2023 First Quarter Market Update
By AJ Loughry, CFA
The first quarter of 2023 saw another period of elevated volatility & fluctuating market narratives. Bank runs resulting in the failure of two of the 20 largest banks in the US drove headlines for the quarter, as Silicon Valley Bank & Signature Bank were put under control of the FDIC after being strained by significant deposit outflows. Despite the two biggest bank failures since the Great Financial Crisis, both equity & fixed income markets moved higher on the quarter with the S&P 500 up 7.5% and the Bloomberg Barclays Agg Bond Index up 3%.
The market trends of 2022 reversed sharply to start 2023 as the most beaten-up parts of the equity markets, including growth-oriented & international companies, led the market rally, and yields on fixed income moved lower. A combination of short covering & systematic flows, driven by trend-following strategies that entered the year with large short positions, along with hopes of a looming pivot in monetary policy helped drive these moves in January. Narratives quickly flipped in February however after a string of strong economic data reads and comments from Central Banks led markets to once again price the terminal rate higher, diminishing hopes of a Fed pivot.
The market tone then once again changed dramatically in March following the collapse of Silicon Valley Bank & Signature Bank. After initially seeing volatility spike & markets sell off the back of this news, steps taken by regulators helped to ease concerns of broader contagion effects. The regulators stepped in and ensured that the deposits of both banks would be guaranteed and created a new lending facility that allowed banks to redeem high quality fixed income instruments with unrealized losses at par in order to meet deposit withdrawals. By the end of the quarter, equities had moved above their pre-bank crisis levels and fixed income securities rallied strongly.
While headline index performance for equities was positive, there was a large amount of dispersion across sectors & market caps. Growth oriented sectors led the markets for the quarter with the growth-heavy sectors of Info Tech, Communication Services, and Consumer Discretionary up 21%, 20%, and 16%, respectively. Defensive & cyclical sectors underperformed by a wide margin, with Financials, Energy, & Healthcare sectors detracting between 4 and 5%.
Economic data prints have largely remained above expectation in Q1 as well. While inflationary data continues to move off the highs set in 2022, core inflation in particular has remained sticky as the elevated savings from the COVID-era stimulus have allowed consumers to continue to spend at high clips despite rising prices. Labor shortages continue to remain an issue for the Fed. Additionally, jobs added throughout the quarter were robust and unemployment claims remained subdued, despite the large number of job cuts announced by tech companies in recent months.
Fixed income saw positive performance on the quarter after dramatic drops in yields following the banking stresses. Signs that rate hikes were causing stress on the financial system led market participants to once again price in rate cuts in 2023, despite the Fed guiding towards no cuts for the year. While the yield curve steepened following these stresses, the 2s10s curve remains inverted by over 50 basis points and will continue to be monitored moving forward.
Source: Bloomberg Barclays, MSCI; FY2022 as of 12/31/2022. For Equities, & Fixed Income, Q1 2023 as 3/31/2023. For Alternatives Q1 2023 & YTD 2023 as of 3/31/2023.
Both equities and fixed income saw positive performance in Q1 despite the drama that unfolded in the financial sector, reversing the strong trends seen in 2022.
The most beaten-down parts of the equity markets saw the best performance in Q1, with the international developed markets slightly outperforming the S&P 500. High levels of short covering to start the year was a major driver of these moves.
Fixed income markets rallied sharply as well, largely off the back of the failure of Silicon Valley Bank and Signature Bank as market participants anticipate a looming pivot from the Fed to avoid further financial stress.
Source: Bloomberg; FY2022 as of 12/31/2022;. Q1 2023 as of 3/31/2023. YTD 2023 as of 3/31/2023.
High levels of short covering and hopes of a Fed pivot drove strong outperformance for the most beaten down sectors of the S&P in Q1. IT, Communication Services, and Consumer Discretionary advanced between 16 & 21%. The more cyclically & defensive sectors that held in much better in 2022 underperformed in this environment.
