and an uncertain economic outlook that deteriorated in the wake of recent U.S regional bank failures. While concerning, it’s important to realize that underlying economic fundamentals and corporate earnings proved incredibly resilient through the first quarter. And those two factors, steady economic growth and strong earnings, are the real long-term drivers of market performance, not the latest disconcerting geopolitical or financial headlines.   

As such, while we are prepared for continued volatility and are focused on managing both risks and return potential, we understand that a well-planned, long-term-focused, and diversified financial plan can withstand virtually any market surprise and related bout of volatility, including multi-decade highs in inflation, historic Fed rate hikes, geopolitical unrest, and rising recession risks. 

Thank you for your continued trust in Milestone and for the opportunity to assist you in working toward your financial goals. We understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Successful investing is a marathon, not a sprint, and even intense volatility is unlikely to alter a diversified approach set up to meet your long-term investment goals. Therefore, it’s critical to stay invested, remain patient, and stick to the plan, as we’ve worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline. 

Here is our Milestone Market Report on economic data, capital markets, commodities, and currencies through March 31st, 2023: (click image for PDF version)

Sources: Bloomberg, Thomson Reuters, Refinitv, Teranet & National Bank of Canada, Sevens Report, CNBC, New York Times, YCharts, Federal Reserve, Yahoo, AP News, Forbes, Financial Post