May 2023
US Economy: Signs of cooling.
Claims for U.S. unemployment benefits hit 1.8 million in April, the highest level since December 2021, while manufacturing activity remained in contraction and consumer spending was flat. Real estate was almost uniformly weaker, with existing home sales (-2.4%) and building permits (-8.8%) substantially down, while surprisingly, new home sales (+9.6%) bounced on modestly lower mortgage rates.
US Stocks: Bigger was better.
U.S. equities performed reasonably well, with non-cyclical stocks generally outpacing those more sensitive to economic growth. Mega-cap stocks have played an outsized role in both market performance and earnings year-to-date. Apple (+2.9%) and Microsoft (+6.6%) accounted for about 40% of the April return on the S&P 500; Amazon accounts for more than 83% of the earnings growth forecast for the entire S&P 500 in 2023.
Foreign Stocks: Mixed bag.
Developed foreign market returns were similar to the U.S., given the added boost of a weaker U.S. dollar. Within emerging markets, Eastern European countries including Poland (+13.5%) and the Czech Republic (+7.7%) seemed to regain investor confidence despite the ongoing conflict in Ukraine, whereas China’s equity market fell (-5.2%) on the weakest economic growth outlook since the early 1990s, Covid aside.
Fixed Income: Another hike.
Headline inflation in March (the latest reading) continued to inch downward as measured by the Personal Consumption Expenditures (PCE) Index at 4.2% annualized. But core PCE (excluding food and gas), the Fed’s preferred gauge, was unchanged at 4.6%, which mildly ruffled bond markets as investors factored in another interest rate hike for shorter maturity bonds. Meanwhile, muni bonds posted a small loss as investors sold bonds to pay their tax bills.
Real Assets: Commodities drag.
While the bulk of the real assets space saw returns on par with equity markets, commodities continued to struggle in an environment less concerned with runaway inflation and more focused on economic weakness: Industrial metals were down 3.8% in April. On the fixed income side, Treasury Inflation Protected Securities (TIPS) were flat, given that long-term expectations for real (inflation-adjusted) interest rates were largely unchanged.
Alternatives: CTAs bounce.
Hedge fund strategies continued the trend of relatively modest or flat performance, while Commodity Trading Advisors (CTAs), or hedge funds that use a managed futures strategy, benefited from more directionality in a number of trading sectors including within fixed income, interest rates, currency and commodities. As mentioned last month, CTAs tend to add value in markets characterized by developing trends that persist.
Source of data: Bloomberg
Equities Total Return
| APR | YTD | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | 1.6% | 9.2% | 2.6% |
| U.S. Small Cap | (1.8%) | 0.9% | (3.7%) |
| U.S. Growth | 0.9% | 14.8% | 2.2% |
| U.S. Value | 1.3% | 2.2% | 0.6% |
| Int’l Developed | 2.8% | 11.5% | 8.4% |
| Emerging Markets | (1.1%) | 2.8% | (6.5%) |
Fixed Income Total Return
| APR | YTD | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | 0.6% | 3.6% | (0.4%) |
| TIPS | 0.1% | 3.5% | (4.0%) |
| U.S. High Yield | 1.0% | 4.7% | 1.0% |
| Int’l Developed | (0.1%) | 2.2% | (5.6%) |
| Emerging Markets | 0.6% | 2.7% | 4.8% |
| Tax-Exempt | |||
| Intermediate Munis | (0.4%) | 1.5% | 2.9% |
| Munis Broad Mkt | (0.1%) | 2.7% | 2.6% |
Non-Traditional Assets Total Return
| APR | YTD | 1 YR | |
|---|---|---|---|
| Commodities | (0.8%) | (6.1%) | (16.6%) |
| REITs | 0.3% | 2.0% | (16.1%) |
| Infrastructure | 2.6% | 6.7% | 2.4% |
| Hedge Funds | |||
| Absolute Return | 0.2% | 0.0% | (0.1%) |
| Overall HF Market | 0.3% | 0.3% | (2.0%) |
| Managed Futures | 1.9% | (3.5%) | (2.8%) |
Economic Indicators
| APR-23 | OCT-22 | APR-22 | |
|---|---|---|---|
| Equity Volatility | 15.8 | 25.9 | 33.4 |
| Implied Inflation | 2.2% | 2.5% | 2.9% |
| Gold Spot $/OZ | $1990 | $1634 | $1897 |
| Oil ($/BBL) | $80 | $95 | $109 |
| U.S. Dollar Index | 119.4 | 127.6 | 119.5 |
Our Take
While forecasting tends to be a pursuit akin to tilting at windmills, it is only natural for us as investors to assess whether market developments represent an inflection point for markets or the economy. Our view is that there are plenty sources of uncertainty that could fuel ongoing volatility. In the last few months, we have seen data that has turned a bit sour with the bulk pointing toward recession. For example, the jobs market looks less rosy even if the unemployment rate is pretty close to where it’s been: We’ve seen an uptick in layoffs and new job openings are as low as they have been in two years. Real estate data has been gloomy as well: After falling 2.4% in the most recent month, existing home sales are down more than 22% in the last year. Meanwhile, new home starts and permits are also down as mentioned above.
