Quarterly Economic Review: First Quarter 2023

The first quarter of 2023 saw strong gains for stocksand bonds. Investorsentiment was fickleduring the quarteras optimism over the resiliency of the U.S. economywas tempered by concerns that tighter financial conditions could deraileconomic growth. In early March, the failure of two U.S. banks and the collapse of Credit Suisse, one of Europe’slargest and oldest banks, led to a pullback, but the stock market reboundedfollowing aggressive governmentintervention. The bond markets have been less sanguine about the potentialthreats to the U.S. economy. The U.S. Treasuryyield curve remained sharply inverted, a recessionary signal that suggestsinvestors believe the economy will weaken. Falling bond yields and an attractive level of current incomeboosted fixed income returns. The retreat in energy prices was a drag on bothcommodity and stock prices in the sector.

In the U.S.,equity sector performance was mixed. U.S. large cap stocks, particularly in thetechnology and consumer communications sectors, were once again dominant despite mixed earnings results.Technology stocks rose by an astounding 22% for the quarter. On the other hand, sectors with weak earnings growthexpectations, notably energy, and health care, declined. Financials, hard hitby the banking crisis, lost 10% duringMarch resulting in a loss for the quarter. The outperformance of Europeanequity markets, which began last October, continued into the new year as fears of an energycrisis in Europeabated and businessactivity picked up. Emerging marketslagged developed marketsin response to tensions betweenthe U.S. and China.

Recent economicdata has been unexpectedly robust. U.S. GDP growth in the fourth quarter oflast year was an annualized 2.9%. The consumerhas remained resilient, supported by a solid labor market but thepersonal savings rate has declined sharply, and credit balances are rising.Recent jobs data has been more robustthan expected although job openings have declined, and wage gains are slowing.Inflation remains much higher thanthe Federal Reserve would like although it is trending downward. One area thathas demonstrated weakness is housing where a recent uptick in mortgage rates is squeezingaffordability into the important spring selling season.The dearth of homes for sale will limit transaction volume. The two failed U.S. banks, Silicon ValleyBank and Signature Bank, were vulnerable due to poor risk management andconcentrated exposure to speculativeinvestments. Overall U.S. banks are well capitalized with sufficient liquidity,but the risk of financial instability has triggered a contraction in lendingactivity which likelywill lead to a drop in businessand consumer confidence.

U.S. equityvaluations are elevated for this late stage in the economic cycle whenvaluation levels typically approach lower points. The concentration of the U.S. stock market in the technology sectorand the recent surge in stock prices are also concerning. International equity indexes are more diversified with morefavorable valuations and have the potential for currency support if the U.S.dollar continues to trend downward.With taxable bonds yielding 4.4% at quarter-end and municipals yielding 3.3%(tax equivalent yield of 5.5% based on the maximum federal tax rate),high quality publicfixed income is for the first time in many years a reliable sourceof income. The risks from higher interestrates and a potentialeconomic slowdown do not appear to be fully reflected in the bond prices ofmore vulnerable borrowers. At the same time, the rapidly expanding private credit sector offers yields over 10%,higher than the long-term expected returns on equities, typically with lessvolatility than public bonds. Tighterfinancial conditions and geopolitical threatsare likely to keep marketvolatility elevated. Investorswould be well-served to position portfolios based on a forward view of assetclass returns and risks.

Click below to read our full Quarterly Investment Newsletter for Q1 2023.