Q1 2023 Market Perspective

The financial markets have wrestled with the reality of higher interest rates for the past twelve months. Back in March 2022 the U.S. Federal Reserve (the “Fed”) started raising the federal funds rate and became more aggressive with rate hikes as the year progressed. Faced with persistent inflation and uncertainty as to how deep the Fed will push the economy into recession, investors sold both equity and fixed income investments resulting in significant asset declines in 2022. Towards the later part of 2022, expectations began to shift as inflation declined and the Fed drew closer to the end of this current rate hike cycle. Global equities and fixed income assets rallied in the fourth quarter of 2022 and this positive momentum continued into the first quarter of 2023.

Broadly speaking, global equities and fixed income asset prices increased during the first quarter. Inflation in the U.S. has continued to trend lower, and the market now expects that the Fed will soon stop raising interest rates and will be cutting rates by the second half of the year. Heading into the year, we were encouraged by the prospect of reaching this point (where interest rates peak and inflation falls closer to the Fed’s desired target), and while market returns have been mostly favorable over the past several months, we are not out of the woods yet.

Starting with the failures of Silicon Valley Bank and Signature Bank and the Swiss government supported takeover of Credit Suisse by UBS in mid-March, the markets are now facing heightened levels of uncertainty as it relates to the possibility of an economic recession. In other words, cracks within the economy are forming and it is still too early to determine how deep this economic contraction will be. As it relates to banking security, we reiterate that our clients’ investments held with our custodians are safe and we are keeping a close eye on the situation. For additional information please refer to Schwab’s Asset Safety document.

Investors will closely scrutinize economic data as it is released, looking for insight into the strength of the consumer and how the overall economy is responding to tighter credit conditions. For most of the past year, any disappointing economic results were discounted by investors who believed a slowing economy would result in less restrictive Fed policy. Going forward, we expect that any poor economic results will be viewed as actual “bad news” by investors. Contributing to the headline risks for stocks this summer will be politically-charged negotiations on the national debt ceiling, which needs to be raised to avoid a default on government debt.

While we anticipate an uptick in market volatility for the remainder of this year, versus what we have experienced over the past several months, we reiterate that a contracting economy is a natural part of the economic cycle. Investors can prepare for constantly changing market conditions by creating an investment policy statement, which establishes your long-term objectives and overall investment strategy, and adhering to that policy through the ebbs and flows of the market cycle. In other words, plan for volatility in advance of it happening.

Q1 MARKET RETURNS

Index Returns [1]

Major Asset Class Returns in Q1 2023

FED FUND RATE EXPECTATIONS & FED DILEMMA

Almost immediately after the failure of Silicon Valley Bank and Signature Bank, market expectations of Fed policy shifted. On March 1st (see chart A) the market expected the fed funds rate to increase into the summer and hold throughout most of the year. On March 31st (Chart B) expectations shifted to include one more rate hike followed by rate cuts starting as early as June. The main factor leading to this drastic shift in rate expectations is concern over tightening credit conditions. The Federal Reserve Bank of Dallas recently released a survey report from credit unions in its district that showed worsening business activity, including falling loan volume, tightening credit standards and terms, and a sharp increase in loan costs. [2]

This presents a dilemma for the Fed which is attempting to manage the banking issue while simultaneously fighting inflation. The Fed has signaled a different path for interest rates, with Fed Chairman Powell recently stating that cutting rates in 2023 is not the Fed’s baseline expectation. While the Fed does not feel that the issues in the banking sector will be widespread, we believe the Fed will still need to at least pause future rate hikes after its next meeting. This discrepancy between market expectations for interest rates and the Fed’s guidance could be a source of market volatility throughout the year.

Chart A; March 1st Fed Fund Rate Expectations

Chart B; March 31st Fed Fund Rate Expectations

SPILLOVER FROM RECENT BANK FAILURES

We believe the recent bank failures resulted from some avoidable specific bank risks, as well as negligence in oversight from both bank management and regulators. We do not expect a widespread contagion of failure for other banks. However, light has been shed on an underlying problem banking institutions are facing, which is a significant drop in customer deposits. Even before the banking issues showed up in March, deposits at banks had been in steady decline since the Fed started raising interest rates last year. Bank clients have reduced their deposits, choosing to invest in higher yielding money market funds and Treasury bonds.

