April 3rd, 2023
We began the year with a mismatch in expectations between the general market sentiment and the Federal Reserve (“the Fed”) regarding the projected path for interest rates. The Fed had penciled in a target terminal rate between 5-5.25%, which it planned on holding for the remainder of the year. The market’s expectations, reflected in Fed Funds Futures, were that the Fed’s aggressive rate hikes would push the economy into a recession prior to year’s end, forcing the Fed to cut rates by September.
Much has changed in the first three months of the year. Fed funds rate hike expectations briefly rose to 5.75-6.0% as the possible terminal rate, and then in March the adverse effect of the rate hikes hit regional banks. Three banks had to be taken over by regulators, and an investing chill went through the entire banking sector, increasing the odds of a potentially non-shallow US recession. The Fed decided on a 25-basis point March rate hike bringing rates to 4.75-5.0%, but the market believes there is a roughly 90% chance that this will be the final rate increase. Despite Chairman Powell’s insistence that rate cuts aren’t on the 2023 agenda, market expectations show rate cuts as early as June, culminating in a Fed Funds rate of 3.25-3.5% by mid-year 2024. Time will tell.
It appears that the market’s expectations that the Fed would push too hard and break something have come to fruition. The Fed’s steadfast hawkish approach all changed upon the mid-March trio of bank failures, including the second largest in US history: Silicon Valley Bank. Which I’m sure you’ve heard of by now. The failures were largely due to poor risk management but are indirectly attributable to the Fed’s aggressive rate hikes and an inverted yield curve. Simply put, the banks carelessly invested deposit reserves in long-dated Treasuries had lost value rapidly due to the Fed’s rate hikes, and when faced with snowballing customer withdrawals, resulted in significant realized losses along with vanishing depositors.
The run on Silicon Valley Bank was rapid. This particular bank had some idiosyncratic risks due to its unique exposure to a very concentrated venture-capital/early-stage company customer base. Primarily tech, and primarily located in Silicon Valley, these folks were also neighbors and part of a close-knit group. This kind of contagion risk is less likely in the general banking sector, but this reflection certainly shows us how quickly fear can take hold when news moves fast.
Confidence in the Fed has clearly been tarnished for the time being – banking sector failures while inflation is scorching hot is among the most spectacular failures in economic policy in recent memory. Having said that, I expect that the banking contagion has been contained and limited to a handful of poorly managed banks, and deflationary data will continue to flowing our way – luckily last month did see improvement – prior to the May 3rd Fed meeting. Thus far, the winds seem to be blowing in a favorable direction with market sentiment shifting and some ease among investors as we start the month of April.
And now, your Monthly Market & Economic Update by the numbers.
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Warmly,
Mark S Sauer
Market Update
Global Equities: Stabilization in the regional bank turmoil, at least for now, helped push equity markets higher in weekly trading. For ther month of March, the S&P 500 gained 4.26%, the Nasdaq was up 10.47%, and the Dow Jones Industrial Average gained 1.89%. Developed International stocks outperformed as European banks shrugged off liquidity concerns, leading to a 3.9% weekly return. Emerging markets were mostly even for the month.
Economic Update
Fed’s Preferred Inflation Metric Eases: Personal Consumption Expenditures (PCE) inflation data for February came in slightly softer at 0.3% vs 0.4% expected. The Fed’s measures inflation using the Core version of PCE, which strips out food and energy and which also came in below its 0.4% consensus estimate at 0.3% for the month. Core PCE is running at 4.6% annually, so the Fed still has some work to do, particularly in the Services and Housing components.
Charts of the Month
S&P
Our first Chart of the Month shows the year-to-date performance of the market-cap weighted SPDR S&P 500 ETF (Ticker: SPY, orange line) compared to the equal-weighted version, Invesco S&P 500 Equal weight (Ticker: RSP, blue line). While the two ETFs tracked closely to start the year, the regional bank fallout has led to a major divergence, with RSP falling more than SPY due to overweight to smaller market cap financials. SPY also benefitted from its relative overweight to big cap tech, which has become the new “safe” investment and the beneficiary of potential rate cuts which the market now predicts will occur later this year.
Nasdaq
Our next and final chart is a weekly view of the Nasdaq. The Nasdaq has shown incredible resilience this year after and abysmal 2022. Just last month the index rose a massive 10.47%. During the month the Nasdaq retested the 50-week moving average (blue line) and showed it had the strength to move upward. Furthermore, the Nasdaq broke above a huge supply/demand level (green line at 12828) which has acted as a ceiling the better part of the last 6-months. These combined moves largely suggest that we’re moving out of our long-term down trend and that our market regime is shifting from bears to bulls. Economic data has a long way to go, but these technical indications suggests the remainder of this year could end quite positively – perhaps the market knows something the Fed does not?
