ACG Market Review – Q1 2023

(Download the full report HERE)

Global Highlights

  • Economy – Investor focus shifted from declining inflation and a potential Fed pivot to the health of the banking sector and overall economy
  • Equities – An early quarter stock rally was quelled by hotter than expected inflation and further Fed tightening
  • Fixed Income – Higher rates often indicate higher returns, however, risks remain in certain areas of fixed income

Economic Uncertainty and Market Volatility

Equity and fixed income markets began 2023 on a smooth upward trajectory with surprisingly resilient economic growth, declining inflation, and the possibility of looser monetary policies going forward. Towards the middle of the quarter, optimism appeared to wane as investors began interpreting strong employment and consumer confidence data not as a sign of economic strength but rather as a green light for the Federal Reserve to continue to hike rates. In early March, banking sector turbulence dominated the news, with a focus on regional bank deposit flight and unrealized losses on bank balance sheets. The volatile quarter ended with somewhat of a reprieve through stabilizing measures provided by the Fed, Treasury, and FDIC; however, uncertainties remain around the health of the economy and further rate hikes.

Shifting Inflation Dynamics

The outlook on inflation is beginning to improve, as the Consumer Price Index (CPI) rose +6% year-over-year in February. While still historically elevated, this is the eighth consecutive monthly decline and a significant improvement from the recent high of +9.1% in June 2022. In tandem with steady price moderation, the underlying drivers of inflation are shifting as well. An interesting pattern emerges when components are separated into fastchanging “flexible” and more stable “sticky” price segments. “Flexible” constituents such as food and energy have already declined, while “sticky” constituents such as services and particularly shelter have continued to increase.

It is notable that shelter is responsible for around one-third of the CPI and more than 70% of the most recent total CPI increase. However, the shelter CPI calculation uses rents which are slow to re-price, historically lagging actual home price changes by roughly a year. So, a significant portion of the current inflation data is based on past rent increases, whereas more recent data indicates that rent increases have generally slowed and home prices are under pressure. It is reasonable to assume that the future trajectory of rents and house prices will likely be the road forward for inflation as well.

To combat inflation, the Federal Open Market Committee raised rates twice during the quarter, conducting 25 basis point rate hikes in both February and March to reach the target range of 4.75%-5.00%. In the March press conference, Chair Powell maintained the message that interest rates would remain elevated for an extended period of time while also softening the language around the need for further rate hikes. With the emerging disinflationary trend and tumult following the Silicon Valley and Signature Bank failures, the Fed appears comfortable taking a pause to consider price stability versus financial stability risks.

Equity Market Rebound and Recoil

Largely positive index performance numbers mask what was a volatile and event-filled Q1. The S&P 500, following a strong Q4 2022, returned +7.5% on a total return basis for Q1 2023. The 2022 trend of value outperforming growth strongly reversed to start the year, with the Russell 1000 Growth Index gaining +14.4% for the quarter compared to +1.0% for the Russell 1000 Value. In March especially, lower long-term bond yields and Fed pivot expectations provided an outsized tailwind for growth equities as these are generally viewed as longer duration investments. The Information Technology and Communication Services heavy Nasdaq was a standout performer, finishing the quarter up +20.8%. Contrarian investors faded the perhaps overly bearish sentiment following a four-quarter losing streak. Notable outperformers include tech giants Meta and Apple, which returned +76.1% and +26.9%, respectively, for the quarter. Financials were understandably the worst-performing sector to start the year, finishing the quarter down -5.6%.

The Russell 2000 Index, which tracks U.S. small-company equities, was disproportionately affected by the banking crisis. First, by a higher Financials sector weighting in the index relative to the S&P 500. Second, regional banks such as Zions Bank and KeyCorp received outsized scrutiny compared to their large cap peers for the risk of contagion and deposit flight. The Russell 2000 index finished the quarter up +2.7%, giving up earlier gains of nearly +14%.

Throughout the quarter, international markets had their own set of problems associated with failing financial institutions, one of which was the high profile forced takeover of Credit Suisse by UBS. Although levels are still lower than the highs of 2022 and during the COVID sell-off in 2020, the cost of insurance against credit default, as measured by the pricing of credit default swaps (CDS), saw a significant increase across European banks. Aided by a slightly weaker dollar, international equity returns were among the highest of the quarter, with the MSCI EAFE index gaining +8.5% in Q1. While international stocks have lagged the US for much of the post-Global Financial Crisis market environment, an extreme relative valuation discount and a declining US dollar could prove to be major tailwinds for foreign assets going forward.

Despite the challenging economic environment, consensus earnings forecasts predict growth in each remaining quarter of 2023. In addition, markets tend to do well after an inflationary peak and a trough in consumer confidence. Much will depend on the impact of the banking crisis on economic growth and whether the Fed’s tightening cycle has officially concluded…

Continue reading by downloading the full report HERE which includes exhibits and sections that discuss:

  • Bond Market Defensiveness
  • The Fed’s Predicament
  • Market Index Review – March 2023
  • Inflation Slowly Declining, But Also Becoming More “Sticky”
  • Mortgage Rates Up & Home Prices Down
  • Not All Bonds Are The Same
  • Duration Risk Vs. Reinvestment Risk
  • Banking Sector Issues
  • Money Market Mayhem
  • Commercial Real Estate Lending
  • European Banking Issues
  • Fundamentals & Corporate Earnings
  • Environment for Active Managers is Mixed

Sources in the report:

  • Morningstar
  • Hedgeye
  • Merrill Lynch
  • Bloomberg
  • Bureau of Labor Statistics
  • Federal Reserve Bank of Atlanta
  • Standard & Poor’s
  • CoreLogic
  • Case Shiller
  • FactSet
  • Hartford Funds
  • Charles Schwab
  • FDIC,
  • Statista
  • ACG
  • Bank of America Merrill Lynch
  • Longview Economics
  • Moody’s
  • DC Comics
  • LPL Research