A major difference between this current banking issue and what occurred back during the 2008 Global Financial Crisis is that banks at that time were caught taking excess risk on their balance sheets (such as lending with low standards, issuing complex securities, and taking on too much leverage). Silicon Valley Bank’s problems this year, for example, stemmed from taking deposits from a concentrated group of customers and investing in long-dated U.S. Treasuries and federally-backed mortgages. Clearly Silicon Valley Bank suffered from a breakdown in management, but the investments they made in their balance sheet were not high risk. We believe the stress banks are feeling today is a byproduct of sudden financial system tightening in the Fed’s fight against inflation after decades of easy money and near-zero rates.

One clear result from all of this is that lending conditions will tighten, magnifying the downside risks to the economy.

INFLATION AND CONSUMER STRENGTH

Prices paid by consumers for goods and services eased further in February, and the Core Personal Consumption Expenditures (PCE) price index is currently at 4.6%. [3] The Fed’s efforts to reduce inflation is working, however the rate of decline is slower than the Fed would like, and inflation remains above the Fed’s target annual rate of 2%. For clarity into the Fed’s position on inflation, here’s an excerpt from New York Fed President John Williams’ recent speech: “While the Fed has taken decisive steps to bring inflation down, lags exist between policy action and their effects. It will take time for all of our inflation gears to move at a pace that takes us to our 2% target. I expect inflation to decline to around 3.25% this year, before moving closer to our longer-run goal in the next two years.” [4]

Consumer spending has been driving the U.S. economy, supported over the past couple of years by low levels of unemployment, solid wages, low costs to borrowing, high levels of savings, and a high degree of confidence broadly speaking. We anticipate consumer spending slowing this year, yet consumers have continued to be resilient. We know borrowing costs are going up, savings rates are declining, and that unemployment should slowly start to increase, all of which should cause a slowdown in spending. Investors will be paying close attention to reports on the strength of the consumer.

SUMMARY

This should come as no surprise, but the Fed has a difficult job to do as it attempts to control inflation, maximize employment, and maintain financial market stability. The Fed remains committed to restoring price stability, however the recent banking stress is likely to make their path more uncertain. As we mentioned earlier in this note, there is a big disconnect between market expectations for the fed funds rate and guidance from the Fed itself.

Investors attempting to time the market and predict the Fed’s path forward face similar challenges. The best case, we believe, is that economic data softens enough so the Fed pauses hiking rates, but not so much that it forces the Fed to cut rates in the next few months. In other words, if the economy is contracting worse than expected, that should ultimately be a short-term negative for stocks. If the Fed stops raising rates, inflation comes down, and economic data is stable, then market strategists will once again start calling for a “soft economic landing”, which should ultimately be positive for stocks.

The most productive course of action, especially during times of market uncertainty, is to remain committed to your long-term investment strategy by staying properly allocated to maximize your returns relative to an appropriate amount of risk for your plan. To do this, we need to make sure that we remain current with any updates to your financial situation, as we actively manage your strategies and execute on your behalf.

APPENDIX

Chart A: 2023 Total Return of Major Asset Class Indexes

1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 – https://www.dallasfed.org/research/surveys/bcs/2023/bcs2302
3 – https://tradingeconomics.com/united-states/core-pce-price-index-annual-change
4 – https://www.newyorkfed.org/newsevents/speeches/2023/wil230331

IMPORTANT DISCLOSURE:

Hightower Altium Holding, LLC (“Altium”) is an SEC registered investment adviser with its principal place of business in the State of New York. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of Altium, please contact Altium or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

The information contained herein is provided for general informational purposes only, reflects the opinions of Altium which may not come to pass, and should not be construed as personalized investment advice. This newsletter contains certain forward-looking statements that indicate future possibilities.

Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that the views and opinions expressed in this newsletter will come to pass. Additionally, this newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore. Information presented herein is subject to change without notice.

The performance results presented herein simply reflect the performance of various benchmark indices over a period of time and do not represent any actual performance results of Altium. Past performance is no guarantee of future results and there can be no assurance that any particular strategy or investment will prove profitable.  Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index. The figures for each index reflect the reinvestment of dividends, as applicable, but do not reflect the deduction of any fees or expenses, or the deduction of an investment management fee, the incurrence of which would reduce returns. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. Bonds and fixed income investing involves interest rate risk. When interest rates rise, bond prices generally fall.