Markets posted their second consecutive quarter of gains to start 2023, with the S&P 500 Index returning 7.48%. This may come as a surprise to some given the headlines out of the banking sector this March, but 1Q 2023 was a broadly positive one for the diversified investor. Specific banks did experience some real problems, but as we laid out in our note here, all indications are that these were one-off issues rather than systematic ones. For example, Silicon Valley Bank (NYSE: SIVB) was particularly exposed to high-risk early-stage startups, Silvergate Bank (NYSE: SI) was very cryptocurrency-focused, and many of the banks that struggled did a notably poor job mitigating interest rate risk. To illustrate how company-specific these issues were, financials outside of banks were barely negative as a sector despite these extreme cases, with strength in credit card and insurance companies helping to offset the weakness in certain bank stocks within financial indices. Technology stocks were major contributors to quarterly returns, and blue chips like Apple, Microsoft, and Meta posted stellar quarters, with Meta bouncing back to post a whopping 76% gain. As a result, the tech-heavy Nasdaq outperformed strongly, posting its best return since the second quarter of 2020.
International markets posted positive performance in the first quarter as well. In fact, developed international markets as measured by the MSCI EAFE Index outperformed the S&P 500, with the Eurozone driving returns and the U.K. and Japan posting smaller but still positive performance. The European Central Bank and Bank of England both raised interest rates significantly over the course of the quarter in efforts to combat inflation. Emerging markets underperformed on a relative basis but still posted positive returns as well.
Within fixed income markets, most asset classes generated another quarter of gains. Corporate, municipal, government, and securitized assets all moved higher, as yields fell on all but the very shortest portions of the yield curve. This effect was particularly pronounced on the longer end of the curve, as the 10-year Treasury fell by over 40 basis points in the quarter. There is an inverse relationship between price and yield, so prices on longer-dated bonds rose as yields fell, and longer-dated bonds generally outperformed.
Condor’s Market Outlook
Given the events of the first quarter, investors will obviously be keeping a close eye on the banking sector in the coming months. We have laid out our thoughts here in more detail in previous notes, but to reiterate a few of the main points: The banks that have struggled were not large enough to be subject to CCAR stress testing. The largest, most systemically important banks (and the banks like Schwab that you may have some exposure to with us) have better balance sheets with far more mark-to-market securities to maintain their liquidity in the case of large withdrawals. Additionally, governments and regulators in the U.S. and abroad have been quick to provide support to prevent broader contagion. If they were willing to do so for Silicon Valley Bank, there is almost no chance they would let a larger, more systemically important institution go under without the same make-whole protections.
Inflation data continues to come down, but at a notably slow pace. A surprise output cut by OPEC members last week will not help matters here, although the Fed’s preferred measure of inflation does exclude energy prices. Wages are also taking the spotlight moving forward given the tight labor market and several companies citing rising wage costs in their earnings. That said, while higher wages are inflationary, we do not view this as a significant negative as more money in workers’ pockets is also beneficial for their consumption and in turn overall economic growth. The leisure and hospitality, healthcare, and government sectors showed notable job gains, while we have seen some limited job cuts in the technology sector that will bear watching.
There is still a disconnect between the market’s expectations for the Federal Reserve and the Fed’s own signaling around rates. Amid the increased uncertainty during recent bank runs, markets have once again turned to expect rate cuts later this year. In contrast, the Fed remains adamant it will remain data-dependent and will not cut until inflation is tamed. The Fed’s dot plot shows expectations for the Fed Funds rate to end the year above 5%, while surveys place investor expectations for the year-end rate closer to 4%. This is a disconnect that will need to be addressed in coming quarters.
Attention will also turn to the debt ceiling later in the second quarter. This is always a tricky situation to discuss, as we are neither political commentators nor Beltway insiders. Ultimately, however, the ramifications of a U.S. default would be so severe and well-known that political actors should be highly incentivized to avoid the economic damage and reach an agreement. While we may see plenty of brinkmanship and alarmist headlines, and even a deadline down to the final days or hours, markets have (unfortunately) grown accustomed to these political games and can weather the storm.
Internationally, European data and expectations have strengthened, and the World Bank has increased its 2023 GDP estimates for China now that that country is moving away from its zero-Covid policies. China has become increasingly important as the country develops and expands its middle class, and strength there could prove important in providing the next leg of global growth in coming quarters.
The market’s performance in the first quarter provides a welcome reminder of the importance of staying invested. No one would argue that there were no risks to domestic equities to start this year, but returns were still quite positive. While there are legitimate concerns that markets are pricing in, consumer spending has proven durable as evidenced most recently by strong retail data for March, and the labor market remains strong with a 3.6% unemployment rate and 1.7 job openings for every unemployed person. Regardless of short-term prognostications, a long-term investment horizon and diversified asset allocation will remain key drivers of long-term financial success.
