Economic Flash: Signs of Fragility

people walking in orange corridor

April 2023

US Economy: More fragile.

As the Fed pressed forward with tighter monetary policy, most economic data indicated an economy that continues to slow and flirt with recession, with retail sales (-0.4%) falling and unemployment on the rise (from 3.4% to 3.6%). Importantly, the first real consequence of high interest rates manifested in the collapse of Silicon Valley Bank and Signature Bank, with the Fed implementing a backstop program to reassure all depositors.

US Stocks: Resilient rebound.

Intramonth, large-cap US stocks had fallen nearly 5% peak-to-trough before optimism grew that deteriorating economic data and tighter liquidity conditions would force the Fed to reconsider its course. Large-cap stocks finished the month up over 3.6% with big gains from rate-sensitive tech (12.1%) and communications (10.4%). Small-cap stocks, which are more sensitive to both economic growth and credit disruption, did not benefit (-4.8%).

Foreign Stocks: Ditto the US.

While the banking crisis extended overseas, as long-struggling Credit Suisse was taken over by rival UBS, so too did the recovery and rapid turnaround that marked US large-cap: Both non-US developed and emerging markets posted comparable returns to the US at month-end. While ongoing war in Ukraine weighed on Eastern Europe, Asia was broadly positive, with China (+4.5%) benefitting from relative economic strength.

Fixed Income: Longer was better.

The Fed’s preferred inflation gauge, the Core PCE price index, slowed more than expected but inflation remains a concern even if the latest monthly increase brings the annualized rate down to 3.6%, a positive sign. This result, coupled with the banking turmoil, contributed to interest rates falling. With this backdrop, longer-maturity bonds outperformed in most sectors of taxable and tax-exempt, whereas cash and equivalents lagged.

Real Assets: Infrastructure leads.

As investors focused more on economic fragility than inflation, real assets quietly struggled with the notable exception of infrastructure (+2.4%), which benefits from both defensive characteristics and secular tailwinds. Both REITs and commodities were in negative territory. Over the last 12 months, infrastructure equities are down just 3.5% whereas broad-based commodities are down 12.5% and REITs 19.4%.

Alternatives: Small negatives mostly.

Hedge fund strategies continued to post modest or flat returns through the persistent volatility in both the stock and bond markets, although deteriorating credit conditions offer both risks and opportunities to the space going forward. Managed futures strategies, which are geared to take advantage of pricing trends, suffered in March as the markets did an about-face and caught many managers off-guard.

Source of data: Bloomberg

Equities Total Return

U.S. Large Cap 3.7% 7.5% (7.8%)
U.S. Small Cap (4.8%) 2.7% (11.6%)
U.S. Growth 6.2% 13.8% (10.9%)
U.S. Value (0.9%) 0.9% (6.4%)
Int’l Developed 2.5% 8.5% (1.4%)
Emerging Markets 3.0% 4.0% (10.7%)

Fixed Income Total Return

U.S. Agg. Bond 2.5% 3.0% (4.8%)
TIPS 2.9% 3.3% (6.1%)
U.S. High Yield 1.1% 3.7% (3.6%)
Int’l Developed 2.1% 2.3% (7.7%)
Emerging Markets 1.3% 2.0% 3.2%
Intermediate Munis 1.9% 2.0% 1.5%
Munis Broad Mkt 2.2% 2.8% (0.3%)

Non-Traditional Assets Total Return

Commodities (0.2%) (5.4%) (12.5%)
REITs (1.7%) 1.7% (19.4%)
Infrastructure 2.4% 3.9% (3.5%)
Hedge Funds
Absolute Return (0.1%) (0.2%) 0.5%
Overall HF Market (1.2%) 0.0% (3.1%)
Managed Futures (6.5%) (5.3%) 0.9%

Economic Indicators

MAR-23 SEP-22 MAR-22
Equity Volatility 18.7 31.6 20.6
Implied Inflation 2.3% 2.2% 2.8%
Gold Spot $/OZ $1969 $1661 $1937
Oil ($/BBL) $80 $88 $108
U.S. Dollar Index 120.5 127.4 115.2

Glossary of Indices

Our Take

The risk that the Fed may raise rates too far too fast has been one we have highlighted since early 2022, when it became clear the Fed would start to raise rates. Cash, core fixed income (in 2023), and diversifiers have generally benefited portfolios in light of this environment. Surprisingly, as stated earlier, equities have generally held up well in 2023 – despite turmoil in the banking sector. But that is mostly due to the resurgence in the mega-cap tech stocks. Investors are likely expecting that a recession will lead to lower interest rates and ultimately help tech stock valuations. It is way too early, we think, to take the market rebound as a sign that all is well.

As we stated back in January 2022, we are likely in the midst of a market regime change for a variety of reasons, the ramifications of which continue to surface. For example, the trillions in bank deposits that were getting essentially zero or negative interest have started to move out of banks into higher-yielding money market accounts. This has been creating stress primarily for the regional banks some of which during the easy money era forgot the basic rules of banking, including how to compete for deposits. With that said, there was some encouraging news on this front in the recent weekly H.8 report released by the Federal Reserve, which indicated deposit outflows seem to be abating.

We will discuss in detail what recent developments mean for markets and our portfolios in our Q2 2023 Economic Commentary.