Q1 and Q2 2023: Where We've Been, and Where are We Going?
2022: What happened?
Trying to sum up 2022 in one word could potentially conjure up terms such as painful, frustrating, and even disastrous. Recalling profitable investing strategies in 2022 is difficult. There were very few, if any at all. Equities saw major indexes bleed off well into the double-digit percentages (e.g., Nasdaq -33.1%).1 This was largely due to the Fed’s extremely large and frequent rate increases, reacting to screaming hot inflation, and foreshadowing an imminent (arguably: present) recession. We saw a total of 7 rate increases throughout the 2022 calendar year, beginning in March of 2022, ranging from 25 to 75 basis points. This took the Federal Funds Rate from 0.25% all the way up to a lofty 5.00%. This put not only the market indexes into a tumble, but also real estate, lending, new construction, and a slew of other industries and sectors.
As the old adage holds true of “rates go up, bond prices go down,” we saw the fixed income market also performing extremely poorly. The Morningstar US Core Bond Index shed 12.9% in 2022.2 With the Fed Funds Rate skyrocketing, bonds had no choice but to trade lower in terms of their market price. The relationship between par/face value and price is such that:
- If the bondholder (investor) holds the bond until maturity, they receive the full par or face value of the bond at issue.
- If the bondholder (investor) sells the bond prior to maturity, they receive the current market price for the bond. It could be more or less than the par/face value at issue.
Those selling their bonds into a high and steadily-increasing rate environment tend to not fare well. Often it becomes a strategic decision. If the holder deems the amount lost off par value is less than the sum of a higher yield to maturity on another bond, it may be a beneficial strategic move. When the sale is borne from necessity or an emergency such as a liquidity need, the result is typically not favorable. This would be primarily how the Q1 run on the banks of 2023 came to fruition. We will touch more on that later.
Thus, we had a market “vacuum” of sorts, in which both stocks and bonds performed poorly in unison. As mentioned above, the Nasdaq performed the worst of the 3 major indexes. Comprised mostly of tech and highly-leveraged, debt-heavy organizations, the cost to borrow and grow became quite costly. Many of these companies are fueled by research and development, business expansionary strategies, and heavy cost of capital. When we think of the difference between interest charges on a 3% loan and a 6% loan on millions, even billions, of dollars, the financing cost is quite high. Combine that with a company trading with a high P/E (price to earnings) and substantial debt-to-equity (several/many Nasdaq-listed companies) become the target of downward speculation leading to poor performance. Earnings suffer, forward outlook suffers, leading to reduction in share price from selling. The Dow Jones Composite Index, made up of extremely large and well-capitalized companies, did comparatively better at a -8.8% return for 2022. Companies more well-capitalized and flush with cash often weather increasing rate environments much more effectively. The S&P 500 Index fell in the middle with a -19.64% return.1
Among other catalysts definitively weighing in on the market in 2022 were the onset of the war in Ukraine, speculated higher energy prices, and a “contrarian” labor market pushing inflation ever higher. These all played in to what could be categorized as a frustrating year for the US economy and markets, as well as globally. Will this continue into 2023? We will look to address that as we move forward.
Q1 2023: A run on the banks
It was déjà vu all over again. Seeing the news of Silicon Valley Bank’s (SVB) collapse seemed like an all too familiar feeling to 2008: The Great Recession. However, was this the same? Not quite. What occurred in 2008 stemmed from bad policy as it pertained to sub-prime mortgages, kicking off a fateful series of events that would lead to an astounding retraction in GDP of -4.3% in one quarter and roughly -20% on all major stock indexes.3 What happened to Silicon Valley Bank and subsequently, Signature Bank of New York, stemmed from something far different.
While some individualistic poor business decisions came into play (large write-offs losses on certain investments, fruitless ventures, etc.)4, the majority of the reason could be attributed to the systematic and interest rate-related factors present in the economy. By August of 2021, most banks were flush with cash deposits from customers, fresh off government-issued stimulus. The majority of clients/customers, ripe with cash, had no need for loans.5 Banks, needing to generate returns in lieu of revenue from account holder loans, bought government bonds. Government bonds, backed by the US Government, are considered a safe means to generate yield on account holder deposits. In fact, the government requires banks to use this as means to generate conservative yield, to some extent. As aforementioned, we know that when interest rates rise, bond market prices go down. We also know that if held to maturity, the holder will receive the full face/par value back. However, what if in an emergency situation the holder needs to sell those bonds prior to maturity to meet urgent needs? Enter the concept of “cash sorting.”
