Stocks rallied in January, propelled by cooling inflation, a better-than-expected start to earnings season, and healthy economic data. A new, upbeat mood began to overshadow investor concerns over interest rates. The positive momentum carried over into February when even a .25 percent interest rate hike could not derail the market’s climb.
However, stocks began dropping as economic data released throughout February diminished investor hopes of a pause in rising rates. Even with the market’s already low expectations, Q4 earnings were underwhelming. Only 68 percent of companies comprising the S&P 500 exceeded Wall Street’s earnings estimates, falling short of the five-year average of 77 percent. Earnings declined for the first time since Q3 2020, falling by 4.9 percent. 
Stocks entered March holding onto modest year-to-date gains, but the final month of the first quarter would prove to be its most dramatic. Interest rate fears flared up once again, ignited by congressional testimony by Powell, who suggested that rates may need to be hiked higher and faster than the Fed had anticipated. 
ECONOMIC CONDITIONS: U.S. – Housing Turn
GDP: The nation’s economy grew at a 2.6 percent annualized rate in the fourth quarter, which was revised from the earlier estimate of 2.7 percent. 
LABOR: The unemployment rate rose from 3.4 percent to 3.6 percent, reflecting a jump in the number of people looking for work. The increase in the number of job seekers helped relieve wage pressures. Wage growth increased less than the expected 4.6 percent. 
HOUSING: Housing starts rose 9.8 percent—the first increase in six months. The increase was driven by a 24.0 percent increase in multifamily construction. Single- family home starts were up a more modest 1.1 percent. 
Sales of existing homes gained 14.5 percent in February, marking the first increase in 12 months and the largest increase since July 2020. The median price decreased slightly (-0.2 percent) from February, to $363,000. 
New home sales rose for the third straight month, climbing 1.1 percent in February; however, year-over-year sales declined 19.0 percent. 
INTERNATIONAL: Optimism Grows
In Europe, despite rapidly rising interest rates and the banking sector turmoil in March, economic activity was surprisingly positive. The euro-area composite PMI for March rose to a 10-month high of 54.1, which was well above expectations. This strong momentum was almost entirely driven by the service sector, where the PMI increased from 52.7 in February to 55.6 in March, while the manufacturing sector continued to struggle as shown by the drop in the manufacturing PMI to 47.1 at the end of Q1.
U.S. EQUITIES: Stocks held onto solid gains in the first quarter as investors navigated corporate earnings, shifting monetary signals, and troubles in the banking sector. The Dow Jones Industrial Average rose 0.38 percent while the Standard & Poor’s 500 Index gained 7.03 percent. The Nasdaq Composite led, picking up 16.77 percent. 
DEVELOPED INTERNATIONAL EQUITIES: For the quarter, the MSCI-EAFE Index jumped 7.65 percent.8 European markets were up strongly for the three-month period. Italy picked up 14.37 percent, France tacked on 13.11 percent, and Germany added 12.25 percent.
However, the U.K. lagged, gaining just 2.42 percent for the quarter.9 Returns were much more subdued in Pacific Rim markets, with Hong Kong adding 3.13 percent, and Australia rising 1.98 percent. Japan was among the better performers, gaining 7.46 percent. 
EMERGING MARKETS: Emerging markets (EM) posted positive returns over the quarter though the MSCI World Index lagged. The start of the year brought with it renewed optimism about EM, given the re-opening of China’s economy. However, February and March saw U.S.-China tensions re-escalate and a widespread loss of confidence in U.S. and European banks. Central banks continued to raise interest rates, and March saw U.S. rates reaching their highest level since 2007.
The best-performing market was the Czech Republic. Mexico outperformed against a backdrop of improving economic data while Taiwan and Korea were beneficiaries of optimism about global growth. Peru, Indonesia, and Chile outperformed as well.
China was ahead of the index. Although U.S.-China tensions resurfaced during the quarter following the shooting down of a Chinese high-altitude balloon in U.S. airspace, optimism about the re-opening of the economy and an apparent easing of regulatory pressure on the internet sector were positive for the market.
FIXED INCOME: Global Rate Hikes
U.S. FIXED INCOME: Central banks continued with their interest rate hikes, though some adjusted their stance. The Federal Reserve (Fed) announced two rate hikes in the quarter of 25bps each, marking a slowdown.
