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Q2 2023 Markets In Focus: Keeping an Eye on Recent Bank Failures and Persistent Inflation

The banking turmoil in the first quarter raised uncertainty for the economy, lowered market sentiment, and increased the chance of a recession in the next year.

The Federal Reserve remains on the same course now as at the end of last year, continuing to tighten monetary policy to fight inflation pressures. Here’s what we’re keeping an eye on, as we review the economic updates from the last quarter and look at what may be around the corner.

Pressure on the Banking Sector

The biggest headlines stemmed from the second and third largest bank failures in U.S. history. The market was caught off-guard by the news in mid-March when Silicon Valley Bank failed and the Federal Deposit Insurance Corporation (FDIC) took over the receivership. Two days later, the government also closed Signature Bank and the FDIC was named receiver.

Fortunately, a joint effort by the FDIC, the Federal Reserve, and the U.S. Department of Treasury ensured that all depositors at those banks would be made whole, regardless of whether their total deposits exceeded the FDIC limit of $250,000 per individual depositor, per insured bank.

These failures show that some banks may have trouble managing their balance sheets in a rising interest rate environment.

  • Silicon Valley and Signature Banks ran into trouble because they were matching potential short-term liabilities (like deposits) with long-term treasury and agency mortgage-backed securities.
  • While these bonds face little to no credit risk, the value of longer-duration bonds resulted in unrealized losses as interest rates rose last year.
  • If enough depositors are concerned that a bank may experience more withdrawals than it’s prepared for, people may want to get their money out, rather than risk getting nothing after other depositors withdraw their money.
  • As these banks were hit with large withdrawals, they were forced to sell their bonds at fire-sale prices and realized the losses, causing a bank run. U.S. authorities stepped in to ensure public confidence in the U.S. banking system.

And the Fed went further to maintain liquidity in the banking system. It instituted the Bank Term Funding Program to provide banks with one-year loans and pledge high-quality bonds as collateral. This means that banks should be able to avoid selling bonds at a loss if a liquidity need arises in the future.

Pressure on the banking sector could continue as the year progresses, especially for smaller banks.

In the week following the collapse of Silicon Valley Bank, small U.S. banks lost $108 billion in deposits. Deposits at the 25 largest banks grew by $120 billion. If these outflows continue, it would decrease profitability for smaller banks and could lead to significant tightening of lending standards for these banks. If that happens, consumers and companies would have less access to loans, which could lead to a chilling effect on economic growth in the U.S.

Inflation, Jobs, and The Fed

Like last year, inflation remains the most important thing on the Fed’s radar as levels continue to be stubbornly high.

  • The prices that people pay (known as the core Personal Consumption Expenditures price index) remained more than twice as high as the Fed’s target for February, at 4.6% versus the long-term target of 2%.
  • While it’s come down from the high point of 5.4% in February 2022, it’s remained consistent over the past three months.

The Fed increased interest rates for the ninth consecutive time at the most recent meeting on March 22, even as some called for a pause.

  • One of the main causes of stress in the banking sector is the higher interest rates that caused long-term bond values to decline, so continuing to raise rates may exacerbate the problems.
  • However, Fed officials likely saw a pause as a possible signal to the market of a lack of confidence in the U.S. banking system.

We believe that the restrictive monetary policy from the Fed will continue to tighten financial and credit conditions, soften the labor market, and bring down inflation. The Fed is also confident in its ability to engineer a soft landing as the summary of economic projects showed that the 2023 gross domestic product (GDP) forecast was only revised downward by 0.1%.

Further complicating the Fed’s interest-rate conundrum, the Organization of Petroleum Exporting Countries and its allies (OPEC+) announced new oil production cuts of around 1.16 million barrels per day recently.

  • In June 2022, the Fed reacted with a jumbo hike of 0.75% when surging oil prices led to the consumer price index reaching a high of 9.1% year over year.
  • Whether the Fed will look through the oil price shocks or react as they did last year depends on how inflation expectations shape up in the coming days, and the response of the energy sector to rising oil prices.
  • The Fed may raise the interest rate another quarter percent to 5.25% at the May meeting if the surge in inflation remains within the limits. It could go higher if there is an upward shift in long-term inflation expectations.

