The first quarter of 2023 was a pleasant one compared to what we’ve been dealing with for the past year. The S&P 500 was up +7.50% for the quarter and YTD. International markets were up +7.65% for the quarter and YTD. Emerging markets were up a bit less at +3.54% for the quarter and YTD. The general bond market was up +2.96% for the quarter and YTD. Short treasuries were up +1.58% for the quarter and YTD.
Last Quarter Round Up
The Federal Reserve (Fed) raised interest rates by 25 BPS in March, and we believe they will do the same at the May and June meetings, with a likely halting for the July meeting. It’s impossible to know exactly what the Fed will do, but we feel inflation is not coming down quickly enough and further rate hikes will be needed. These increases would bring the Fed Funds rate to about 5.25%, which is in-line with our previous projection of between 5 and 5.5%. The Fed has not yet gotten control of inflation and although inflation has improved, we feel rate increases will need to continue. On another note, the M2 money supply shrank again in the first quarter, meaning financial conditions are tightening and inflation should respond by coming down. Some analysts believe the M2 money supply is more important as a focus and should be more actively managed by the Fed. We tend to agree with this line of thinking and find it encouraging that after M2 skyrocketed in 2020 and 2021, that it is now starting to recede. Even if the Fed is not purposely trying to affect M2, it makes sense that it would fall based simply on “mean regression” where when something goes statistically out of whack, as M2 did in 2020 and 2021, then it will naturally come back closer to its normal mean, which for M2 is about 6 % growth per year.
The labor market has remained quite resilient and that continues to be a main driver of inflation. The Fed’s interest rate increases have had a very mild effect on the labor market so far. This is one reason why we feel the Fed will need to push the interest rate envelope further. And because of that, a recession remains a possibility.
Current Quarter Outlook
Our views on recession have shifted a bit from a 70/30 confidence of recession to more like 50/50. Part of this shift is due to continuing improvement in inflation, with a still strong economy and labor market. The latest annual inflation reading was 6.0% in February. Down from a high of 9.1% last June. We have further refined our thoughts on the coming stock market recovery which we feel will begin in the second half of this year. Timing is very hard to estimate, but we expect to be seeing positive signs as early as August. And getting back to end of 2021 market levels sometime in 2024. If we do have a recession, we continue to believe it will be relatively short and mild. We also believe the overall market regime is starting to shift from one of recession fear and Fed concerns, to one of looking ahead to better corporate earnings and market recovery. We’re not quite at that stage, but that is where we feel we are headed. Some good news for a change.
Not much to talk about politically here in the U.S. Yes, Presidential election politics is starting to get some attention, but it’s very early, and it will get a lot worse as we get closer to 2024. A bigger topic to discuss might be the U.S. banking system and how the recent failures of Silicon Valley Bank (SVB) and Signature Bank might be a larger issue. We’re not banking experts, but from what we’ve learned, SVB and Signature banks simply did a poor job of managing the risk of their asset base. The simple truth is that if you invested your assets in longer dated bonds the value of those bonds will drop in the event of interest rate increases. Interest rates have gone up dramatically in 2022 and into 2023 and that put those investments at some banks in a precarious position. Are there likely other banks that could fail? Absolutely. Do we feel this is a systemic banking problem with greater repercussions to come? No, we don’t think so. But we do feel that these two bank failures will cause many banks to re-think their loan portfolios and will likely cause overall lending to contract. This further tightening of financial conditions will actually play nicely into the Fed’s need to drive inflation down. But it could also help push the U.S. economy closer to recession, though we tend to think banking adjustments will be relatively minor.
Globally, and in the small amount of space remaining, we’ll add some comments on the war in Ukraine. Russia has mobilized several hundred thousand new soldiers to throw at Ukrainian forces in a likely spring offensive surge. As we’ve stated before, Russia has all the means to win this war given it has more men, guns and equipment. But Ukraine continues to shock everyone with its ability fight back. Recent changes from NATO and the U.S. will allow more powerful equipment, such as battle tanks, delivered to Ukraine’s forces. We don’t know this for a fact, but we tend to believe these changes are an acknowledgement that if Russia throws more troops into this fight, and Ukraine doesn’t have the more powerful equipment needed to repel them, then Russia will win. The U.S. and NATO can live with a divided Ukraine as long as Poland remains protected. They cannot live with a full Russian victory.
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This newsletter is for general information only and should not be considered investment advice. Investors should consult with a trained investment professional to discuss their particular situation.