At Nixon Peabody Trust Company, we continually evaluate real-time economic data and short- and long-term forecasts to build customized strategies that grow your money. If the flood of financial headlines leaves you a bit confused, you can be confident that we’ve designed a portfolio-positioning strategy to maximize your success.
For many of our clients, fixed-income investments in US government bonds are a more compelling option for the months ahead, after valuations shifted for stocks and bonds and the Fed decided to raise interest rates to a level not seen in nearly two decades.
In equity portfolios, selectivity and diversification are critical. Companies with strong balance sheets, capable management, and the ability to grow market share and participate in growing end markets are best prepared to thrive in the current environment. And diversification across sectors, geographies, asset classes, and market capitalization is key.
Just as important as diversification is thoughtful rebalancing—trimming back on investments that have been strong performers and selectively adding to weaker performers. Specifically, we are assessing holdings that may have moved “too far, too fast” during the first-quarter stock market rally to determine whether to sell or reduce our positions. We are also evaluating opportunities to upgrade or diversify portfolios to take advantage of opportunities in small company stocks, non-US stocks, and inflation-sensitive investments.
In the alert below, I dig deep on some key factors driving the Q1 economic performance. If you have questions or comments—about your personal portfolio or any of the trends and strategies I’ve outlined here—please reach out to me or any member of your Nixon Peabody Trust Company team. We’re always happy to hear from you.
Q1 2023 in review
Stock and bond markets rebounded strongly in the first quarter, rallying to close the quarter despite the second-largest bank failure in US history. Equities responded positively to hopes that inflation will continue to ease, which would pave the way for the Fed to pause rate hikes. Global equities, as represented by the MSCI All Country World Index, rose by 7.44% for the quarter. The S&P 500 Index gained 7.48%. Market leadership was narrow during the quarter, with nearly 90% of S&P 500 gains coming from ten stocks. The 17% gain for the NASDAQ Index reflects the rebound in many of the leading technology stocks that performed poorly in 2022. US small company stocks, as represented by the Russell 2000 Index, gained 2.73%. Developed international stocks, as measured by the MSCI EAFE Index, rose by 8.65%. European stocks were helped by the avoidance of worst-case economic scenarios connected with Russia’s invasion of Ukraine and a falling dollar. Emerging markets stocks gained nearly 4%.
Growth stocks rebounded strongly after a difficult 2022, while value stocks suffered amidst upheaval in the financial services sector. The Russell 1000 growth index outperformed its value counterpart by more than 13%. In S&P 500 sector terms, technology, communications services, and consumer discretionary were market leaders. Financial services, energy, and healthcare fell behind.
The bond market stabilized after one of the most difficult years in history, with hopes rising that the Fed would follow a mid-year pause with a pivot to rate cuts later in the year. The Bloomberg Aggregate Index returned nearly 3% for the quarter; the Bloomberg Municipal Bond Index provided similar returns. The yield on the two-year Treasury Note ended the quarter slightly above 4%, below the 2022 year-end yield, but remaining dramatically above year-earlier levels.
The yield curve
The yield curve depicts how the yield on fixed-income investments varies as a function of the years remaining to maturity. The yield curve is typically upward-sloping, with longer-term bonds yielding more than shorter-term bonds. When the yield curve is inverted, as is the case today, short-term bonds yield more than long-term bonds.
Yield curve inversion has historically been one indicator of impending recession; other macroeconomic data released during the quarter reinforced concerns that the US economy would face a recession in 2023.
The starting point for yields matters when thinking about the fixed-income approach I described above. With short-term bonds yielding more than 4%, the bond market should provide a combination of income and capital preservation if inflation moderates in the months ahead.
The dominant themes for the quarter included turmoil in the banking system, inflation that remains above the Fed’s long-term targets, and uncertainty about Fed policy. China’s pivot away from the zero-COVID policy boosted economic growth but continuing geopolitical friction between the United States and China contributed to market volatility. At quarter-end, investor debate focused on whether the economy was headed to a hard landing marked by a severe economic downturn or a soft landing featuring a milder downturn.
The failure of two banks contributed to a challenging quarter for regional bank stocks, with investors worrying about deposit flight and unrealized losses on bond portfolios. Although speculation about potential bank failures faded from headlines into the start of the second quarter, there are important macroeconomic implications associated with recent events. Credit conditions are likely to tighten, with banks likely to prioritize building liquidity and capital buffers over lending. A “credit crunch” would make it harder for the US economy to avoid recession.
Inflation and central bank policy
The Fed’s job did not get easier during the first quarter. However, inflation is continuing to decline from last year’s peak levels. Energy and food prices have come down, while goods inflation has largely fallen in response to lower demand and strengthening supply chains. Services inflation remains elevated, with housing-related costs, food away from home, and lodging among the elements contributing to inflation remaining above the Fed’s long-term target of 2%. Housing is the largest component of core inflation. Although real-time measures of rents and home prices are slowing significantly, there will be a substantial lag before the current housing slowdown is fully reflected in inflation reports.
The job market
The tight labor market complicates the Fed’s rate-setting deliberations. Wage pressures are contributing to rising services inflation and to the concern that inflation expectations will become “unanchored” from the Fed’s 2% target.
The ratio of job openings to job seekers remains high, in part because labor participation has not returned to pre-COVID levels. The hopeful view is that job openings continue to come down while labor participation rebounds, allowing the job market and wage growth to soften without creating a significant increase in unemployment. We do expect the job market and economic momentum to slow enough to allow the Fed to pause its rate hike cycle but think that unemployment is likely to overshoot the Fed’s expectations.
Although the US economy may not avoid recession, the strength of the consumer should help cushion any economic downturn. Consumer balance sheets are in good shape, with savings remaining robust and household debt and debt servicing ratios far below the heights reached during the global financial crisis. Some credit stress is emerging among the lowest-income households, but so far, it has been contained. The housing market is slowing, but in contrast to 2008, lending standards are much stronger, housing inventories are much lower, and most US mortgages are fixed-rate rather than adjustable.
Chinese economic growth
China’s sudden pivot from its zero-COVID policy to a full reopening boosted global economic growth and market sentiment. Chinese households have been forced savers since the start of the pandemic, with household bank balances significantly higher than the level at the beginning of 2020. These funds helped fuel a stock market rebound in China and a boost in consumer spending inside and outside of China. The boost from the Chinese reopening in 2023 is likely to fall short of expectations, as China’s debt burdens and the falling home prices will be a constraint for government and consumer spending.