Against this backdrop, markets have been volatile with widening credit spreads. U.S. and European investment grades posted positive returns towards quarter end, but high yield was negative with poor performance from the banking sector dominating. (Investment grade bonds are the highest quality bonds as determined by a credit rating agency; high yield bonds are more speculative, with a credit rating below investment grade).
The U.S. 10-year yield fell from 3.92% to 3.47%, with the two-year going from 4.82% to 4.03%.
DEVELOPED INTERNATIONAL FIXED INCOME: The Bank of England (BoE) approved two rate hikes of 50bps and 25bps, respectively. The European Central Bank (ECB) remained more hawkish by comparison and hiked rates twice in 50bps increments.
The Bank of Canada enacted a rate hike of 25bps but signaled a pause immediately upon doing so, while the Bank of Japan (BoJ) made no further adjustments to its yield curve control policy, despite core inflation rising. The BoJ also appointed a new governor, a development markets are assessing for any implications for monetary policy, particularly with respect to yield curve control. Germany’s 10-year yield decreased from 2.65% to 2.29%. The UK 10-year yield fell from 3.71% to 3.49% and two-year decreased from 4.07% to 3.44%.
QUARTERLY FOCUS: What TECH-nically Happened in Q1?
The crisis in Q1 2023 was triggered by the collapse of a major hedge fund that had significant exposure to highly leveraged positions in the technology sector. This caused a liquidity crunch for many banks, including Silicon Valley Bank (SVB), which is known for its focus on technology and innovation. SVB had lent significant amounts of money to the hedge fund, and when it collapsed, SVB was left with a large amount of unpaid debt.
While the current crisis shares some similarities with the Global Financial Crisis (GFC) of 2008, there are also important differences. The GFC was caused by a number of factors, including the subprime mortgage crisis, and resulted in a widespread and prolonged recession. In contrast, the current crisis is more contained and does not reflect broader systemic risks in the financial system.
One reason for this difference is that the regulatory environment today is much stronger than it was in 2008. In response to the GFC, regulators implemented a number of reforms aimed at increasing transparency and reducing risk in the financial system. These reforms include higher capital requirements for banks, stricter regulation of derivatives markets, and the creation of new financial supervisory agencies (see chart below – left pane).
The tighter lending standards emerging from the banking crisis in Q1 2023 are likely to have a significant impact on borrowers. We can see in the chart below (right pane) the dramatic spike in lending standards. Banks will be less willing to lend money, and those that do will likely require higher credit scores, larger down payments, and more stringent income verification. This could make it more difficult for individuals and businesses to obtain financing for homes, cars, and other purchases. These conditions may lead to a slowdown in economic growth as businesses struggle to access the capital they need to expand and create jobs. Overall, the banking crisis and resulting tighter lending standards are likely to have a far-reaching impact on the economy and individuals’ financial well-being.
DPWM OUTLOOK: The Role of Alternatives
When market volatility rears its head, it’s an opportunity to highlight the benefits of using Alternatives in portfolio allocation. Alternatives are investments that are not traditional stocks, bonds, or cash. They offer access to unique investment opportunities such as private equity, hedge funds, real estate, and commodities. These asset classes help diversify your portfolio and tend not to move in tandem with the broader market, delivering non-correlated – and typically higher – returns in the long run. This creates a more stable portfolio with less vulnerability to inflation and market turmoil. As you can see in the chart below, including Alternatives within an allocation of stocks and bonds helps to reduce day-to-day fluctuations while improving overall returns.
Generally, alternatives can be a valuable addition to a portfolio, but it’s important to understand the risks and limitations. Alternatives can be illiquid, meaning they cannot be easily bought or sold, and they often have higher fees than traditional investments. As a financial advisor, it’s important to carefully evaluate each of our client’s individual needs and risk tolerance before recommending any investment. Here at Denver Private Wealth Management, we emphasize a prudent allocation to Alternatives within portfolios as a way to not only dampen volatility but to gain exposure to areas of the private markets that are unique from public stock and bond markets. Contact your advisor to discuss Alternatives that make sense for your portfolio.
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Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at email@example.com.
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