Worldwide equity markets advanced 7.3% in the first quarter as investors processed the prospect of lower inflation and interest rates. The Silicon Valley Bank (SVB) failure was perhaps the most noteworthy event during the quarter and called into question the strength of certain banks and the Federal Reserve’s appetite for further monetary tightening.
Investor turnaround in risk tolerance was evident in sector performance. More cyclical sectors such as Technology, Communication Services, and Consumer Discretionary were the strongest performers, while the winners of 2022 subsided: Utilities, Health Care, and Energy.
Underlying these strong sector performances is the market’s increased concentration of large capitalization stocks. The largest ten stocks now represent 27.3% of the overall market, compared to 24.3% at the beginning of the quarter. Two reasons explain this trend.
First, these companies have a higher sensitivity to changes in interest rates, which have come down since the SVB crisis. Part of this derives from the prediction that tightening credit conditions will slow the economy, taking some burdens off of the Fed. Concerns about the safety of deposits caused many Americans to move their cash from banks and into short-term treasuries, driving yields down. These actions manifested in the yield on the 2-year treasury, which began the quarter at 4.43% and now sits at 3.77%.
Second, large companies have better access to public credit markets to meet their borrowing needs. In contrast, credit access for riskier small and medium-sized companies that rely more heavily on banks will recede as regulators seek to stabilize the banking sector. SVB was a pillar of funding for smaller startups, and its failure had practical and symbolic implications. Practical in that there will be at least one fewer source of funding available. Symbolic in that riskier lending will again be out of favor as it was in the aftermath of the 2008 crisis.
Equity market valuations have increased during the quarter to finish at 18.6x forward earnings, above the long-run average of 16x but below the 21x multiple a year ago. With earnings expectations staying flat during the quarter, the future trajectory will depend on company results released in the coming weeks.
Investors factored significant optimism into the market rally during the quarter. However, inflation remains materially high, and customers less willing to accept price increases are pressuring margins. After a difficult year like 2022, we see opportunities to own excellent companies at reasonable prices. Many industries of the economy will still perform well in 2023. Following are our thoughts on several sectors and our positioning in place.
Energy – We decreased our exposure slightly as recession fears reduced commodity prices. A milder-than-expected winter in Europe took some demand off the table in the short term. We maintain an overweight position as the global macroeconomic environment supports a bullish outlook on oil prices based on supply declines due to the Russia / Ukraine conflict and OPEC production cuts.
Financials – We entered the quarter with an underweight position, particularly in the banking industry. Since the SVB crisis, we have reduced our exposure further. We expect bank stocks to suffer from higher regulations and tighter lending availability, resulting in lower net interest margins and profitability.
Health Care – We increased our position as the sector partially reversed its strong performance in 2022. Investors sold relatively safe names in this sector to take higher positions in more risky options. We believe there is an opportunity for outperformance in the medium term as these more stable companies have maintained strong business prospects and pricing power (evident in new drug releases and health insurance premium increases).
Information Technology – We increased our exposure but maintained an underweight position. Investors again learned how resilient larger companies can be to recessionary environments when demand for their products is resilient and recurring. Software providers remain crucial to our economy and have avoided CFO budget cuts.
Artificial intelligence (AI) and data center demand has only increased in the last few months as preliminary insights into capabilities have inspired growing excitement for future applications. One need only look at the introduction of AI interfaces like ChatGPT, Bing AI, and Google’s Bard to see the potential. Demand for new software ideas will drive the need for larger server capacity at data centers and supportive infrastructure.
Fixed Income Markets
After the Federal Reserve engineered interest rate increases throughout 2022, and another two moves this quarter to 5.0%, it faces the first major hurdle of its inflation-fighting campaign. In mid-March, the banking industry and its regulators faced the latent problem of massive unrealized losses in banks’ securities portfolios. Regulators moved in to take over Silicon Valley Bank and Signature Bank and directed that UBS acquire Credit Suisse. The somber effects of these takeovers reverberated throughout regional banks, with a severity dependent on each bank’s unrealized losses. Investors turned to the safety of U.S. Treasury securities, pushing prices up and yields down.
Congress tasked the Federal Reserve with two primary functions: conducting monetary policy and supervising financial institutions. The Federal Reserve’s Congressional mandate regarding monetary policy is to “promote the goals of maximum employment, stable prices, and moderate long-term interest rates. In addition, the Fed has established a 2% inflation rate target. The Fed strives to promote financial system safety and stability in the separate area of supervising and regulating financial institutions.
As stated above, the Fed is a year into a monetary campaign of raising rates to corral inflation. Core inflation was 5.52% in 2021, 5.70% in 2022, and is currently 5.53%. Inflation has not been transitory but instead becomes more entrenched with each passing month. The Fed should continue to raise the overnight interest rate until they have reached a level comfortably over the core inflation.
Now for the new challenge. Woven throughout monetary policy decisions are the supervisory operations of the Federal Reserve and their role in fostering the current instability. Banks exist to take deposits (liabilities) and convert them into loans or investments (assets). Managing the length of maturities in the asset-liability gap, the banker’s term for assessing interest rate risk is job one. The banking crisis during the quarter stemmed from decisions based on the mistaken belief that inflation would remain benign and interest rates would not rise appreciably.
When the Fed started raising rates aggressively, banks slowly, then suddenly, faced the prospect of holding bonds worth much less than at purchase. As the last twelve months unfolded, many wide asset-liability gaps deemed manageable with zero percent interest rates became a problem. At the same time, banks faced the prospect of paying higher rates to keep depositors from fleeing for higher yields elsewhere. For the failed banks, the gap was too broad.
Moving forward, the Federal Reserve would be wise to heed the lesson from our last great inflation period; raise interest rates to well above the inflation rate and leave them there until a point in time when you are very confident that inflation is moving back to an acceptable target range. Other shocks like our current one will come, and politicians will scream and throw fits at the effects of higher rates, but high inflation is just too insidious to tolerate.