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It has been a very eventful quarter. The year started with hopes that we may avoid or see only a shallow recession. As a result of slowing economic growth coupled with the retrenchment of the banking sector in the wake of several bank failures, a recession has become more probable.
While it appears that regulatory failure and management oversight were the main issues, the regional banking crisis is more nuanced than that. In the last two years, deposits at banks have doubled due to stimulus payments and market appreciation. Meanwhile, interest rates have increased significantly causing the bank’s investment portfolio bonds to lose value to levels below the deposits on hand. This caused an asset/liability mismatch. The speed of interest rate increases has seemingly caught many banks unprepared. With over 60% of people in the U.S. using mobile banking and having the means to transfer money online helped accelerate withdrawals. This left us concerned about the ripple effect a banking crisis could have on the economy.
The Federal Reserve stepped in to backstop the banks by purchasing bank held government and treasury bonds at face value. These bond purchases allowed banks to raise cash to cover deposits. While not an explicit guarantee, it has helped provide support for the banks. In the last few weeks, the Federal Reserve has used over $300 million of its balance sheet to do so. The markets rebounded in late March on the news of the support to banks.
As a result, banks will now hold on to more cash, lend out less and be generally less profitable. Tighter lending and credit markets will cause the economy to slow down. We expect continued shakeout in the banking sector with the larger banks taking share from both small and medium sized banks.
After several years of significant hiring by all the major tech firms, most are now having to reduce their headcount given slowing sales. On the positive side, we are seeing rapid developments in artificial intelligence (AI). Microsoft was an early investor and adopter of ChatGPT, an AI tool used to answer questions for people in search engines, which we believe has given it a first mover advantage. Many other technology firms are quickly racing to develop their own AI tools. These cost cutting measures plus the excitement around AI has led the technology and communication services sectors to outperform.
Source: FactSet Financial Data and Analytics
U.S. Equity Markets
Despite high levels of volatility over the quarter, equity market performance was better than expected. The quarter began strong as the hardest hit stocks of 2022 rallied the most. As we entered February, Fed Chairman Powell indicated they were going to continue to raise interest rates and they would stay higher for longer. This dashed the hopes of many investors who believed that the Fed would pivot and start cutting rates, which resulted in the markets selling off. In March we saw a banking crisis that resulted in three major banks failing and put others in jeopardy. This spurred the concern that we are now headed for a recession causing other cyclical parts of the market, like energy and materials, to sell off. However, with the Fed stepping in to shore up the banks, it allowed for a relief rally at the end of the quarter.
The technology and communication services sectors outperformed, while energy, utilities and financials sectors performed the worst. Despite all this, the Nasdaq was up 17% and the S&P 500 was up 7.5%. Meanwhile, the Dow Jones, which has larger weights in the financials and energy sectors, was slightly up at 0.9%. Small Cap stocks were hit the hardest, but then rebounded ending is positive territory (+ 2.7%) for the quarter.
Source: FactSet financial data and analytics
U.S. Fixed Income
Since February, the front end (or 12 months) of the Treasury yield curve has steepened as a result of the Fed interest rate increases. Farther out on the curve, interest rates have declined on the speculation of a recession. This has caused price appreciation/positive performance in bonds, especially longer dated bonds. 
Credit spread between corporate and treasury bonds have been widening. Credit spreads typically widen when there are credit concerns and increased potential for default. Credit spreads were fairly tight and did not indicate a recession until the recent banking crisis.
The commodity markets are anticipating a recession with demand decreasing. Oil prices have fallen from $80/barrel to $75/barrel over the quarter. We don’t believe there will be a massive sell off in oil given that U.S. oil producers have been limiting production. Also, with China re-opening post Covid, we think there is demand. We have seen commodities increasing in two cases. First, copper prices have been increasing due to global demand for more electric batteries and limited supply of copper. Secondly, due to the global banking crisis, gold has been increasing as a safe-haven asset.
Inflation peaked in June 2022 and has been steadily falling each month since then. The most current Consumer Price Index (CPI) reading was 6% annualized. While the easy deceleration has happened, the challenge becomes getting the rate back to the Fed target of 2%. Inflation remains sticky in many parts of the economy, most notably wage growth. Goods inflation has fallen while services inflation has continued to increase. There have been many reports about the airlines and railroads having negotiated higher wages, and retail stores have also increased wages to remain competitive. To get rid of high inflation, demand needs to fall. That usually occurs during a recession.
Interest Rates/Fed/U.S. Economy
Given the persistently high inflation, the Fed has been focused on raising interest rates to bring inflation down. Since March 2022, the Fed has increased interest rates nine times, bringing the rates from essentially 0% to 4.75% during that period. This has been one of the fastest periods of interest rate increases we have seen in recent history. Historically, there has been a lag effect between raising interest rates and how the economy reacts. We have just started to see the economy slow down. As mentioned before, Chairman Powell wants his legacy to be as an inflation fighter. To bring inflation closer to the Fed’s mandate of 2%, interest rates would need to continue increasing. Given the banking crisis and level of national debt, the Fed is walking a tightrope. Investors are hoping that the Fed pauses or even cuts interest rates by year end.
The Treasury yield curve has been inverted over this period, which historically has indicated a recession 12 to 24 months out. Usually, the yield curve reverts when the Fed starts to cut interest rates.
Economic data continues to soften. The Purchasing Manager’s Index (PMI), which measures manufacturing activity, continues to be in contraction mode with a reading below 50. Retail sales in February declined by 0.4% month over month. Existing home sales, which is facing over 7% 30-year fixed mortgage rates, has declined 12 months in row. The only area that continues to be supportive is the jobs picture with employment remaining fairly tight. However, with more economic pressures we expect that job layoffs will pick up.
With China reopening since lifting the zero Covid policies in December, it has seen a strong uptick in services and domestic consumption. However, the manufacturing rebound is struggling due to the external demand. The latest PMI reading was 50, down from the prior month, and just on the cusp between expansion and contraction. China is continuing to deal with its indebted real estate sector and has been trying to implement reforms to turn it around. Despite these challenges, IMF is expecting China to grow GDP by 5.2% this year versus only 3% in 2022.
Europe is facing much of the same conditions as the U.S. with high inflation levels and having to raise interest rates quickly to reduce inflation levels. Europe saw inflation at 8.5% annualized in February and the European Central Bank raised interest rates by 0.50% in March to help bring down inflation levels closer to its target of 2%. The U.K. had 10.4% annualized inflation in February and the Bank of England also had to raise interest rates in March. While goods inflation is falling in Europe, the service side inflation remains sticky. As we saw with the U.S. financial sector, European banks have also faced pressures. Credit Suisse, one of the oldest Swiss banks, quickly unwound after Silicon Valley Bank and Signature Bank failed, and UBS stepped in to buy it out as a steep discount. Everyone is watching to see how other European banks fare.
We believe economic conditions will continue to tighten. The effects of higher interest rates and inflation are just taking hold now. This, in conjunction with the pull back on lending should slow the economy even more. We remain cautious on some of the cyclical parts of the market. We have increased cash levels in the portfolios reflecting that valuations are not exactly inexpensive. Given the economic outlook and growth we don’t believe the market has fully priced in a recession. Our focus at Anchor remains protecting client assets and providing a smoother ride over market cycles.