Markets in Review
The economy and stock market head into the second quarter of 2023 dealing with both headwinds and tailwinds after an unexpectedly strong start to the year. It was anything but smooth sailing though. A potential banking crisis tainted the first quarter, a great divide between the Federal Reserve – which seems firmly committed to its inflation fight, investors who stubbornly expect interest rate reductions before year-end, and a tough outlook for corporate earnings.
Between inflation concerns and expectations for what is probably an inevitable hard-landing recession, combined with the failures of multiple banks temporarily sparking fears of another 2008-style financial crisis, investors had a lot of bad news to digest. However, the markets appeared to struggle forward through all the negative headlines.
However, there is still room for caution as the majority of market gains in the first quarter were due to the performance of just a handful of mega-cap growth technology stocks like Apple, Microsoft, and Nvidia. The Dow Jones Industrial Average squeaked out a 0.38% gain for the first quarter. In contrast, the S&P 500 rose 7.03%, and the tech-heavy NASDAQ rocketed up 16.77%, largely on the backs of the aforementioned large-cap technology names. For example, Apple and Microsoft, which account for approximately 13% of the S&P 500, returned 27% and 20% for the quarter respectively. This means that out of 500 stocks, those two stocks alone contributed over 3% of the S&P 500’s 7.03% quarterly return. In other words, the first quarter was anything but a broad-based market rally.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, rose 2.34% for the quarter.
Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited significantly worse returns relative to growth-based investing this quarter. Like the Dow Jones Industrial Average, the Russell 3000 Value Index rose just 0.32% for the quarter. The Russell 1000 Value Index and Russell 2000 Value Index performed similarly, returning +0.41% and -1.24% respectively. Value-based investing has clearly suffered so far this year as the Growth stocks that were destroyed in 2022 came roaring back … at least for now.
Investors continued to deal with the fight against inflation and tighter monetary policy this quarter, including two more 0.25% interest rate hikes following the 0.75% and 0.50% rate hikes from Q4 of last year. This sent yields – which move in the opposite direction of prices – higher during the beginning of the quarter as 10-year and 2-year Treasury bond yields rose above 4.00% and 5.00% respectively. The 2-year yield hadn’t seen those levels since right before the Great Recession in 2008-2009.
Furthermore, the beginning of the quarter saw continued widening in several Treasury yield curve inversions where long-dated rates fall below short-dated rates. Specifically, the “2s-10s” curve which measures the difference between the 10-year and 2-year Treasury bond yields dropped as low as -1.10% before the banking crisis (or turmoil) began, at which point the inversion reversed as high as -0.26%, signaling increased expectations for Fed rate cuts in the not-too-distant future. However, as the banking fears eased somewhat, the 2s-10s curve dropped back to finish out the quarter at -0.56%. With the backdrop of less drastic monetary tightening and increased demand for “risk-free” bonds paying higher yields than we have seen in some time, the Bloomberg US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, rose 2.96% for the quarter.
Unstable financial systems can either find a way to heal or continue to evolve into more unstable systems. The outcome largely depends on the actions taken by policymakers, regulators, and market participants. In the last couple of decades, policymakers have extended the limits of financial engineering beyond any historical precedent. Maybe they have a few rabbits to pull out of their policy hat for one last gasp at fixing an ailing system?
If policymakers and regulators take effective measures to address the root causes of instability and restore market confidence, the financial system can heal and become more stable. For example, after the Great Financial Crisis of 2008-2009, policymakers implemented a range of reforms aimed at improving financial regulation and increasing the resilience of financial institutions. These reforms helped to restore confidence in the financial system and reduce the likelihood of another crisis. Unfortunately, the extreme and unprecedented policy response after the Great Financial Crisis led to massive deficit increases. Massive deficit increases tend to lead to higher inflation, higher taxes, slower economic growth, and a litany of negative long-term consequences for the economy and financial system.
Will the Rubber Band Snap?
The 2020 Pandemic did not help and basically forced policymakers to continue their extraordinary policy action with unknown consequences stretching the system’s rubber band even further. The culmination becomes a cycle of boom and bust, with periods of rapid growth and optimism followed by sudden collapses and downturns. It is important to note that financial systems are complex and dynamic, and predicting their future trajectory is challenging under normal circumstances. However, predicting what policymakers will do next is difficult because unforeseen cracks and fissures in the financial system, like the recent banking crisis, can change policy response dramatically.
What are the long-term consequences of massive debt expansion in the U.S.? There is no definitive answer to this question.
However, some potential long-term consequences could include:
Increased interest payments: As the U.S. government continues to borrow more and more money, it may become more expensive for the government to service its debt. Consequence? Higher interest rates and increased interest payments could strain the federal budget and limit the government’s ability to fund other programs and initiatives.
Reduced economic growth: High levels of debt can also be a drag on economic growth, as they can crowd out private investment and increase uncertainty about the government’s ability to repay its debts. Consequence? Reduced consumer and business confidence, lower levels of investment, and slower economic growth over the long term.
Inflation: Another potential consequence of massive debt expansion is inflation, as the government may choose to print more money to pay off its debts, leading to a devaluation of the currency and rising prices for goods and services.
Fiscal crisis: In the most extreme scenario, the U.S. government may be unable to service its debt and could face a fiscal crisis, potentially leading to default or a downgrade in the country’s credit rating. This could have significant consequences for the global financial system and the U.S. economy as a whole.
Investors Don’t Like Uncertainty
It’s worth noting that while these are all potential long-term consequences of massive debt expansion in the US, they are not inevitable. There are a variety of policy solutions that could help address the issues.
Financial market participants are struggling to answer the following questions as we all attempt to determine whether there might be a sustained bull or bear market on the horizon:
Will inflation cool and move towards the Fed’s target of 2.0%?
Will the economy fall into recession? How deep or severe will it be?
Will corporate profits continue to decline over the next few quarters as higher interest rates challenge the economy?
Will the Fed stop rate hikes or even pivot to reducing rates to support the economy near-term?
What Comes Next?
Everyone is struggling to figure out what comes next. Bull market, bear market, or simply an extended period of volatility and uncertainty.
Investors have become conditioned to ignore almost everything but the Fed’s interest rate policy. Stock valuations are still high and are unsupported based on long-term earnings trends. Lending conditions have become tight and will likely get even more restrictive, leading to less growth. Debt limit negotiations are likely to be contentious. Additional fiscal stimulus is unlikely and has already exacerbated the uncontrolled growth in government debt, causing financing costs to skyrocket.
Our best guess is that market conditions remain generally negative and volatile until uncertainty fades and the Fed decides to pivot to lower interest rates. The good news for investors is the Fed may start to pivot by year-end, or shortly thereafter. Confirmation of current market expectations for a pivot should unleash a sustained move to the upside, although it will still depend on the depth and duration of the expected recession. Until then, we will likely experience quite a bit of downside volatility with brief periods or bursts to the upside as investors attempt to read the Fed’s tea leaves. At WBI, we believe the most important aspect to investing is to protect capital. Over the past five years, the company has continued to invest heavily in our investment and wealth management technologies. Our mission is to provide investors with better investment performance and a more successful client experience.
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
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