April 2023 Market Commentary
May 11, 2023
Markets are always faced with uncertainty, even in the best of times. Differing interpretations of uncertainty effectively creates a market. Where one investor sees warning signs and wants to sell, another sees potential and is willing to buy. When uncertainty becomes elevated, as is the case right now, investors typically take one of two tacks; sell first and ask question later or take a wait-and-see approach. The former often results in downside volatility. The latter often results in more range-bound markets.
In April, investors continued to wrestle with uncertainty, but generally took a wait-and-see approach. The uncertainty was, and continues to be, precipitated by multiple unresolved questions: Is the economy headed for recession? Economic activity slowed sharply in the first quarter, but underlying details were encouraging. Should a recession occur, how bad will it be? After raising rates yet again on May 3, what will the Fed do next? Current Fed projections show the central bank holding rates steady through the end of the year. Market expectations show the Fed cutting rates by 0.25% at each of its last three meetings of the year. Who is right? Will the US default on its debts? The Treasury has warned of such an outcome if the debt ceiling is not raised by June 1. Can/will Congress act in time? Will reverberations from the collapse of Silicon Valley Bank in mid-March continue to emanate, or has the banking turmoil been contained following JP Morgan’s acquisition First Republic Bank?
Reflecting the current uncertainty, equity market performance for the month was mixed. Large cap equities (S&P 500) returned 1.5%, bringing year-to-date gains to a respectable 8.6%. Small caps (Russell 2000) fell 1.9%, however, as lingering banking sector concerns had an outsized impact on smaller banks. Broader concerns about a possible recession also weighed more heavily on small caps, which are generally viewed as more economically sensitive than their larger brethren. International returns were also mixed as developed markets (MSCI EAFE) gained 2.5%, while emerging markets (MSCI EM) fell 1.3%.
First quarter GDP slowed to 1.1%, down sharply from the 2.6% growth recorded in 4Q22, and well below the consensus forecast of 2.0%. The decline was driven primarily by decreased business spending on inventories which shaved a full 2.3% off the headline number. Encouragingly, and importantly, consumer spending accelerated to 3.7%, its fastest pace since 2Q21. While a recession may yet happen, the strength in consumer spending suggests that it may not be as imminent, or severe, as some fear.
In addition to strong consumer spending in 1Q23, labor markets remain an economic bright spot, though recent data suggests conditions are softening. Nonfarm payrolls added 253K jobs in April, a reacceleration from March, which at 165K was the smallest increase since December 2020. Job openings fell to 9.6 million in March, the lowest level since April 2021. Revisions to weekly jobless claims data shows claims bottomed in September 2022 and have increased since, which is more consistent with the large-scale layoff announcements emanating primarily from the Tech and Financial sectors. Though it has been slow to rebound, the labor force participation rate is now at its highest level since the start of the pandemic, a positive for businesses and industries still faced with labor shortages. All of this points to labor market conditions that are softening, not collapsing.
The collapse of Silicon Valley Bank (SVB) continued to reverberate in April, culminating in the seizure and sale of First Republic Bank to JP Morgan by regulators at the end of the month. First Republic had come under intense pressure following the failure of Silicon Valley Bank. That pressure eased some after a consortium of large banks provided a $30B cash infusion in mid-March. However, First Republic’s demise was sealed when it revealed on its earnings call in late April that investors had withdrawn over $100B in deposits in the weeks following SVB’s collapse, leaving regulators with few options other than seizing it. The question now is whether that puts an end to the crisis. If the first week of May was any indicator, the answer appears to be no, as several regional banks continue to face significant pressure suggesting more failures are possible.
On May 3, the Federal Reserve increased the Fed Funds rate by 0.25% to a range of 5.00-5.25%. In a sign, however, that the Fed is nearing an end to its current rate hike cycle, the language in its accompanying statement was adjusted to remove the prior statement that “some additional policy firming may be appropriate” and in its place stated that the Fed will examine the cumulative effects of its rate hikes over the past year to determine “the extent to which additional policy firming may be appropriate.” For its part, markets expect the Fed to cut rates by 0.75% by year end, whereas the Fed expects to hold rates steady. Should that prove to be the case, markets could experience bouts of volatility as investors are forced to adjust their forecast to match that of the Fed.
As if investors didn’t already have enough to consider, they must now contend with the need for Congress to raise the country’s debt ceiling by June 1 to avoid a default. Conceived during World War I, the debt ceiling has been raised 78 times since 1960, often with little fanfare. However, over the past 20 years, increasing the debt ceiling has become increasingly political, and contentious. Failure to raise the debt ceiling could roil financial markets and the broader economy, resulting in as many as eight million lost jobs according to some estimates. While the general expectation is that Congress will act to avoid a default, based on recent history it will only come after brinksmanship by both sides which could lead to elevated financial market volatility in the near term.
Fixed income markets as measured by the Bloomberg US Aggregate Bond index, the broadest measure of the US bond market, gained 0.6%. Point-to-point, bond yields were little changed over the course of the month, with the 2- and 10-Year Treasuries dropping just 0.02% and 0.05%, respectively. However, that disguised meaningful intramonth volatility that saw yields on the two bonds move by nearly 0.50% and 0.30%, respectively. Yields hit monthly lows early in April on continued fallout from the banking issues that dominated March activity. As the month progressed, yields slowly rose as the market became more comfortable in assuming the Federal Reserve would continue with at least one more hike. In addition to that hike, the market started to erase some of the aggressive rate cutting they had priced in for the remainder of 2023. An initial assumption of four cuts coming in 2023 was whittled down to three by month end. Aside from the banking issues, yields vacillated on inflationary news, encouraged by the downward trend seen in most of the data, but tempered by the slow pace of declines.
While Treasury yields were down slightly on the month, municipal bond yields increased. Two-year AAA muni yields rose ~0.30%, while the 10-year AAA yield gained 0.08%. A lack of supply had kept municipal yields lower, but April proved to be the strongest month of supply so far this year. With municipal supply picking up and demand fairly soft (April is a low month for maturities – thus low reinvestment demand), yields adjusted upward.
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