The economic and financial landscape has changed dramatically over the past weeks due to the banking crisis that began with the failure of Silicon Valley Bank and concerns about the stability of mid-size regional banks, which have increased volatility in financial markets.
There could be lasting economic consequences with financial market conditions having tightened considerably in recent weeks. Credit growth to the non-financial sector could downshift, exerting headwinds on U.S. GDP growth in coming quarters. Lingering uncertainty should keep credit spreads wider in the coming weeks and months, and many banks could tighten lending standards, at least in the near term.
U.S. real GDP is expected to contract at least 1.0% later this year and into early 2024. Businesses are expected to hold back fixed investment spending in coming quarters and will likely start downgrading hiring plans. A vicious cycle could take hold in which tighter financial conditions lead to slower growth, further monetary tightening, then even slower growth, and so on.
Although a mild recession in the year's second half has remained the most likely outcome, several positive developments have boosted the odds that the economy could avoid a recession. First, February's solid jobs report indicates that the labor market has remained robust. Second, inflation has receded at a pace that is faster than previously anticipated. In addition, there have been tentative signs that wage growth, an underlying driver of prices in the labor-intensive service sector, has begun to moderate. Another reason for cautious optimism is that easing inflation and solid income growth would improve consumer purchasing power.
To the extent that the underlying trend in economic activity is softening, the economy needs to weaken more to end inflation quickly. The ISM services index has shown that activity expanded continued to expand in March. Manufacturing activity continued to lose steam but at a reasonably gradual pace. There are still some rocky times ahead for the manufacturing sector. The unwinding of pandemic-era spending that disproportionately benefited goods and higher financing costs are still headwinds to demand.
The solid jobs market is keeping consumers feeling upbeat about current conditions. However, a drop in consumer confidence has signaled some caution ahead. Yet, sticky inflation and climbing interest rates have cast gloom over the future.
The weariness of the elevated rate environment has been on display with housing data. Builders continued to curtail development. While pending home sales jumped at the beginning of the year, helped along by the slide in mortgage rates that began mid-November, mortgage rates have climbed a bit recently as stronger-than-anticipated inflation, jobs, and spending data have pushed up market expectations for further Federal Reserve policy tightening. Mortgage rates are expected to trend lower later in the year as the end of Fed tightening comes closer, which, along with some further easing in home prices, should help improve affordability.
January through March provided a very eventful quarter of market behavior to say the least! Two Federal Reserve rate hikes, crises in the banking sector, and concerns about a possible recession on the horizon could not impair a strong rebound in equity and bond markets after a difficult 2022. After a few months of relative market tranquility, volatility skyrocketed in early March with the collapse of Silicon Valley Bank. However, as authorities rapidly stepped in to put their “finger in the dike” of the banking system, markets quickly settled down. More than anything else in Q1 investors seemed more focused on the likely end of the Fed’s rate hiking cycle and less so on the deterioration in corporate earnings growth which began surfacing in Q4 of 2022.
Both stocks and bonds gained ground in Q1 despite surging but temporary volatility that began two-thirds of the way through the quarter. The broad U.S. equity indexes finished March on a positive note and for the quarter the large-cap S&P 500 posted a 7.5% return, the Russell Midcap was up 4.0%, and the small-cap Russell 2000 gained 2.7%.
Growth stocks far outpaced Value stocks, resuming their recent performance dominance in March and for the full quarter (in part due to the large percentage bank stocks constitute in the Value index). For all of Q1 large, mid, and small-cap Growth stocks dramatically outpaced their Value counterparts reversing a performance trend that was a hallmark of 2022.
International equities also posted positive returns for March and Q1. Returns were more or less on par with broad U.S. equity markets. In Q1, the MSCI All Country World Index ex-U.S. was up 7.0%, the MSCI European, Australian, and Far East Index was up 8.7%, and the MSCI Emerging Markets Index was up 4.0%.
The bond market had a turnaround in Q1 after providing an uncharacteristic sea of red ink in 2022 due to rapidly rising interest rates across the maturity spectrum. The bond market in Q1, sensing the end of the rate hiking cycle and anticipating a recession in the coming quarters, rallied on the prospects that inflation will also continue to fall as will interest rates. The Bloomberg U.S. Aggregate Index was up 2.5% in March and 3.0% for Q1, the High Yield Index gained 1.1% in March and 3.6% for Q1 while the Global Aggregate ex-U.S. was up 3.7% in March and 3.1% for all of Q1.
The outlook for stocks remains uncertain given the present concerns about the fragility of regional and smaller banks and the beginning of what appears to be a trend of declining corporate earnings performance. In addition, the U.S. seems headed into what is likely to be a period of slower economic growth if not an outright recession. The stock market does not like uncertainty as recent volatility attests. Given this backdrop, stock valuations remain somewhat elevated from historical standards with much of that being driven by a relatively small handful of well-known mega cap Growth stocks which represent a surprisingly disproportionate share of the overall capitalization of the broad stock market. These same stocks took a beating last year.
However, the outlook for bonds has brightened since last quarter largely due to the likelihood that the Fed is closer to the end of its rate hiking cycle, inflation is coming down, and now bonds actually offer a respectable coupon rate after years of ultra-low interest rates.
There continue to be downside risks to the capital markets which should be kept in mind as 2023 progresses. Those risks include the Fed possibly overshooting their rate increases, a deeper than-expected recession occurs, more stress in the banking system emerges due to the industry’s deposit level declines, an increase in credit defaults as the economy slows, and of course a possible escalation in the conflict in Ukraine with its potential impact on the prices of oil and commodities.
A longer-term view of markets suggests the tailwinds stock and bond investors enjoyed for the past decade or more including massive fiscal stimulus as well as declining and ultra-low interest rates will not resurface any time soon. Securities’ values are more likely to be driven by the organic operational successes of businesses and not help from the federal government. That will likely result in market returns being lower than in the recent past.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a December reading at the 25th percentile (data series from January 1957 to March 2023.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity in February registers at the 61st percentile (data series from April 1979 to February 2023).
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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