Surprising Market Resilience

April 7, 2023 –

It has been an unpredictable start to the year amid swings in expectations for interest rates. Markets moved from gains in January, assuming inflation was easing, to quickly reversing in February on reports of stronger than expected inflation and employment reports. Volatility was ratcheted up by the Silicon Valley Bank and Signature Bank failures in early March, followed a week later by the forced buyout of chronically troubled Credit Suisse, one of Europe’s largest banks. During this, the Federal Reserve persisted in its tough line on inflation by continuing to hike short-term interest rates.

The two primary influences in the market recently, bank failures and Fed policy, are interrelated. Rate increases were the catalyst, directly or indirectly, for Silicon Valley Bank’s collapse. Bank failures are likely to result in tightening of lending standards, which could contribute significantly to a decrease in lending and reduction of capital available. In effect, the tightening of standards is doing part of the Fed’s job for it. A possible silver lining to the banking troubles may be the cooling effect this restriction of lending has on inflation.

There is a lesson for investors in the Silicon Valley Bank failure. One reason for the collapse was the mismanagement of its sizable bond portfolio. As deposits accumulated, the bank invested in government-backed bonds with long maturities. The credit quality of the portfolio was not a problem. But, in reaching for higher yields by loading up on long maturities, the interest rate risk associated with long maturity bonds became a fundamental problem. The bank was forced to recognize the loss in value of these older bonds with fixed, lower interest rates, as rates on similar newly-issued bonds climbed. We have preferred bond portfolios of laddered maturities (equal amounts of a series of maturity dates), acknowledging the impossibility of predicting future interest rates. This approach alone may not have saved the bank, but it has served bond investors well by reducing exposure to interest rate changes.

Surprisingly, while these issues were going on, U.S. stocks rallied more than 7% for the second consecutive quarter and the bond market to gained 3%. Despite constant discussion in the past year of an economic downturn, the most anticipated recession in recent memory has yet to materialize. Although a recession can never be ruled out, the financial landscape is changing, and the economy is working through this inflationary period. The markets seem to be looking months ahead to a stable economy with lower interest rates and, presumably, lower inflation, along with decent corporate profits.

As managers of client portfolios, we take all these current events into consideration in making investment decisions for both long-term and short-term strategies. But owners of those portfolios are best served by taking a big picture perspective and keeping in mind the purpose of the money invested. For the majority, the ultimate uses are seven years or more in the future or, in some cases, for the next generation.

U.S. Stocks – Again this quarter, company earnings and forward guidance will figure large in the direction of U.S. stocks. Higher interest rates affect company profits and stock prices in several ways, and how management adapts is key. With U.S. stocks having gained over 7% each of the last two quarters, there is still room for gains, but stock selection will be important. Since January 1^st, the S&P 500’s gains have been very concentrated with big advances in a handful of stocks in three sectors: technology (Apple, Microsoft, and Nvidia), communication services (Netflix and Meta), and consumer discretionary (Tesla). These tech-centric, large-growth stocks benefited from renewed hopes of an end to rate increases. Given this outperformance concentrated in one corner of the market, we are reviewing portfolios to ensure the U.S. stock diversification is on target and we are rebalancing when needed.

Foreign Stocks – Foreign equities have also performed well so far this year. European markets had braced for the economic impact of the disruption of Russian oil and gas supplies. Surprisingly, severe shortages were avoided, energy costs are lower than expected, the European economy is healthy and corporate earnings are generally strong. In addition, for U.S. investors, the reversal of the decades-high U.S. dollar is a significant tailwind for foreign stock returns. Emerging markets are still burdened by higher borrowing costs, but China’s reopening should improve economic activity in those markets. As with mature market foreign stocks, the decline in the U.S. dollar would boost returns in these emerging market securities for U.S. investors.

Fixed income – The Federal Reserve has said it intends to keep short interest rates high until inflation comes back to a target level near 2%. There are opportunities in the bond market, with interest rates across all maturities higher than the past several years and the economy likely slowing. We are now cautious regarding credit quality, moving lower quality positions to higher quality and extending the range of maturities in portfolios. We “ladder” portfolios of individual bonds with similar dollar amounts in each maturity from two years to seven years. We use tax-exempt municipal bonds in taxable accounts, which are attractive on a tax-adjusted basis. In retirement accounts and other tax-free or tax-deferred accounts, we invest in quality corporate and taxable municipal bonds, CDs, treasuries, and government agency bonds. Cash is even gaining attention after years of sub-1% yields. Money markets and the shortest maturity bonds are now yielding around 4%. We define cash as a quality short-term fixed rate asset with less than 12 months to maturity.

While we review many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. As always, your comments and questions are welcome. Please call us or stop by the office any time.