As featured in Trading Herald:
Q1 2023 reflection
Q1 2023 in summary:
- After the 2022 storm, better returns for investors
- Bonds contributing to portfolio construction: solid returns and diversification
- Tech-stocks leading a bear market rally or Europe leading a new bull market?
- Dollar weakness continues; gold close to its highs
- Recession avoided for now, inflation falling but not as quickly as hoped
- Banking sector challenges: 2023 is not 2008
- Central banks nearly done?
- Paid to wait - but waiting for what?
The resilience of the global economy in the face of higher interest rates has been a major surprise, with the data continually coming in ahead of expectations over the past two months. The performance of the US labour market is particularly impressive, with jobs being created at a brisk rate, keeping unemployment low, despite well-flagged concerns in sectors like housing and tech. Wage growth has slowed a little, but remains positive; and some restraint will please the Fed as it looks for moderation in future drivers of inflation. Surveys suggest that consumer confidence is rebounding from extremely low levels, perhaps helped by easing fuel prices, and the latest surveys of firms show renewed acceleration in activity and new orders, led by services sectors in the US and Eurozone.
The reopening of the Chinese economy as Covid restrictions have eased appears to be having a huge impact, with a resurgence in spending on tourism and leisure, and a big recovery in air and road traffic - this bodes well for further easing of supply bottlenecks in industrial supply chains too. Even the UK, facing perhaps the most challenging outlook of the major economies, has been more resilient than many expected. Recent revisions show that resilient household consumption helped push the economy back into marginal growth in late 2022. Consensus forecasts still point to a slight recession in the UK later in 2023, but other major economies are now expected to avoid recession.
The flipside of better-than-expected growth has been stubborn inflation: few doubt that the peak in inflation has passed, particularly as base effects will make year-on-year comparisons easier through the summer. However, core inflation in many economies is falling slower than forecasted, especially in services where it has been buoyed by significant wage rises in tight labour markets. Once again, the UK looks vulnerable: headline inflation is still above 10%, and disruptions in food supply chains and pending energy price cap increases suggest the journey back to target might not be a smooth one.
It had been suggested that this cycle would see central banks hiking interest rates until something breaks: with the failure of Silicon Valley Bank and several smaller US banks, and the necessity of a forced merger to keep Credit Suisse in operation, has that breaking point now been reached? Some investors feared a rerun of 2008, with dominoes falling in a frozen banking system, but it is clear that 2023 is very different to 2008. While 2008’s crisis was centred on bank solvency - losses on real estate and other lending wiping out bank equity, leading to bankruptcy - 2023’s problems were more about liquidity and mismatches between short-term liabilities and long-term assets. Tech-enabled banking allowed customers to withdraw deposits very quickly, and banks holding assets like medium-term Treasuries - which they would not expect to lose money on if held to maturity - could not sell those assets to meet withdrawals without crystallising significant mark-to-market losses. For a bank like SVB, with a highly concentrated depositor base and apparently limited hedging against losses in their bond portfolio from higher interest rates, it was a sudden and perfect storm. But in contrast to 2008, this is a situation that could be managed by providing more liquidity to the system, not one where the system could freeze due to a rolling wave of insolvencies as banks experience massive losses from irresponsible and excessive lending.
Of course bank credit losses will likely pick up if the economy slows. Many are concerned about commercial real estate exposures in particular, with vacancy rates in offices still very high as working patterns have changed through the pandemic. Higher interest costs will undoubtedly present problems for some borrowers when they come to refinance debt. And banks’ readiness to extend credit will also be reduced - effectively a tightening in the system that does some of the central banks’ job for them! But the differences in the banking system today compared to 2008 should stop markets from trying to fight the last war again: especially for the larger banks, and especially for European banks, the system now has much stronger equity capital to absorb losses and much better access to liquidity - the product of post-crisis regulation and stress tests. Markets could yet wobble again over systemic bank fears, but central banks have given the clearest possible demonstration that they think the risks are contained: the Fed, ECB, Bank of England and even the Swiss National Bank have all gone ahead with planned interest rate hikes since the market wobble.
