The first quarter of 2023 saw asset prices continue to rally off their October 2022 lows. U.S. equities led the way with a 7.24% gain, followed by international stocks returning 6.92%. Bonds were up a solid 2.96% for the first quarter, despite the Federal Reserve maintaining a policy of interest rate increases. It wasn’t a completely smooth quarter for the market as volatility continued to be present. Equities had a stellar first month only to give up most of those gains by early March, but eventually bounced back at the end of the quarter.
|INDEX||ASSET CLASS||2023 YTD|
|DJ U.S. TOTAL STOCK MARKET||U.S. STOCKS||7.24%|
|MSCI AC WORLD EX-USA||INTERNATIONAL STOCKS||6.92%|
|BLOOMBERG U.S. AGGREGATE BOND||BONDS||2.96%|
Higher stock prices raised the S&P 500’s forward price/earnings ratio to 17.81x compared to 16.65x at the end of 2022. These valuations are still dependent on the expected future earnings of the companies that are components of the S&P 500 index. Companies report quarterly earnings and often times provide guidance on strengths and potential challenges for the year. The trend for the most recent Q1 earnings reports is a strong top line revenue number, but a weaker bottom line earnings number due to increased costs. Investors want to see strong, increasing bottom line numbers in order to feel confident about paying a 17.81 price/earnings multiple.
A Banking Crisis?
In the first quarter of 2023, the collapse of Silicon Valley Bank (SVB) and several other regional banks conjured up fears of another financial crisis reminiscent of The Great Recession of 2008. Within the span of less than two weeks in March, SVB went from releasing some seemingly innocuous news about losses in their bond portfolio to a complete collapse. Initially, it seemed that SVB suffered from just a perfect storm of negative events, chained together to lead to its demise. Now with hindsight and a banking report from the Federal Reserve, we’ve gained more insight into the bank’s downfall. The Fed did take some responsibility in the failure of their supervisors to recognize the seriousness of the situation and not acting quickly enough. They also lay blame on the bank’s leadership in lack of risk management.
A bank can have many internal flaws, but they don’t become a problem until depositors start withdrawing large amounts of money. Banks are in the business of lending money so they’re not equipped to handle a run on the bank when customers have lost confidence in them. Many banks like SVB purchased bonds when interest rates were low and had unrealized losses in their portfolio when the Fed began dramatically raising rates. Interest rate increases have a negative effect on bond prices. That doesn’t matter if you plan to hold those bonds to maturity, but if you’re forced to sell in order to raise cash, then those unrealized losses now become realized losses. So if many banks were in a similar position in holding bonds with unrealized losses, what made Silicon Valley Bank more susceptible to a bank run? SVB’s main clientele are tech startups with much larger deposits than your average retail bank customer. Almost 97% of their deposits were above the $250,000 FDIC insurance limit.
The current financial institution in a precarious situation is First Republic. Banking regulators are working with other major banks to broker a deal to take over First Republic in hopes of preventing contagion to the greater financial system. Even if this deal goes through smoothly, we may have to wait to find out what vulnerabilities other banks are unaware of or hiding.
In the last market update, I wrote, “A perfect scenario for 2023 would be a recovery in the equity markets, despite a likely recession, and a rally in bond prices as interest rate risk wanes.” While it’s still very early in the year to know if this will continue, we are starting to see this “perfect scenario” play out with rising equity prices and a recovering bond market in spite of increased chance of a recession in the later part of the year. Investors doubt that inflation will reach the 2% level any time soon, but the deceleration of the annual increases seems promising. A tight labor market continues to keep prices high as workers demand higher wages and better working conditions. Expectations are that the Fed is nearing the end of their rate increases and there are some who believe the central bank may pivot back to an accommodative policy afterwards.