January started the year off in a positive direction, with the S&P 500 returning 6.3% for the month. February returned some of January’s gains with the S&P 500 retreating -2.4%. March saw the market bounce back to the highs for the year with the large cap index rebounding 3.7%. In all, the S&P 500 gained 7.5% for the quarter, which is the best first quarter start for the index since 2019.
It went mostly unnoticed, but the market has delivered two quarters in a row of positive returns! Broadly speaking, the market has regained about half of the losses registered at the October lows. There is still a long way to go, but we’re encouraged that the market seems to have regained its footing, at least for the time being.
The headline that continues to move the market has been the campaign by the Federal Reserve to fight inflation by raising interest rates and tightening the money supply. Having raised the effective Fed Funds Rate from near 0% to 4.65% in just over a year, the Fed’s policy move has been the most aggressive rise in rates in more than three decades.
The Fed’s motivation for raising rates is an attempt to lower inflation back down to their target of 2%. The raising of rates is meant to slow the economy, which in theory will dampen wage growth and cool the growth in prices of goods and services. So far, their efforts seem to be working. Inflation peaked at 8.9% last summer and has steadily declined to the most recent reading of 5%.
The Fed has an unfortunate history of pushing their policies too far, creating unintended economic consequences. There’s a saying on Wall Street that “the Fed will continue raising rates until something breaks.” In March something broke. There were a handful of bank failures last month, most notably Silicon Valley Bank, which is the second largest bank failure in U.S. history. The suddenness of the collapse caught almost everyone by surprise and raised concerns of another 2008-style financial crisis. However, those concerns have calmed considerably in recent weeks.
By all accounts, Silicon Valley Bank became a victim of their unique business model. Unlike most banks, they served a small mostly corporate client base with unusually large deposits. They also made a significant risk management error by placing much of their capital reserves in long-term bonds, which are highly sensitive to changes in interest rates. Since bond values go down when interest rates go up, the rapid rise in interest rates caused the value of these bonds to drop. When their customers became concerned about the safety of their deposits, they began rapidly withdrawing their deposits, resulting in a classic bank run. Thankfully, the Fed, Treasury Department, and FDIC intervened quickly to insure bank deposits and restore confidence to the banking system.
There are key differences that makes the recent banking turmoil different than the financial crisis of 2008. The primary difference is that the agencies in charge of the financial system have better tools at their disposal and reacted quickly, containing the risk of contagion. In contrast, in 2008 partisan bickering prevented any intervention for weeks while the financial systems spiraled into a near collapse. Also, crisis-era regulations have made banks much stronger financially and have restricted their ability to take significant risks with their capital.
While rising rates have created many difficulties, a silver lining is that savers can finally earn a decent yield on their cash holdings. While banks have been slow to increase the yield they offer for deposits, there are plenty of alternatives that offer much more attractive yields. Many money market funds and short-term treasury bonds have yields topping 4%, motivating households and businesses to search beyond their banks for better yields for their savings.
Despite the seemingly high level of pessimism in the press and among investors, the economy remains in reasonably good shape. Unemployment remains near historic lows and real GDP is expected to grow 1-2% in 2023. Inflation appears to have peaked last summer and has been steadily declining. Many strategists believe that a recession is not a certainty and that if there is a recession, it is likely to be mild. So, we remain optimistic that markets will continue to recover and eventually reach new highs. Hopefully much sooner than many are expecting.
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