First quarter 2023 market commentary

One could very well mistake the strong performance of the U.S. stock market in the first quarter of 2023 for a clear signal to start investing aggressively. While we’re eager to see how market conditions develop, our perspective is that prudence is still warranted.

The Markets Rebound in Q1

The strong performance of U.S. stocks over the first three months of the year is hiding significant turbulence and negative developments in the world economy.

After a difficult showing in 2022, stocks rebounded broadly in Q1 2023 as the S&P 500 Index climbed 7% and the tech-heavy Nasdaq Composite Index surged an impressive 16% on strong performances by sector leaders like Meta and Tesla. (Source: Briefing.com). In the bond market, after a tumultuous 2022 saw the Bloomberg U.S. Treasury Index return -12.5%, bond performance was muted in Q1 2023 as the 10-year Treasury Note closed the quarter at a 3.56% yield — virtually unchanged from January when it yielded 3.58%.

The positive performance of the U.S. stock market paired with the relative yield stability of U.S. Treasuries may suggest a positive investing climate. But nothing could be further from the truth. Beneath the surface, the U.S. financial markets are exhibiting tremendous volatility.

Indeed, an analysis of the different sectors within the equity markets reveals contrasting performances. The Consumer Discretionary sector (led by Amazon and Tesla) and the Technology sector (led by Microsoft and Apple) delivered the best performances, each gaining more than 10% on the quarter. The Healthcare and Utility sectors were the laggards with negative performances of -6.4% and -4.40%, respectively. (Source: State Street Global Advisors). In the first quarter, we essentially saw the equity market shift from the sectors that performed well in 2022 to the ones that performed poorly in 2022.

Volatility persists

The recent bank failures and the ensuing stress surrounding credit extension signaled a turning point in the yearlong effort by the Federal Reserve to normalize monetary policy after providing extraordinary liquidity measures during the Covid pandemic. The lingering effects of certain Covid-era policies continue to be felt in the markets.

The biggest source of volatility came like a thunderbolt in a serene sky. Within a one-week period, the U.S. banking system experienced the two largest bank failures since the Great Recession of 2008. Silicon Valley Bank — with over $200 billion in assets and significant exposure to the technology and venture capital sectors — succumbed to a classic bank run in a matter of days. Shortly thereafter, Signature Bank — with over $100 billion in assets and exposure to the cryptocurrency sector — was also shut down by banking regulators. These very sudden, very public collapses triggered a crisis of confidence among investors who interpreted them as harbingers of further economic calamity.

Both of these failures were unintended consequences of the sharp rise in interest rates by the U.S. central bank over the past 12 months. Financial markets across the world experienced dramatic volatility as a result. To illustrate, the yield on two-year Treasury Notes plummeted from 5.07% on March 7 to 3.88% just seven days later. The last time we saw such a dramatic decline was in the 1980s when Paul Volcker was chairman of the Federal Reserve.

Thanks to an emergency injection of cash by the U.S. central bank and promises by the Federal Deposit Insurance Corp. (FDIC) to make all depositors whole, relative calm was restored to the U.S. markets. In Europe, the first major threat to a financial institution of global significance was averted when the Swiss banking authorities hastily arranged the takeover of Credit Suisse, founded in 1867, by its main competitor UBS on March 19.

Historically, these shocks to the financial system have taken time to fully play out. Bear Stearns failed in March 2008 but it took another six months for the Great Recession to reach a crescendo, which occurred when Lehman Brothers went bankrupt in September 2008. While we welcome the restored sense of stability in the markets and tend to believe the U.S. banking system is strong and resilient, the next few months will reveal whether the measures taken to this point will be sufficient to avoid further economic unrest.

The fight against inflation continues

The U.S. economy has remained resilient but inflation, while certainly trending in the right direction, is still too high for the Federal Reserve to declare victory.

The financial pundits have been warning us about an imminent recession for the last 18 months, yet the economy continues to soldier on. The unemployment rate in the U.S. is hovering close to a 50-year low, clocking in at 3.6% in February. The Job Opening and Labor Turnover Survey, while down slightly from the 12 million openings recorded a year ago, still shows 10.8 million job openings — that’s almost two open jobs for every unemployed individual! (Source: U.S. Bureau of Labor Statistics). This is hardly the making of a recession.

On the other hand, prices have stayed stubbornly high as efforts to curb inflation have yielded mixed results. The Consumer Price Index (CPI), a popular inflation gauge, read 6% for February 2023. While that’s down from the 8.2% peak recorded in June 2022, it’s still well above the 2% target the Federal Reserve has its sights set on. (Source: U.S. Bureau of Labor Statistics).

From our perspective, there are two ways things could play out. Either the U.S. central bank will have to accept a higher rate of inflation and ease monetary policy by lowering interest rates in the second half of 2023 or the stock market will have to adjust to the negative impact of a recession on corporate earnings. History tells us that neither of these outcomes is likely to occur without also creating substantial volatility in the markets.

Our message to clients

Given the economic uncertainty caused by the global pandemic, the extraordinary liquidity measures that occurred as a result, and now the difficult process of normalizing policies, we believe it’s appropriate to maintain a defensive posture in our investment models.

As always, we are constantly reviewing our investment models to ensure your asset allocation and risk profile align with your long-term financial goals. The rapid rise in interest rates we’ve seen over the last 18 months has created attractive investment opportunities in short-term money market funds, short-term Treasuries and short-duration bond funds. We are actively investing a portion of our client portfolios in these securities.

For those with longer investment horizons, we are focusing our equity portfolios on dividend-paying U.S. companies with strong balance sheets and high credit ratings. There may be a time when more aggressive investments are warranted, but in light of the stress impacting some segments of the banking sector, we don’t believe now is one of those times.

Should you have any questions, we encourage you to connect with us at Elevage Partners.

Warm regards,
Thierry Hasse
Chief Investment Officer

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The information contained herein represents the views of Elevage Partners at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein In addition, there can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Any statement non-factual in nature constitutes only current opinion which is subject to change. These materials are provided for informational purposes only and do not constitute investment advice. Any reference to a security listed herein does not constitute a recommendation to buy, sell, or hold such security. Past performance is no guarantee of future results. The historical returns of any securities and/or sectors mentioned in this commentary are not necessarily indicative of their future performance.

Information that is provided through hyperlinks within this market commentary are third-party content, which although believed to be accurate, have not been independently verified.