Q1 2023 Commentary: The Splash and Ripples

I have fond memories of my grandfather picking up the smoothest stones and gracefully skipping them over the water at the lake next to his house. Then I’d give it a try. Sometimes we got to count the hops but often we’d count one splash and then all the ripples.

The market’s narrative this quarter began to move away from the splash that is the Federal Open Market Committee (FOMC) raising interest rates and toward the ripples this splash is causing.

The stock market as represented by the MSCI ACWI World stock index, returned 7.31% in the first quarter, bringing up the trailing 1-year performance to -7.44%. International developed country companies lead the charge, with the MSCI EAFE index returning 8.47% during the first quarter. The MSCI Emerging Markets Index returned 3.96% for the quarter. The S&P 500 Index returned 7.50% for the same period.

The year also started well for the Bond market, with the Bloomberg Global Aggregate Index, a diversified world bond index, up 3.01%, bringing the trailing 1-year performance to -8.07%.

Based on the return numbers, it’s hard to see the ripples, but this quarter made it very clear that the ripples exist.

Let me start with an update on the splash. In February and March, the FOMC raised rates by 0.25% each meeting. The rhetoric from the Fed began the year preparing us for further increases, reiterating that they would continue to raise until they saw persistent downward movement in inflation. Then, the ripples started.

The biggest ripple last quarter was the state of banks, with FDIC-insured banks holding bonds that are valued at depressed prices. Banks such as Silicon Valley Bank and Signature Bank had customers concentrated in specific industries, such as tech and crypto, that made them susceptible to liquidity problems and bank runs. This rattled the banking sector but especially raised concerns with small and regional banks.  

While we view this situation as stabilized currently, this ripple highlights a new public pressure on the FOMC. Now, with each increase in rates, the narrative will focus on the additional stress that this puts on the market value of bank assets. Last quarter illustrated how this may modify future interest rate increases. In March, it was largely expected that the FOMC would raise rates by 0.50% until the banking concerns began. They raised by 0.25% instead.

While the liquidity of banks has drawn a lot of attention, we think the more overlooked ripple here is that lending from the banking system will slow. Slowing lending decreases cash availability and should, in turn, lower inflation. It also increases the probability of recession. While the FOMC talks a lot about employment as a benchmark, decreasing bank lending is likely the ripple that front-runs lowering employment.

Stepping outside of the banking system, expectations of slowing rate increases rippled through to the value of the US dollar. The value of the dollar, which had gotten extraordinarily high, has now fallen back to less extreme levels. This provided a tailwind for US investors in international companies and helps to explain some of why international stocks had such a strong first quarter.

The best part of the splash and then the ripples is that eventually those ripples get smaller and smaller until you can’t see any of the disturbance that once was there. While we don’t expect the ripples are finished, we are hopeful that the FOMC will at least pause interest rate increases at some point this year. Our focus will remain on preparing the portfolios for the next phase of the cycle while also keeping an eye on longer-term client goals.

_{The S&P 500 Index is a market capitalization-weighted stock index. It is comprised of about 500 stocks of the largest capitalization companies that are traded on U.S. stock exchanges. The MSCI Emerging Markets Index measures the performance of 1379 large- and mid-cap stocks across 24 emerging markets countries. The MSCI ACWI Net Index measures the performance of large and mid-cap companies across 23 Developed Markets and 27 Emerging Markets. The MSCI ACWI Net Index subtracts foreign taxes applicable to US citizens. The Bloom-berg Global Aggregate Index measures the return of the global investment grade debt across 24 markets. Both measure the return assuming that interest, capital gains, and dividends are reinvested.}

‍