Meanwhile, the U.S. jobs market remains tight. The unemployment rate fell to 3.4% in January, the lowest point since 1969.

  • Unemployment increased slightly to 3.6% in February, mostly because the labor force participation rate increased during the year.
  • Hiring in January and February was also extremely strong as the U.S. added 504,000 jobs in January and 311,000 jobs in February, both well above economists’ estimates.
  • These gains continue to put pressure on wages as average hourly earnings increased 4.6% year-over-year in February.

There are some cracks forming in the jobs market, however. The quarter was filled with announcements of layoffs, mainly from the Tech sector. These came mostly from companies that hired aggressively during and after the pandemic on hopes of high growth rates, and are now forced to right-size for an economy that may be slowing.

Market Performance

Market performance over the first quarter of 2023 can be broken out distinctly between the three months.

  • January saw a strong start to the year, with the Standard & Poor’s 500 Index increasing by 6.2%.
  • February saw the market take a step back with the index down 2.6%.
  • However, what was most surprising, especially given all the negative headlines of bank failures and questions as to whether the Fed was pushing rates too far, is that the S&P 500 posted a positive return of 3.7% in March.

In all, the S&P 500 returned 7.5% over the first quarter of 2023, with broad international markets not far behind, returning 6.9% to start the year (measured by the MSCI ACWI Ex USA NR).

Growth stocks started the year strong, with the Technology sector returning 21.6% and the Communication Services sector returning 21.2%. These were two of the sectors that saw some of the largest losses in 2022.

On the other hand, Financials is the worst-performing sector year-to-date and is down 5.6% on the year. Most of the decline occurred in March when the sector was down 9.5% given the tumult experienced by the bank failures.

The Energy sector, which was the best-performing sector of 2022, declined 4.4% in Q1 2023.

Core fixed income also fared well to start the year with the Bloomberg U.S. Aggregate Bond Index returning 3.0% in the first quarter. This positive return came as rates decreased over all points of the yield curve except the immediate front end (Fed Funds Rate through 6-month T-bills).

The front end of the curve increased as the Fed raised interest rates by 0.25% at each of the first two meetings of 2023.

The Outlook

The outlook for the rest of the year remains uncertain and there are many risks that could tip the scale toward a hard landing.

  • First, there is the potential that the pressure that we’ve seen in the banking sector continues. While there may not be any additional bank failures, the effects of the massive withdrawals from smaller banks could lead to a much more severe decline in lending to businesses and individuals. Tighter lending standards could therefore slow down the economy even more than anticipated by the Fed rate hikes alone.
  • Also, the risk remains elevated for geopolitical conflicts that could slow growth to the point of recession. There is still no clear conclusion to the conflict between Russia and Ukraine, and a March meeting between leaders Xi Jinping and Vladimir Putin could signal China’s backing of Russia in the war, which may mean the support of Chinese supplies to their cause. Tensions remain high in the conflict and have the potential to go higher.
  • Finally, there’s the risk that inflation could stay higher for longer, especially with new production cuts by OPEC+ meaning that the Fed will have to increase rates by more than what the market expects. This would not only further erode consumers’ purchasing power, but it would also put more pressure on stock prices as valuations adjust to a higher risk-free rate.

However, given all these risks, the fact remains that the U.S. jobs market is strong, consumer confidence remains healthy, and the Fed remains committed to stability in U.S. markets. The Federal authorities also stand behind the U.S. banking system.

For these reasons, we believe it is reasonable to expect a situation where inflation returns to normal without a deep recession and large negative impacts to economic growth.

For more on how investors can remain calm in times of uncertainty, check out Why Recent Banking System Failures Raise Questions for Investors.

Investment advice offered through OneDigital Investment Advisors LLC, an SEC-registered investment adviser and wholly owned subsidiary of OneDigital. Any economic forecasts made in this commentary are merely opinion, and any referenced performance data is historical. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. All investments are subject to risk of loss, and any investment strategy may lose value. Past performance is no guarantee of future results.