Effective Date: March 31, 2023
By any objective measure, stocks, bonds, and portfolios had a good quarter but investors and markets remain on edge. US and international equity markets each gained approximately 7% and bond markets gained 3% continuing their recovery from last year’s decline. While many investors remain skeptical of market gains, it is possible the market bottomed in October of last year as it has gained 18% over the last five months. The market path going forward will depend on monetary policy, inflation, and the economy, all of which remain uncertain. Portfolios are positioned for a continued recovery as we last rebalanced in October 2022.
INDEX RETURNS YEAR-TO-DATE
MSCI EAFE International
MSCI EM Emerging Markets
Barclays Aggregate Bond
10 YR Treasury Yield
Markets were positive this quarter as investors weighed economic data, inflation, and monetary policy. Economic data was stronger than expected as many investors and pundits have been expecting a recession while the economy adjusts to higher interest rates and the end of COVID era stimulus. On March 10th, Silicon Valley Bank (SVB) failed after a bank run making it the second largest bank failure in the US history. Markets declined approximately 5% over the next week but have since recovered and closed out the month near year-to-date highs. The SVB bank failure has caused interest rates to decline and changes in expectations about future monetary policy. Investors are now expecting the Fed to raise interest rates once more this spring before lowering interest rates later this year in response to an expected slower economy.
As we wrote in our March 13th Market Update, SVB failed because of poor risk management and unique factors. There are other banks that have some of the same risk factors as SVB but to a lesser extent. The FDIC and Fed program announced on March 12th to provide banks with additional liquidity and funding is expected to prevent a widespread banking crisis.
MARKET INDICATORS & OUTLOOK
US equity valuations
Geopolitical & Ukraine War
The only update to the market indicators table above is that we added “Geopolitical risks” be negative with the Ukraine war. Including the Ukraine war, it appears geopolitical risks are elevated with China’s more aggressive positioning towards Taiwan, North Korea’s missile tests, and potential conflict between Israel and Iran due to Iran’s nuclear program. These risks are always present in markets and difficult to predict leaving investors to react if and when they come to fruition.
Investors seem to have two prevailing views for the economy and markets. The first view, and one that appears to be held by most investors, is that there will be a recession later this year caused by high inflation and the Fed’s rapid rise in interest rates. There are economic data points, such as the inverted yield curve, that suggest a recession is imminent. As we have been communicating the last year, a recession is possible but not necessarily imminent as employment and other economic data remains robust. For example, the three employment reports issued so far this year have all been stronger than expected and above the trend of the last twenty years. With employment being the main economic driver of the economy, it is difficult for a recession to occur without employment data weakening prior to the start of a recession. In addition, the average stock market decline from a recession is 30%. The market declined 28% at its low in October 2022, so it is possible the stock market has already made its cycle low, especially if the Fed is stopping rate hikes.
A second investor view is that the economy remains relatively stable, if there is a recession, it is minor and the markets can continue a recovery. This possibility is certainly believed by fewer investors as sentiment surveys and positioning data suggests investors have large cash and low equity allocations. One of the most compelling points of this view is that the economy became so distorted over the last three years by COVID, COVID related policies, and the massive government stimulus programs that inflation may decline without the economy materially weakening as that money is spent and not replaced. As a result, the economy may be able to withstand higher interest rates, at least for a time.
Investor sentiment is terrible, but the market has quietly gained 18% since its October 2022 low. While we have ideas about what will happen next, we put more weight into quantitative analysis to understand what has happened in similar periods in history. Of course, each time is different but often there are similarities. For example, according to Bespoke Investments, one of our data providers, there have been ten prior occurrences since 1950 when the market was negative the previous year and positive in the first quarter like this year. The market was positive the rest of the year all previous ten times and had strong total returns for the entire year. In a second and unrelated analysis, FundStrat, another research provider, analyzed quarterly returns over the last fifty years and the market has never had two consecutive positive quarters like the last two quarters during a bear market. The implication of this analysis is that the market can make a new all-time high and the October 2022 low may have been the cycle low. As always, past performance is not a guarantee of future results but does provide context about how the market has silently been resilient the last five months, seemingly unnoticed by most investors.
PORTFOLIO IMPLICATIONS & RECOMMENDATIONS
Portfolios are positioned for a continued recovery as we last rebalanced in October 2022. Portfolios are overweight US equities and underweight bonds, cash, and real estate. Our plan is to rebalance the entire portfolio again when markets recover from their 2022 decline. As always, we do rebalance portfolios individually as you make deposits or withdraws from your account. Dividends and interest are reinvested when received.