Cash sorting, quite simply put is: Moving cash or near risk-free assets from a lower yielding account or security to a high or higher yielding account or security. For example, a customer at the bank has $100,000 in deposits earning 0.15%. They soon find they can earn 3.5% or more on a short-term treasury bill, secondary market CD, or even a money market fund with their financial advisor or online brokerage outfit. At a spread of 3.35% (or roughly $3,350 annually) the average investor finds their cash or near risk-free assets are going to yield better for them somewhere else. They then “sort” or move their cash out to other higher yielding investments. SVB, holding a large amount of long-term US debt that lost value since purchase due to skyrocketing rates, was forced to realize losses by selling those bonds to cover relentless customer outflows to higher yielding accounts and securities. In the end, liquidity became tight, news spread like wildfire (via social media), and we began to see regional and local banks come under fire. SVB failed and we were left with our first bank failure/takeover in the current recessionary environment. Signature Bank of New York met the same fate on the Sunday following.
Q2 2023 and Beyond: Are we there yet?
We continue to see an inflationary situation, both domestically and worldwide. However, the Fed has indicated that the frequency and size of rate hikes may be on the downtrend; but also making known they will continue if “necessary.”6 In March we saw inflation cooling in a somewhat anticipated manner. The CPI numbers for March of 2023 came in at 0.1% increase over month and at 5% over prior year. Compared to the 0.6% increase over month and 6% over year for February, this was a welcomed bit of news.7 The target for the Fed remains near 2%, which we are far off at this point. With that being said, the desired result is coming forth; albeit, slowly. CPI and PCE numbers tend to be a better real-time indicators of policy effectiveness than lagging indicators. This we consider a step in the right direction vs. mostly steps in the wrong direction we saw in 2022.
The labor market continues to remain somewhat of an enigma in its reaction to inflation. We are continuing to see strong job numbers with low unemployment. Powell has firmly indicated he and the Fed desire to see the labor market weaker. The logic is that less jobs equates to less workers, higher unemployment, and less dollars available to spend and drive inflation higher.8 Yet, even after 7 rate increases in one year that took the rate to 5%, we are still seeing a strong labor market. There are simply too few workers, too many jobs, with minimum wage levels increasing average pay. Even as recent as March, we saw an unexpected 0.1% drop in the unemployment rate. The silver lining here is job numbers are a lagging indicator.9 What this means is the deflationary tactics may be taking affect, just not manifesting in the job numbers at this time. We may need to wait one, two, or more quarters for this to manifest in the labor market. The labor market finally weakening would indicate that we are at least moving into the bulk of the deflation cycle.
Oil remains the true dark horse of the economic landscape. Prior to the onset of the war in Ukraine, we saw oil trading in a reasonable range of $50 to $60 per barrel (WTI Crude). It reached a high of nearly $106 per barrel in April of 2022. Speculation was even higher, with some analysts predicting it could go to $120 or $130 a barrel. Yet, over a year later, we now find ourselves back with $70-$75 per barrel oil. The market has completely absorbed sanctions, withholdings, and redirection of oil from Russia.10 In the end, the effect from the conflict in Ukraine was a net zero for energy here in the USA. The two catalysts we feel could upset the trend are the re-opening of China from COVID lockdowns and OPEC production cuts. China’s consumption could rise more than 1 million barrels per day, coming out the other side of COVID lockdowns.11 Combine this with OPEC surprising the world in the first week of April with a 1.1 million barrels per day cut, it sets up a potentially bullish (increasing price) forecast on oil.12 For the final trifecta we would add that the northern hemisphere is coming into the summer travel season as the southern, moves into their winter. This is a catalyst that Powell and the Fed will be watching closely. Gas potentially going over $4 per gallon as a result of higher crude prices will without a doubt have an inflationary effect. The Fed is watching (and likely, praying) that does not become a factor.
There are reasons to remain cautiously optimistic. We are seeing much more encouraging CPI and inflation numbers. The job numbers and unemployment have not slowed, but once again, they are lagging rather than current, indicators. Oil does continue to remain rather low. A sharp increase in oil prices could negatively affect the Fed’s projected trajectory in taming inflation; which at the moment they conveyed is one more 25 basis point increase for 2023.13 The key will be continued watch of regional and local banks. First Republic Bank, as of the day this article is being published, has been seized by the FDIC. They were subsequently auctioned off with JP Morgan emerging as the high-bidding winner.14
The Fed will continue to watch this closely and will likely factor it into their policy decisions to tame inflation moving forward. They have already broken something and do not want to completely shatter it to pieces. Our belief is it would be foolish to expect a rate decrease this year and actually, would be disastrous if by some chance it did happen. With that being said, there is a strong possibility of a pause in increases which could lead to some growth within the equity markets. The overriding theme remains need for liquidity, diversification, and cautious investment or reinvestment into equity markets.
No, we are not there yet. There might be even the faintest glimmer of light at the end of the tunnel, though.
Author: James M Korzik, co-founder and CCO of First Light Wealth Advisors, LLC
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