U.S. Equity Style & Market Capitalization Returns
Source: Bloomberg; 2022 as of 12/31/2022. Q1 2023 as of 3/31/2023
Q1 saw a dramatic reversal of the 2022 factor trends, with large cap growth outperforming large cap value by over 13%. Multiple expansion for the growth-oriented names led this performance, as growing expectations for rate cuts in 2023 benefited stocks with long-duration cash flows.
Small caps & value notably underperformed in Q1 as stresses across regional banks added concern to the possibility of a cyclical slowdown in the US. This pressure weighed on small caps and value names as they are traditionally more cyclically sensitive than their large cap & growth-oriented peers.
Equity & Bond Market Volatility
Volatility returned to markets in the first quarter following the collapse of Silicon Valley Bank & Signature Bank. Fears of financial contagion & the ripple effects on tightening bank lending standards led to a dramatic repricing of the bond market.
Volatility continues to be concentrated in the fixed income market as highlighted by the MOVE Index which briefly moved above levels seen in the midst of the COVID crash. Equity market volatility on the other hand has remained much more subdued, with a brief spike in the VIX before settling back under 20. After an initial modest selloff, the S&P 500 fully recovered to pre-SVB levels by the end of March.
US Treasury Curve
The US treasury curve shifted dramatically throughout the quarter. Yields initially moved higher in January & February as the Fed continued to hike rates to combat persistent inflation. Strong economic data prints added to this pressure as 1 year treasury yields breached 5% by early March.
Rates then fell dramatically following the collapse of Silicon Valley Bank & Signature Bank. Investors anticipate that the banking stresses will force the Fed to pivot on policy, with the market pricing in rate cuts throughout the second half of 2023, despite the Fed’s base case continuing to hold rates steady throughout 2023.
Equity Market Dispersion
Source: Goldman Sachs
While the S&P saw strong headline performance in Q1, this performance was almost entirely driven by a small subset of mega cap technology-oriented stocks. Apple, Microsoft, Nvidia, Tesla, Meta, Amazon, & Google drove nearly 90% of this performance as the companies benefited from lower yields & a flight to quality following the SVB fallout.
Outside of these names, equity market performance was much more subdued. The S&P 500 Equal Weight Index & the small cap-oriented Russell 2000 Index advanced just under 3% as the broader equity universe struggled to gain momentum.
Inflation Continues to Move off Highs
The trend of moderating inflation continued throughout Q1. Headline CPI decreased to 5% in March, levels last seen in early 2021. Declining energy prices continue to be the main driver of decreasing headline inflation.
Core CPI also declined only modestly in Q1, with the year over year rate moving above headline inflation as costs of rent increased further. Shelter costs flow into CPI on a lagged basis & are expected to show moderation in the coming quarters, but sticky consumer spending may keep these measures elevated longer than the Fed desires.
Labor Markets Remain Tight
Another consistent theme in Q1 of 2023 was a tight labor market. While the participation rate continued to climb throughout the quarter, the unemployment rate remains stubbornly low at 3.5%.
Businesses, outside of the tech sector, continue to be reluctant to cut employees given structural shortages in labor, and may force the Fed to continue to leave rates elevated for longer than otherwise given the inflationary backdrop.
Asset Class Analysis
Equities: Move to Under-weight
Anticipation of a Federal Reserve pivot away from its current rate hiking program has fueled an equity market rally to start the year. Despite regional bank pressures, the overall economic outlook and expectations for corporate earnings growth remain robust, supporting 18x forward P/E multiples for the S&P 500. However, we recognize that the vast majority of the returns were driven by only a handful of technology-oriented mega-cap stocks, while most constituents saw only small gains, if not losses, over the same period. We believe the broader economy is slowing as higher interest rates, and above target inflation levels weigh on profitability and strain balance sheets. Having recovered approximately half of the index’s peak-to-trough losses over the past six months, we are now recommending lightening equity exposure into this strength for those clients who are at or above target-weightings in equities. While the economy may kick the recession can another year out, valuations do not leave enough margin for error, notably as interest rates will likely remain high. Alternatively, we recommend building out Fixed Income allocations in portfolios. We expand on this in the next section, however, we take the view that in the current higher interest rate environment, the hurdle for riskier investments is also higher.