Markets wonder whether that was the last rate hike of the cycle - for the Fed at least. With US 2-year Treasuries now yielding over 1% less than Fed interest rates, the market clearly believes that the peak is here and that rate cuts will follow soon: that signal has worked for every cycle since 1990. Have they got it wrong this time: the Fed’s own forecasts point to one more hike and no rate cuts in 2023, with inflation still expected to be above 3% into the year end. The challenge for central banks is to judge how much lagged effect there will be from the monetary tightening they have already carried out - a challenge made more complicated if banks’ willingness to extend credit is compromised in the wake of the SVB failure. There is still a mismatch between market expectations and Fed forecasts but there is some convergence in the idea that if we are not yet at the peak of Fed hikes, we are now likely to be close.
In the last few Fed cycles, the hikes have stopped only when something in the market or the economy has broken, and the peak in rates has been associated with or followed by significant equity market volatility: for example, the Fed stopped hiking in 2000 a couple of months after the tech bubble had begun to burst; Fed hikes ended in 2006, after US housing prices had begun to fall - by early 2007, US subprime lenders were running into trouble (the broader equity market collapse didn’t happen until 2008). This precedent clearly worries investors who fear the potential of another leg lower for stocks if the rate hikes pause. But of course every cycle is different: in a world which saw peak-to-trough global equity falls of 25% from January to October 2022, others will take the view that the pain of a hiking cycle was front-loaded in this cycle. Time will tell: but of course this debate has scope to lead to more volatility to come.
Investors might feel surprised by market strength in 2023 so far! After all, central banks are still hiking rates, inflation isn’t falling as fast as hoped and growth looks subdued - on top of that, the sight of bank runs and emergency weekend rescue packages raised the ghosts of 2008. But despite a brief outbreak of volatility, markets have rallied, with stocks up for the month of March and for the year-to-date. But there’s always a counterpoint; for every seller, there’s a buyer. Inflation may be stubbornly high, but the supertanker has finally turned. Central banks are still raising rates, but the end of the Fed hiking cycle is in sight, and despite higher interest rates, economic growth has surprised to the upside, remaining much more resilient than expected: recession avoided for now, helped enormously by the reopening of the Chinese economy propping up demand. And of course, 2023 is not 2008: the banking sector today looks very different to that of the last financial crisis.
Perhaps too the sharp losses of 2022 set up financial assets for a period of better returns - especially for bond markets, where yields had held out the prospect of better returns in diversified portfolios. After the worst year in living memory last year, Q1 2023 saw gains from all key segments of global bond markets. Core government bonds returned around 2%, with 10-year US Treasury yields inching lower despite the ongoing Fed rate hikes; longer-dated Treasuries gave better returns, close to 5% in the quarter. Shorter-dated US Treasuries, which are more closely related to market expectations for interest rates in the near term, were buffeted as markets tried to understand the effect of banking sector problems on the real economy and on the Fed’s likely trajectory: after 2-year yields topped 5% in early March, they collapsed to below 4% in the next fortnight, with levels of volatility seen rarely outside periods of market crisis.
Credit did well, despite investor nervousness about bankruptcy risk. High quality corporate bonds delivered marginally better returns than Treasuries, as did lower quality “junk” bonds, with high yields offsetting the impact of slightly wider credit spreads, as investors demanded more compensation for the risk of default. Some sectors saw even stronger returns: local-currency Emerging Markets bonds outperformed as most EM currencies strengthened against the US Dollar, and UK linkers - after significant losses in 2022 - gained over 4%, with inflation protection still in demand and valuations far more reasonable than for years.
