Q1 2023: PFM Quarterly Commentary
The first quarter of 2023 offered something for every market bear, pessimist, and doomsday pundit. Dismal economic data, bank failures, further tightening of monetary policy globally, and even a short-lived threat of an alien invasion in the form of Chinese balloons traversing the county. There was truly something for everyone. With the backdrop of last year’s difficult markets still fresh in everyone’s mind, on the surface it looked like 2023 was unfortunately picking up where 2022 left off.
Investors were laser-focused on inflation and employment data during the quarter, as these benchmarks would undoubtedly impact Fed policy. The data releases for January proved disappointing: inflation ticked higher (reported in February) after many months of improvement and the U.S. economy added what can only be described as a shocking number of new jobs. Both metrics all but guaranteed the Central Bank’s eventual decision to raise the federal funds interest rate by a quarter point twice to 5.0%, the highest level since December 2007.
In our last quarterly commentary, we cautioned that the Fed’s aggressive campaign of interest rate hikes could disproportionately damage the economy more than it might reduce inflation. Only time will tell whether higher rates tame inflation – the jury is still out. However, we have all witnessed their troubling and severe side-effects. As the Fed and other global central banks aggressively raised interest rates over the last year, the fixed income securities held in reserves by banks declined in value. The relationship all fixed income investors should remember is that higher interest rates result in lower bond prices. As the value of the bonds held in reserves fell, large depositors grew concerned that banks might not have enough money in reserve to honor withdrawals. A classic bank run ensued, and in a matter of hours Silicon Valley Bank and Signature Bank, two large regional banks, were shuttered by the FDIC, becoming the second and third largest bank failures in U.S. history. Days later, another large regional bank, First Republic, reported similar concerns. They too were in danger of closure before J.P. Morgan and several other “too big to fail” banks came to the rescue with a $30B unsecured deposit to shore up its liquidity. Across the Atlantic, one of the oldest and most prestigious banks in the world, Credit Suisse, came into liquidity issues of its own which necessitated a $54B bailout from the Swiss National Bank.
Remarkably, all four of these bank failures and re-collateralizations occurred over a nine day span. In response to a growing concern that the situation could proliferate, the Fed pre-emptively bailed out the banking industry by establishing a crisis lending facility called the Bank Term Funding Program (BTFP). Banks could use the BTFP and/or the Discount Window (a pre-existing emergency lending program) at the Fed to pledge their deeply impaired assets at full value as collateral in exchange for temporary liquidity. By monitoring the Fed’s balance sheet, we can calculate how much emergency liquidity was extended in the two weeks that followed. Through the various credit extensions, banks accessed just under $400b in emergency liquidity which was greater than the weeks following the failure of Lehman Brothers in October 2008. Additionally, this bailout erased over four months of balance sheet reductions (quantitative tightening) the Fed worked so hard to achieve, thereby expanding the Fed’s balance sheet to just under the all-time high of $8.9T. In other words, the extent of damage to the banking system as a direct result of the Fed’s aggressive monetary tightening is practically unparalleled.
On the surface, one would presume the markets would respond poorly to the overwhelmingly negative news cycle. However, as is often the case, the mainstream economic narrative differs greatly from the actual underlying forces that move the markets. At the time of this writing, investment markets of nearly every asset class and geography have enjoyed robust returns in 2023, despite banking failures, aggressive global monetary tightening, record layoffs in the technology sector, the most U.S. bankruptcy filings since 2009, a thirteen-year high in subprime auto loan delinquencies, and the biggest January drop in existing home sales since 1979. The truth is that major indexes such as the S&P 500 bottomed back on October 12th, 2022, meaning investment markets around the globe have been rising for six months. And unbeknownst to most, international equities have gained 28.5% since bottoming in October while their U.S. counterparts are up 15.8%. The Nasdaq 100, which fell precipitously during the bear market, has risen more than 20% in 2023 alone, meeting the widely accepted definition of the start to a new bull market. Even global bonds, which suffered the largest annual loss in over two centuries last year, have risen 9.2% since the October lows.
There’s an old Wall Street saying we’d like to share: “The market stops panicking when central banks start panicking.” Back in our Q3 2022 letter, we detailed extensively the panic displayed by central banks around the world. The European Central Bank (ECB), the Bank of Japan (BOJ), and the Bank of England (BOE) all pivoted from their hawkish policies and instituted stimulus measures in response to market instability. In that same letter, we referenced the presidential market cycle, a phenomenon where U.S. equity markets bottom in October of the second year of a first term presidency. Then we mentioned that October is often a “bear killer,” having marked the end of twelve bear markets since World War II. Finally, in our Q4 2022 letter, we explored numerous historical data points that suggested the bear market could have finally ended, paving the way for positive returns in 2023.
Over the years, we’ve meticulously highlighted the importance of central banks’ policies as a primary driver of the investment markets. Capitulation by central banks has halted nearly every meaningful market decline since the Great Financial Crisis, from BREXIT to COVID. The market gains sparked by their pivot toward less aggressive interest rate increases beginning last fall, and their recent enormous bank bailout, further accentuate this point and it’s why we devote so much of our time to following changes in monetary policy.
Markets never move in a straight line and this time will be no different. While there will be volatility in the coming months, there are reasons to remain positive about your portfolio in 2023. First, there’s the aforementioned presidential market cycle. Second, since World War II, there have been only two other instances (1967 and 1975) where the S&P 500 gained more than 5% in January after a 10% decline in the previous year. In those years, the S&P gained 11.3% and 17.1%, respectively, over the remainder of the year. Extending that criteria to the first quarter, in the ten other times the S&P had a positive Q1 return after a loss in the previous year, the market always finished the rest of the year higher. Third, since 1950, when the S&P 500 is up more than 7.5% by Valentine’s Day, the market is higher for the rest of the year 90% of the time, gaining an additional 11% on average. Last but not least, not a single previous S&P 500 bear market in history has made a new low after closing above its 200-day moving average for 18 consecutive days (this was accomplished in mid-February). So, while there’s no crystal ball to predict with certainty where the markets will go, these data points offer us insight and optimism as we enter spring.
As always, we hope you found this piece informative and entertaining and would encourage you to reach out to us with any questions or concerns.
And on an unrelated note, while we have your attention, we’d like to again mention that Peak has a redesigned client portal that many of you already now access via the web and/or app. There, you can track your portfolio, apply analytical tools, receive your quarterly statement electronically, and more. If you don’t yet have portal access and this interests you, just let a Peak team member know.
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