First Quarter 2023 Market Update

Investment Management

April 25, 2023

“In our view, the bar has been raised, and the easy gains are now in the rearview mirror.  Going forward, we believe carefully balancing risk with reward will be the playbook for success.” – Domestic Equity Manager

First Quarter 2023 Market Update

Investment returns were largely positive in the first quarter of 2023, despite a tumultuous series of events in the banking sector during the period.  Markets surged to start the year, buoyed by investor optimism that the U.S. Federal Reserve (the “Fed”) was nearing the end of its tightening cycle and ahead of the curve with respect to inflation, market and economic indicators were stabilizing, and the economy had continued to demonstrate its resiliency.  Things quickly changed in early March, however, when Silicon Valley Bank (“SVB”), the county’s 16th largest depository institution, collapsed following a run on the bank in which depositors attempted to withdrawal more than 80% of the bank’s deposits over a two-day period.  Ultimately, SVB was forced into FDIC receivership, along with another institution, Signature Bank, sending shockwaves through the banking sector.  Regulators acted quickly to put emergency provisions in place, including backstopping the banks’ depositors, aiming to prevent systematic risk within the sector.  These events did not stop the Fed from continuing to hike interest rates, in its attempt to tame inflation, delivering two 25 basis point rate hikes over the course of the quarter.  Since beginning its cycle of rate hikes in March 2022, the Fed has now increased interest rates nine times, for a total of 4.75%.

Domestic equity markets, as measured by the S&P 500 index, were positive for the first quarter, returning +7.5%.  The tech-heavy NASDAQ Composite Index finished the quarter up +17.1%, marking one of its best quarters since 2020.  From a sector perspective, investors flocked back to technology, communication services, and consumer discretionary stocks, as those sectors finished the period up +21.8%, 20.5% and +16.1%, respectively.  Their outperformance over the period was even more notable as these sectors were the biggest laggards of 2022.  Financials were the worst performing sector, down -5.6%, on the heels of volatility brought upon by bank failures and worries around systematic risk in the sector.  Energy stocks also underperformed the broader market, declining -4.7% over the period.  From a style perspective, growth stocks meaningfully outperformed value stocks, another reversal from the trends of 2022.  As measured by their respective Russell-based indices, large cap stocks (+7.5%) meaningfully outperformed their mid cap (+4.1%) and small cap (+2.7%) counterparts.  Developed international equities, as measured by the MSCI EAFE Index, were up +8.6% for the period, continuing their outperformance of domestic equities for the second consecutive quarter.  On the heels of that outperformance, international equities are now outperforming domestic equities on a one-year annualized basis.  Emerging market equities were up +4.0%, as measured by the MSCI EAFE Emerging Markets Index (in U.S. dollar terms).

Despite significant volatility, fixed income returns were also largely positive over the course of the quarter, with the Bloomberg U.S. Aggregate Bond Index finishing up +2.96%.  The turmoil that occurred in markets in early-March led to a rally in the fixed income markets, marked by the 10-year yield dropping approximately 60 basis points and the 2-year yield dropping over 100 basis points over the course of a few days.  As a reminder, bond prices and interest rates are inversely related, so as interest rates rise, bond prices fall.  The 10-year yield finished the quarter at 3.48%, approximately 40 basis points lower than at year-end.  Within the fixed income market, both investment-grade and high-yield bonds posted strong returns of +3.5% and +3.6%, respectively, for the period.  Municipal bonds returned +2.8% and mortgage-backed securities returned +2.5%.  U.S. Treasuries posted positive returns, most notably on longer-duration bonds, such as the 30-year, which returned +6.0% over the quarter.

Silicon Valley Bank and Stress in the Financial Sector

“As this banking crisis reminds us, we live in a time of great uncertainty. Any given day can bring something that is unexpected (and frightening) and that could change markets and the world in ways unimaginable.” – Multi-Strategy Hedge Fund Manager

As the Fed continued down its path of interest rate hikes to combat inflation that began just over a year ago, bond prices have fallen significantly, particularly long duration bonds which are the most sensitive to interest rate moves.  This led to one of the worst years on record for fixed income markets in 2022.  In addition to unrealized losses for investors (in some cases material), an additional consequence of interest rate hikes also started to appear during the quarter, as the banking industry was under severe stress.

To shore up its liquidity in the face of unrealized balance sheet losses on its fixed income securities, SVB was forced to sell a portion of its investments at a loss during the quarter.  As this was communicated to the market, investors became skittish, triggering a tidal wave of depositor withdrawal requests (more than $140 billion over the course of 48 hours) as depositors became concerned about the bank’s solvency.  A run on the bank ensued, ultimately leading to its collapse, pushing the bank into FDIC receivership over the course of only a few days.  Signature Bank, another institution, also failed within days of SVB for similar reasons.

The Fed and other regulators acted quickly to mitigate the risk of contagion in the system, backstopping and guaranteeing all deposits and providing funding facilities to the system.  While the risk of widespread systematic issues appears to be mitigated, the sector continued to experience volatility, causing the regional banking index to decline by almost 25%.  Large money-center banks (e.g., Bank of America, JP Morgan, Wells Fargo, etc.) also experienced stock price volatility, but ultimately were beneficiaries of the depositor flight from smaller and regional banks over the period.  Stress and turmoil in the system was not contained to domestic banks, also spreading quickly to Europe over the period.  Capital flight and broader concerns led to UBS taking over its longtime rival, Credit Suisse, for more than $3 billion, as Swiss authorities stepped in to facilitate the merger and ultimately stem a decline in confidence in the global banking system.  

