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Market Review: The equity markets proved to be quite resilient in the first quarter, climbing the proverbial “wall of worry” to post positive returns. In a quarter full of news flow, the Standard and Poor’s 500 Index gained 7.5%, the Russell 2000 Small Cap Index gained 2.7% and the MSCI All World ex-US International Index rose 7.0%. Equity sector returns in the quarter were a mirror image of 2022. The technology-heavy Nasdaq market leapt 17.1% after dropping 32.5% in 2022 while energy and commodities fell after leading the market last year. In fact, there were shades of 2021 as Microsoft, Apple and Nvidia alone provided one-half of the S&P 500’s return. The Bloomberg Aggregate Bond Index returned 3.0% and the Gold commodity rose 8.0% with virtually all the gains for both taking place after the failure of Silicon Valley Bank on March 9th.
The Banks and the Federal Reserve: A well-known adage states that the Federal Reserve tightens policy until something breaks, and the first casualty was regional bank balance sheets, or more specifically their bond portfolios. Banks buy Treasury and mortgage-backed bonds with the depositors’ funds that they do not use for making loans. For a quick explanation, bonds are issued near par ($100) and mature at par, but their prices will fluctuate inversely based upon the prevailing interest rate environment. The 30-year Treasury issued in May of 2020, with a coupon of only 1.25%, currently trades below $60. The bond will ultimately mature at $100 in 2050, but if a bank needs to sell this bond today at current prices to fund customer withdrawals it will take a hit to its regulatory capital. The collapse of Silicon Valley Bank (SVB) was caused by a combination of a social media-fueled deposit run and the bank’s portfolio of long-term fixed rate bonds trading at large discounts from where they were purchased. SVB reached for yield in a low interest rate environment, creating an asset/liability mismatch akin to the savings and loan crisis in the 1980’s. The crisis of confidence spread and SVB and Signature Bank went into receivership at the FDIC, First Republic Bank required a $30 billion investment from a consortium of money-center banks and global behemoth Credit Suisse was forced into the arms of its peer UBS by the Swiss government. The Federal Reserve largely defused the situation by establishing the Bank Term Funding Program where eligible financial institutions may present their bonds as collateral for a one-year loan that values these assets at par regardless of their market price. It is worth noting that the Federal Reserve’s bond portfolio is also well underwater, but the Fed is free from capital requirements. Regional bank share prices have remained under pressure since mid-March as hundreds of billions in deposits have fled to the largest banks and money market mutual funds. While this “crisis” appears to have been quickly contained, it does serve as a precursor to a tightening of bank lending standards and shines a spotlight on looming refinancing challenges in the commercial property space.
Equities and Bonds: After a rough 2022, growth stocks have carried the equity market both domestically and overseas thus far in 2023 and the U.S. large cap growth category now trades at a 28% premium to its 20-year price to earnings average as per JP Morgan Research. This shows a good deal of optimism given the myriad economic outcomes still yet to play out and the unknown, lagging impact of the Fed’s prior moves. There are less richly valued areas such as small cap value (bank exposure) which is trading at a 7% discount to its 20-year PE average. The economy continues to skirt recession and, though moderating, inflation remains well above the Fed’s 2% target. The Federal Reserve voting members continue to assert their inflation fighting resolve, but the market is not buying it with the Fed Funds futures market pricing in one additional rate hike to 5% – 5.25% with rate cuts beginning in the second half of the year. Post the SVB collapse, the two-year Treasury yield quickly dropped from 5% to below 4% and the yield on the ten-year Treasury fell from 4% to 3.5%. So, the current view across markets appears to be an economic slowdown, but with a non-disruptive soft landing. This would be quite welcome, and at the same time threading-the-needle based upon history. Adding in the debt ceiling showdown, the Ukraine/Russia conflict and increasing Chinese territorial aggression around Taiwan, we anticipate plenty of surprises and opportunities and are managing accordingly. Small cap and international remain the cheapest areas while bonds have lost some appeal in the short term after this recent rally to lower yields.
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