After a challenging February in which resilient economic data and stickier-than-expected inflation forced the market to price in higher interest rates for longer, risk assets bounced to close the quarter on a high note.
Risk-off, risk-on, risk-off? Amid a bank run, the Fed rides to the rescue, but challenges remain.
After a challenging February in which resilient economic data and stickier-than-expected inflation forced the market to price in higher interest rates for longer, risk assets bounced to close the quarter on a high note. For much of the month, markets faced a regional banking crisis sparked by Silicon Valley Bank (SVB), which regulators closed on March 10 after initial efforts to find a buyer, making it the second-largest bank failure in U.S. history. Investor fears began to escalate after SVB announced severe losses on its securities portfolio and a slowdown in funding at the venture-capital-backed firms it served, with shares plummeting before trading ceased. Shortly after, Signature Bank was closed. The impact of these two failures continued to reverberate in subsequent weeks, even after regulators stepped in to assure that depositors at both banks would be fully protected. Credit Suisse, which announced “material weakness” in its financial reporting, received a $54 billion “lifeline” loan from the Swiss central bank (SNB) and was later bought out by UBS with the SNB’s backing. Finally, a group of large U.S. banks said they would deposit $30 billion into First Republic Bank to help it avoid insolvency. The turmoil helped push the S&P Regional Banks sector down 35% for the month, bringing the potential duration of the Fed’s tightening cycle into question.
Normally, a bank run would not be the catalyst to drive risk assets higher, but quick actions by the Federal Reserve, Treasury and FDIC reinforced stability in the banking system and calmed investor nerves. More importantly, in the market’s view, banking stresses could cause the Fed to pause its tightening campaign sooner than expected, despite its decision to hike interest rates by 25bps in March. This latest hiking decision took into account the banking crisis, sticky—though possibly easing—inflation data and a resilient labor market; and although the Fed sought to address financial stability concerns, it also wanted to emphasize continued focus on lowering inflation.
The latest read-through for inflation came on the last day of March, with the Core Personal Consumption Expenditures Price Index (Core PCE), a gauge used to track inflation through the prices of goods and services purchased by consumers, showing a deceleration on a month-over-month basis. The market’s recent volatile trend persisted. In reaction to the banking crisis and its potential ramifications, including pullback in lending from banks to consumers and corporations due to higher loan standards, the market began to once again price in the possibility of rate cuts by the end of the year, boosting longer-duration assets such as growth stocks and longer-maturity bonds (the Russell 1000 Growth benchmark rose 6.8% in March). Fed Chair Jerome Powell pushed back against rate-cut expectations, stressing that they were not in the Fed’s base case, although a pause in rate hikes appears to be more likely. The disconnect between market expectations and the Fed’s steadfastness on higher interest rates is the same dynamic we have highlighted in the past and anchors our more defensive, cautious portfolio positioning views.
Equities and Fixed Income Resilient in the Wake of Market Volatility
Equities generally held up well in March, with the S&P 500 Index returning 3.7%. However, index-level performance masked an underlying rotation in the market as growth-oriented sectors outperformed, with Technology and Communication Services gaining 10.9% and 10.4%, respectively. These sectors led Growth to outperform Value by 7.3%, the largest monthly margin since June 2021. In contrast, cyclical sectors were laggards, with Financials and Energy returning -9.6% and -1.4%, respectively. In our view, the positive returns seen in U.S. equities do not suggest that they are out of the woods just yet. In fact, excluding the Technology & Communications sectors, the S&P 500 was down for the month. This highlights the extent to which the index is skewed toward growth and tech stocks (see display). International equities delivered positive returns during the month, with a weaker dollar serving as a tailwind. We continue to maintain an underweight view on equities given elevated valuations and the potential for further declines in earnings. That said, the rotation from value to growth has pushed up valuation metrics unevenly across the market, and may allow for potential opportunities to add risk exposure over the course of the year.
Tech & Communications Were the Main Drivers of Positive S&P 500 Performance in March
Source: Bloomberg, as of March 31, 2023. S&P 500 Index is represented by the S&P 500 Index, S&P 500 Index ex Tech is represented by the S&P 500 Index ex Information Technology and Communications Services Index.
Fixed income markets posted positive returns amid the market volatility, with the Bloomberg U.S. Aggregate Bond Index and the Bloomberg U.S. Muni Index up 2.5% and 2.2%, respectively. Rates were volatile, with the 10-year Treasury yield ultimately dropping 45bps after gaining 41bps in February. Higher-quality investment grade bonds outperformed lower-quality high yield for the month by 1.4%. Spreads within Bloomberg’s U.S. Corporate Investment Grade Index increased by 14bps compared to the Bloomberg U.S. High Yield BB/B 2% Issuer Cap Index, which climbed roughly 32 bps. We continue to have an overweight view of investment grade fixed income, with a focus on quality across sectors. As it stands, investors are being very well compensated by the higher-rate environment in holding both cash and shorter-duration bonds at a fraction of the risk associated with equities.
Commodities were mixed as oil prices (measured by Brent crude) hit their lowest levels since December 2021, falling 12% by mid-March before recovering in the second half of the month to finish down 4%, as investors reassessed global growth expectations on the back of the banking crisis. However, investors bid up the price of precious metals like gold, which appreciated nearly 8% on the month to $1,969.28/oz. as a safe haven trade. Broad-based commodities returns were generally flat on the month, down 0.21%. While we maintain an overweight view on commodities for portfolio diversification, where applicable, recession risks could hurt short-term demand.
Despite January’s strong start, February and March reinforce our continued belief that investors should remain cautious and defensively positioned for the time being. A higher-for-longer terminal fed funds rate, persistent inflation, hot labor market and weaker earnings will likely challenge markets throughout the year. We continue to favor a focus on diversified, high-quality, shorter-duration assets while retaining the flexibility to add risk as potential opportunities present themselves.
Source: Bloomberg, total returns as of March 31, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex U.S. is represented by MSCI ACWI ex U.S. Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA U.S. 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg U.S. Agg Total Return Value Unhedged USD. Munis are represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg U.S. Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg U.S. High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg U.S. Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg U.S. Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg Ex Energy Subindex Total Return. U.S. 10-Year Yield is represented by U.S. Generic Govt 10 Yr.
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