Summary, First Quarter of 2023:
The first quarter of 2023 brought turbulence as markets attempted to rebound and the Federal Reserve (the Fed) continued to clamp down on inflation by rapidly raising interest rates and selling bonds (commonly referred to as “quantitative tightening”). Meanwhile, a banking scare occurred as Silicon Valley Bank and other banks failed during a rapidly increasing interest rate environment, stoking fears of another global financial crisis. In a twist of good news, China removed its “Zero Covid” policy, which helped heal supply chains and remove some inflationary pressure. Inflation remained high but has shown signs of cooling.
Inflation is moderating as the Fed continues its rate-hiking regime. While the economy is on the path to a more “normal” state, inflation isn’t anywhere near where the Fed would feel comfortable ending its rate hikes. Ironically, the recent bank failures have increased bank lending standards, which has a cooling effect on the larger economy and is believed to be worth 1‒2 rate hikes on its own. The futures market expects the Fed to raise rates one last time in May, then pause and potentially start cutting rates. The combination of rate hikes, supply chains healing, and increased banking standards may be enough to get inflation under control. If so, the Fed could even start lowering rates later this year or early next year, but that will depend on inflation. Unemployment has remained stubbornly high although signs of lower wages and employment have begun to appear. Altogether, a slowdown in the economy is inevitable and may lead to recession, but we believe it would be a short and shallow recession.
Stocks have rebounded a bit in 2023 but appear to remain fairly valued, creating opportunities in some areas. As earnings forecasts typically are for the coming 12 months, the stock market tends to look ahead about a year. Some market participants have been betting that the Fed will stop their rate hiking earlier than they anticipated, which has created volatility both on the upside and the downside. As the stock market continues to attempt to rally, it may do so in fits and starts, because it will be tested by weakening economic growth in the short term. A durable rally likely won’t start until a turnaround shows up in leading economic indicators. In business cycle terms, we are heading into the “contractionary” phase, which precedes the expansionary phase.
In the fixed income world, it’s important to note that as the Fed raises or lowers “rates,” it is only raising or lowering the “Federal Funds Rate,” which is the rate at which banks and other depository institutions lend to each other. By raising or lowering the Fed Funds rate, the Fed directly impacts the short end of the yield curve. As short-term rates increase, the yield curve temporarily inverts as short-term rates grow higher than long-term rates. This has the effect of making short-term bonds more attractive than long-term bonds. This dynamic goes against investment theory, which states that, all things equal, an investor should be compensated more if they are tying their money up for longer. Thus, this situation can’t last forever. Additionally, it also makes it harder for banks to make money, thereby decreasing lending and slowing economic activity. The amount of business activity that flows through banks is widely underestimated, and as the economic environment becomes less advantageous for banks, they decrease lending, which slows economic growth. This dynamic can’t last forever either, and it isn’t intended to. It is a temporary, necessary evil when inflation gets out of line, like it is today. The good news is that this situation will eventually end. In the meantime, we have sought to take advantage of the environment and shifted our fixed income allocations to be short-term and high-quality in nature.
Until next quarter,
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