Value versus Growth: We maintain a relatively balanced approach to Value versus Growth styles, but with a slight bias to Defensive portfolios that are only modestly cheaper than their core benchmark but exhibit greater business resiliency. These managers would be more protective in a market sell-off, but lag in a market rally.
Large versus Small: We complement our Large Cap Defensive exposure with selective, active small- and mid-cap funds. Small caps tend to be more economically sensitive, so we look to be more valuation-conscious in this segment.
Domestic versus International: We maintain an overweight to Domestic stocks, based on the quality of businesses and depth of capital markets in the US. We have modestly reduced that overweighting with the addition of a Defensive International strategy. We are modestly underweight Emerging Markets.
Fixed Income: Move to Over-weight
We would look to increase client Fixed Income allocations to Over-weight via a barbelled approach of investment grade bonds (for some income generation but to also serve as an equity market hedge) and floating rate credit (with attractive income distribution in a higher rate environment and still benign default experience) to complement and diversify away from stocks. The traditional fixed income allocation is highly liquid and can be quickly reinvested into other opportunities that may present themselves in a more challenged market. Floating rate debt exposure is currently offering equity-like return potential while moving up in capital structure seniority and reducing overall portfolio volatility versus equities.
Interest Rate Sensitivity: We had extended our duration as the Fed raised rates throughout 2022. As intermediate and long-rates have since tightened, we recommend leaning shorter duration, notably as short-dated Treasuries yield around 4% while intermediate yields less. Interest rates are a hedge to economic weakness and Fed rate cuts.
Credit Quality: We seek to maintain an overall investment grade credit quality in our liquid fixed income exposures, however, would balance this positioning with illiquid direct lending and structured credit investments that exhibit strong equity-like returns despite lower volatility. We are currently limiting this high yield exposure to alternative credit strategies and private investment opportunities that are less sensitive to daily flows and mark-to-market variability.
Liquid Alternatives: Target-weight
Hedge Funds: Heightened volatility across asset classes is creating a ripe opportunity for diversified and long/short hedge funds. As traditional assets continue to remain under pressure, strategies that can take advantage of short-term pricing dislocations in a choppy market can generate more attractive returns through this challenging period.
Real Estate: We have been adding core-plus real estate opportunities, notably in residential assets for its inflation aligned properties and as a complement to stock and bond portfolios.
Illiquid Alternatives: Target-weight
Valuations are adjusting lower, following public market declines in 2022. Committed capital for opportunistic deployment over the next few years should make this vintage of fundraises highly attractive.
Secondaries and Distressed investing strategies may benefit from a slowing economy as they tend to be opportunistic buyers of good assets at discounted valuations, during a period of market uncertainty. The next couple of years may be an attractive time to be an opportunistic buyer of real estate assets that may be unsold or facing refinancing pressures.
About AJ Loughry, CFA
Mr. Loughry joined Simon Quick in the summer of 2018 following his graduation from St. Bonaventure University. As a Vice President on the Investments Research team, he is responsible for the monitoring of previous investments, as well as quantitative, qualitative, and operational due diligence on a variety of new investment opportunities. AJ frequently participates in meetings and calls with prospective and existing managers. Lastly, Mr. Loughry is a member of the Hiring Committee, where he helps to identify and interview new talent for the firm. At St. Bonaventure University AJ received bachelor degrees in Finance and Accounting, graduating Summa Cum Laude. During his time at St. Bonaventure, AJ was a manager of SIMM, a student-run investment fund with a portfolio of over $300,000. To learn more about AJ, connect with him on LinkedIn.
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