However, economic uncertainties remain. On May 1, First Republic Bank was seized by regulators and its assets were sold to JPMorgan Chase – the fourth bank failure since early March. The failures were triggered by the rapid increase in interest rates by the Federal Reserve (Fed), which drove down the value of the banks’ existing bond and mortgage-backed security holdings. But regulators have remained vigilant and have been quick to respond.
Despite the banking turmoil, the Fed hiked rates one more time, with a 0.25% increase May 3, bringing the total increase in rates since the Fed began its hikes early last year to 5.25%. It was the first time the benchmark rate has exceeded 5.00% since July 2007.
While Fed Chair Jerome Powell hinted that the Fed would likely pause further rate hikes, he stressed that the economy could still face a number of challenges in the coming months. “Credit conditions had already been tightening over the past year or so in response to our policy actions and a softer economic outlook,” he said. “But the strains that emerged in the banking sector in early March appear to be resulting in even tighter credit conditions for households and businesses.”
One economic development that may have played into the Fed’s guidance was the latest gross domestic product (GDP) report indicating that the U.S. economy is continuing to slow. According to the Bureau of Economic Analysis (BEA), GDP rose at a rate of only 1.1% in the 1st quarter – the third consecutive quarter of slowing economic growth. Declines in inventories and fixed investment, such as equipment and facilities, were the largest drags on the economy in the 1st quarter. But on the bright side, consumer spending continued to accelerate, and exports rose.
Inflation has proven persistent with the Personal Consumption Expenditures Index (PCE), a common gauge of inflation, rising 4.2% year-over-year through March, according to the April 28 BEA report. However, the PCE, which tracks consumer expenditures for goods and services, was up only 0.1% from the previous month in March, the smallest one-month rise this year. Excluding food and energy, the index was up 0.3%.
The Consumer Price Index (CPI), which also tracks prices consumers pay for goods and services, also inched up just 0.1% in March and 5.0% from a year earlier, according to the Bureau of Labor Statistics. It was the smallest year-over-year rise since May 2021. However, Core CPI (excluding the more volatile food and energy prices) rose 0.4% in March, and 5.6% year-over-year.
Outlook: The economic uncertainty and volatile investment environment that characterized the 1st quarter is likely to prevail through much of 2023. The challenges of transitioning to a post-pandemic world, continued inflationary pressures, a restrictive monetary policy, and ongoing geo-political tensions, are likely to remain headwinds for the stock and bond markets.
Regardless of equity style or size characteristics, quality factors such as reliable earnings and strong balance sheets will likely be critical issues in equity performance as the year progresses. That said, mega cap technology stocks, which significantly lagged the market last year, look poised to continue their recovery, as investors migrate back to less cyclical, high quality, and low capital intensity stocks.
While small cap and value stocks remain historically cheaper relative to these large cap stocks, these sectors typically perform better when the economy transitions from contraction back to expansion. And we aren’t there yet.
With expectations of a challenging macroeconomic environment, we believe credit risk is elevated and may impact corporate and high-yield bond returns over the balance of the year. Credit spreads have widened, especially in the banking sector, as elevated risks were priced into bond yields.
Before adding significant risk in either fixed income or equities, we believe investors should look for meaningful improvement across a range of critical factors, including more attractive overall valuations, declining inflation, stability in the banking and financial system, and an economy poised for expansion. In the meantime, we continue to believe a defensive stance remains warranted, with a bias to cash and higher quality, shorter maturity fixed-income investments.
U.S. stocks edge up
The S&P 500® Index was up 1.46% in April, from 4,109.31 at the March close to 4,169.48 at the end of April. The total return of the S&P 500 (including dividends) was 1.56%. The total return for the year through April was 9.17%. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 U.S. large capitalization stocks.)
The NASDAQ Index rose slightly in April (up 0.04%) from 12,221.91 at the end of March to 12,226.58 at the April close. For the year, the NASDAQ was up 16.82% through April, as technology stocks continued their rebound off large losses in 2022. (The NASDAQ – National Association of Securities Dealers Automated Quotations – is an electronic stock exchange with more than 3,300 company listings.)