Recessionary Fears – Soft vs. Hard Landing

“The soft vs. hard landing tug-of-war raged on in Q1, with sometimes violent swings in market leadership. Historically, markets tend to rally near a Fed pivot, both in soft and hard landing scenarios. This year was no exception, but the early surge in equities, led by cyclicals and lower quality factors, was wildly disconnected from economic reality.” – Domestic Equity Manager

Coming into the year, consensus views from experts seemed to be that a recession of some variety was unavoidable.  However, the economy has continued to show its resiliency.  Earnings forecasts have come down, but as recently as this month, consensus forecasts still show estimated earnings growth of 1% in 2023 and 12% in 2024.  In our view, the risk to corporate earnings seems to be skewed to the downside, and the probability of the Fed achieving its “soft landing” objective could be waning.  As we wrote about in our prior quarterly commentary, Fed tightening, and monetary policy actions take a considerable amount of time to make their way through our complex and intertwined economy.  Only recently have we seen corporate profits and earnings start to decline due to the lagged effect of these actions. 

In addition, the recent bank failures are likely to exacerbate the slowdown that was already occurring.  Banks were already tightening their lending standards prior to instability in the system, and with deposit bases now under pressure, credit conditions will likely continue to tighten, particularly for small and medium-sized community banks.  These regional banks play an important role in the economy of our country.  According to a recent report, lenders with less than $250 billion in assets account for 50% of commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending.  As credit inevitably becomes more expensive and difficult to access, there is a greater risk of ripple effects throughout the economy, including deteriorating consumer and business sentiment, the potential rise in delinquencies, stress in the labor market, etc.  The continued (but lagged) impact of monetary policy actions, coupled with declining credit availability, will likely represent significant headwinds to future economic growth.     

Inflation and the Federal Reserve’s Path

Given that inflation is still significantly higher than the Fed’s 2% target, they may try to keep rates higher for longer to slow down economic activity, push unemployment higher, and bring inflation closer to target. However, once they do start to cut, they are likely to have to cut far more quickly than the slow pace currently priced into markets. – Global Fixed Income Manager

Inflation continues to run above the Fed’s target, with the most recent Consumer Price Index (“CPI”) readings still elevated at around 6% based on February metrics.  In response, Chairman Jerome Powell came into the year telling market participants the Fed was prepared to lift rates higher than previously expected to cool the economy and continue to battle inflation.  Ultimately, the Fed raised rates twice over the first quarter, although the magnitude of rate hikes was less than in prior periods.  Market participants were unsure as to whether the Fed would raise rates in March, particularly given the stress in the banking system, but ultimately raised benchmark rates by 25 basis points, equivalent to the increase in February.  As a consequence of the turmoil in the banking sector, the fed funds futures curve has significantly repriced, with the market now pricing in an imminent Fed pause and as many as four rate cuts by January 2024.  As the Fed has continued tightening monetary policy and draining liquidity from capital markets, most of the pain to-date has been felt in interest rate-sensitive areas such as housing.  The market is closely monitoring indicators of additional risk, whether that be to corporate earnings, other specific areas of the economy (e.g., banking) or the financial health of consumers.

Final Thoughts

Capital markets continue to be volatile and given the level of uncertainty that exists today, we expect that will continue.  As one of our managers put it in a recent letter, “We are preparing for 2023 to be a year of confusion, volatility, and exogenous challenges that will continue to test conviction and risk management.”  We believe that accurately sums up the sentiment of many investors today.  Considering the uncertainty in markets, our core beliefs continue to be centered around the fact that periods like these are best dealt with by ensuring an effective and well thought out financial plan is in place, paying particular attention to appropriate diversification within portfolios, and always being mindful of risk management.  As we saw this quarter, markets and environments can change rapidly, and a well-constructed, diversified portfolio can be the most effective way to manage through both good and challenging times. 

In addition, for those portfolios for which it is suitable, we continue to see the benefits of incorporating diversifying and alternative investments in portfolios today, which has historically led to better risk-adjusted returns over time.  In certain areas of the market, the dislocation of the past 12-18 months has and should continue to lead to opportunities to earn superior returns for those poised to take advantage and with a long-term mindset.   

As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.

Important Disclosures

Past performance is not an indication of future results.  This publication does not constitute, and should not be construed to constitute, an offer to sell, or a solicitation of any offer to buy, any particular security, strategy, or investment product.  This publication does not consider your particular investment objectives, financial situation or needs, should not be construed as legal, tax, financial or other advice, and is not to be relied upon in making an investment or other decision.

Certain information contained herein has been obtained or derived from unaffiliated third-party sources and, while Prairie Capital Management Group, LLC (“Prairie Capital”) believes this information to be reliable, makes no representation or warranty, express or implied, as to the accuracy, timeliness, sequence, adequacy, or completeness of the information.  The information contained herein, and the opinions expressed herein, are those of Prairie Capital as of the date of writing, are subject to change due to market conditions and without notice and have not been approved or verified by the United States Securities and Exchange Commission (the “SEC”), the Financial Industry Regulatory Authority (“FINRA”), or by any state securities authority.  This publication is not intended for redistribution or public use without Prairie Capital’s express written consent.