What is probably more troubling is the deterioration in consumer spending. We are seeing consumers cut back on air travel, hotels, restaurants, and recreation services. Strip out housing and health care, and real (inflation-adjusted) consumer spending fell 0.3% in March after a 0.4% decline in February, making for a downward trend in four out of the past five months. Spending on “durable goods” (cars, major appliances) also slid in March (-0.8%) and is down in four of the past five months. A resilient consumer has been the backbone of the U.S. economy over the last several years including through the height of Covid, primarily thanks to government stimulus. It would appear that resiliency is now being tested by persistent inflation, end of stimulus, tightening credit/less liquidity, slowing growth, and the aftershocks of the banking failures, with all of this likely to continue in the months ahead.
What Now?
Our expectation was that the banking crisis would not end in March, after the two high-profile bank collapses and regulatory intervention/backstops. With the demise of First Republic Bank at the end of April, the three U.S. banks that have failed so far are equal in size ($532 billion in total assets) to the top 25 banks that failed during the 2008-09 Global Financial Crisis ($526 billion in assets). This demonstrates both the order of magnitude and the high level of responsiveness required and delivered by the Fed and FDIC.
Each of the banks that recently failed suffered from a fundamental flaw: Not appropriately managing interest rate risk. With technology now enabling greater potential for bank runs, as money can move with the tap of an iPhone, bank regulations will likely have to account for that higher agility in the future. Fortunately, regulators responded with a comparable level of alacrity to address the three failed banks, but unfortunately, they have not rolled out a comprehensive plan to completely restore depositor confidence. With regional bank stocks still under substantial pressure from investors, regulators need to double down on inspiring conviction that our banking system is strong and safe.
The impact of geopolitics continues to rise in significance as a potential inflammation point. Abroad, the dynamics driving deglobalization and regionalization persist, whereas at home, the federal debt ceiling game of chicken that plays out periodically seems to involve higher risks in this latest iteration.
Treasury Secretary Janet Yellen hinted that the U.S. government could start having trouble paying its bills as early as the beginning of June. The last time the government cut it this close was the summer of 2011, when U.S. debt was downgraded by the major credit rating agencies. Back then, U.S. stocks sold off 17% and equity volatility tripled (as measured by the VIX Index) even though the government thankfully didn’t actually default. While a U.S. default seems unfathomable, a miscalculation by warring politicians is certainly a possibility. If it does happen, it would likely be a violent but somewhat transitory shock to markets. As with most material shocks that have occurred in history, that is when policymakers would be induced to respond aggressively and quickly to raise the debt ceiling and make any missed debt payments.
All told, despite the risks that have manifested, we have had a pretty good start to the year, with positive returns in most corners of the market. Listing all the potential headwinds above was not intended to forecast doom and gloom but to indicate the potholes that might keep the ride bumpy. With that in mind, we are considering modest adjustments to portfolios such as extending our interest rate risk a bit, and as always, making sure we are appropriately diversified across global equities. We are also looking at stressed areas like real estate and credit for opportunities due to market dislocation.
The investment plan we create for each of our clients is geared to meet short-term needs and target long-term goals. Given the potential for more negative news on the horizon to drive volatility even higher, we believe adherence to that strategic investment plan will continue to provide each client with the structure and discipline required for capital to grow over time. As has been shown over the generations, markets tend to be resilient in the long run as most negative events are likely to be resolved, allowing positive developments to arise.