Global equities prospered, shrugging off bank failures and ongoing fears about the impact of rate rises. Global stocks gained 7% in Q1, led by Europe and Japan; US stocks returned 7% too. UK equities were up less than 3%, but this looks respectable in the context of a strengthening Pound and the UK market’s resilience last year. Emerging markets lagged, despite China’s reopening, partly due to weaker commodity prices dragging on resource-heavy markets like Brazil. And while lower oil prices dragged global Energy stocks down around 4%, and Financials were down slightly amid concerns over the banking sector, technology-heavy sectors powered ahead to double-digit gains. After Value’s recovery in the previous quarters, 2023 so far has been all about large-cap growth - gaining 12%, while Value and Small/Mid-caps made little or no gains.
There are undercurrents here that give pause for thought: do these dynamics reveal a picture for equities that is really as healthy as it appears? The US equity market rebounded rapidly as the authorities stepped in to address liquidity problems in the banking sector, quickly undoing broad market losses since concerns flared in early March, but US banking stocks are still down 25% over that period. In an echo of 2021, market leadership has narrowed: were it not for the contribution of a dozen large technology stocks, broad US equity indices would in fact be negative year-to-date. A sharp divergence between bulls and bears is understandable here. Some fear that current trends look like a huge bear-market rally, a deceptive but unsustainable rebound by the leaders of the old cycle, before a painful fall to new lows. Others counter that after two consecutive quarters of rising equities and with the end in sight for high inflation and Fed hikes, a new bull market has already been established. Broader positive performance from cheaper stockmarkets outside the US perhaps casts another vote for the bulls: large-cap Eurozone equities up 13% YTD and even European Banks up over 5% YTD suggest that there is more going on than simply an echo of the old bull market.
The Dollar had surged through 2021 and much of 2022, but the reversal since then has been significant: a sharp reversal in Q4 last year, followed by modest further falls in Q1 2023, mostly against the Euro and Sterling, as short-term interest rate and economic growth expectations in Europe have pushed higher. Over 12 months, the Pound and Euro have now regained 8-10% against the US Dollar; central European currencies and a few emerging market currencies have done even better over this time. In commodity markets, March saw crude oil prices touch their lowest levels since before Russia’s invasion of Ukraine; Gold on the other hand rallied alongside fears of banking sector weakness and has held these gains, supported too by the weaker Dollar. At $1969/oz, Gold rose 7% in the quarter to approach 12-month highs and indeed is now within 5% of all-time highs seen in August 2020. In the face of falling inflation and rising interest rates, this is a remarkable performance from an asset that generates no income. Copper rose 7% in the quarter: a strong outcome for industrial metals is not usually associated with an economy on the brink of recession.
There has always been an optimistic scenario for this cycle, although the road to that outcome has often looked perilously narrow: in that scenario, inflation moderates enough to enable central banks to pause, and this happens without higher rates strangling the economy. Equity earnings would face pressure from lower economic growth, but would not seem so bad viewed through a lens of high nominal growth, with inflation boosting corporate revenues. Markets could respond very well to such a “soft landing”, with bonds and equities rallying. That rose-tinted view has looked improbable at times, but it cannot be ruled out. Investors may still be looking at this cycle with the playbook of the disinflationary environment of the last thirty years - a world in which central banks would come to the economy’s aid with rate cuts when recession arrived. But this cycle is different: central banks have been clear that they will accept - even embrace - recession, as the key weapon to fight inflation. If the slowdown is sharper than expected, we may have to wait longer for central banks to come to the economy’s aid than in previous cycles.
Many investors will be tempted by cash and bonds, being “paid to wait” with yields at levels not seen for years; and indeed these assets should play a role in diversified portfolios. The picture is more challenging for equities, after a strong run since Autumn lows, with valuations undermined by expensive US growth stocks, headwinds for corporate earnings, scope for renewed concerns in the banking sector and uncertainty over how far central bank tightening still has to go. But with the peak in interest rates likely in sight now, better valuations for non-US stocks and renewed positive surprises in the global economy, investors choosing the relative safety of being “paid to wait” in bonds should ask themselves what triggers they are waiting for to change their view.
N.b. All content is based on data at the time of writing on 4 April 2023.