During the first quarter of 2023, we continue to focus on the same themes as last year, stubborn inflation and a tight job market. Investors expected inflation pressures to decline early in the year, which would signal the end of interest hikes to the Federal Reserve (Fed). Then in early March, the collapse of Silicon Valley Bank made the Federal Reserve's job a bit more complicated. They are balancing between containing inflation and restoring confidence in the banking system. The market consensus is that the Federal Reserve will increase interest rates by 25 basis points (bp) in May and take a pause. At this time, the banking crisis is contained. Still, additional interest hikes could present an issue to the financial sector, especially the smaller banks or banks with low liquidity. We are no strangers to this volatile market and will continue to monitor and make the necessary adjustments to portfolios to mitigate risk.
Many of us have grown accustomed to high prices for every purchase. Despite declining inflation, food prices remain high. On the other hand, energy commodities have reduced significantly. The Consumer Price Index (CPI) News Release for February 2023, posted by the Bureau of Labor Statistics, shows that the food index increased by 0.4% and the energy index fell by 0.6%. As of February, CPI is currently 6.00%, with the next report coming out on the 12th of this month. Inflation has declined, but we are far from reaching the Federal Reserve's target level of 2%. Unemployment has remained strong. As of March, the unemployment rate was 3.5%, a .01 percentage point (pp) decline from its previous month. March non-farm payroll rose by 236,000, significantly less than its 6-month average. Most job growth came from leisure and hospitality, government, professional and business services, and health care (BLS). Despite the recent layoffs in the tech sector, tech rallied earlier this year, making the NASDAQ one of the best performers (Up 16.46% for Q1 2023). GDP for Q4 2022 came back positive at 2.6%. Still, down 0.6 pp from the previous quarter and 0.1 pp less than the forecast. Markets showed signs of recovery at the beginning of the year as inflation declined. Still, it quickly turned around by the recent collapse of three banks, which threw a wrench into the works after all the progress we had seen over the last few months, which poses the question: What will the Federal Reserve do?
In addition to adapting to higher-than-normal inflation, investors have acclimated to this new environment of high inflation and high-interest rates. Most recently, the bank crisis has created more uncertainty in the market as the Federal Reserve faces a more significant challenge in preventing inflation from increasing while avoiding making more issues for the banks. The Federal Reserve is faced with a new challenge as its primary objective to reduce inflation by raising interest rates has now been disrupted by the banking crisis. When it was announced that Silicon Valley, Silvergate, and Signature Bank collapsed, it created more fear among individuals, therefore making it more difficult for the Federal Reserve to decide whether they should continue raising rates or put a pause. Either decision could have a negative impact. Let's examine the two scenarios. First, we'll assume that the Federal Reserve decides to put a halt, despite continuously pushing back on dovish views. It will completely contradict what they have been saying and could further increase fear among consumers and investors. Not raising the Federal Reserve funds rate will send the wrong message, which could imply that there is something we do not know about. People could interpret this as "Banks are in trouble" and cause more bank runs. The second scenario would be that they continue to increase rates, which impacts banks by increasing borrowing costs and decreasing the value of their long-duration bonds. Banks with less liquidity may hurt the most, but the Federal Reserve has created a program that will provide funding to prevent banks from being unable to meet their depositors' needs.
The current Federal Reserve funds rate target sits at 4.75%-5.00%. Last year in December, the Federal Reserve projected a peak of 5.00%-5.25%. The implied terminal rate, see graph, reached 5.69% on March 8 but dropped to 4.58% by March 23 (Goldman Sachs, March 24 Market Monitor). The economy remains resilient, so an interest rate increase is likely. Still, the Federal Reserve may prioritize financial stability in the banking system so that they will be very cautious with their next decision.
Instability in the banking systems in early March increased the recession uncertainty in the markets. The announcement that the 16th largest US bank, Silicon Valley Bank, had collapsed, representing the most significant bank failure since the 2008 financial crisis, set alarms around global financial markets and a decline in consumer confidence. Most of the customers of SVB are large companies in the technology sector, start-ups, and venture capitalists. They are customers with account balances of over $250k FDIC coverage, which is why customers began withdrawing funds due to the fear of lack of back liquidity and creating the bank run.
This issue came to light when SVB took a multibillion-dollar loss by selling US government bonds, triggering a panic among its depositors. Due to the speed and ease of how customers can transfer funds using electronic methods, this took place very quickly. SVB was impacted by the economic decline, increasing interest rates, and how it affected their long-term investments. Shortly after, two more banks, Signature Bank and First Republic Bank, were experiencing similar issues. The fear from investors changed from inflation to liquidity and a decline in the confidence of the banking industry.
The crisis was quickly addressed and contained by the FDIC taking control of SVB and Signature Bank's Assets. The Federal Reserve communicated it would ensure all the deposits and lifted the $250k per account deposit insurance for SVB and Signature Bank customers. The second action was creating a new Federal Reserve program, The Bank Term Funding Program (BTFP). This program provides additional funding to eligible banks to provide liquidity through up to one-year loans with eligible collateral. The purpose was to provide stability and confidence to the banking system to avoid financial contagion.
What can we learn from this? First, diversification is critical in minimizing risk, not just diversifying within asset classes, Stocks, Bonds & Cash, but within classes. Second, reducing over-concentration in any area of your investments is crucial to managing risk. Third, uncertainty is still present, and banks will need to focus on managing their liquidity and risk exposure as we continue to navigate the actions of the Federal Reserve to reduce inflation.
After 14 months of fighting, Russia and Ukraine are no closer to negotiating an agreement to end this devastating situation that has caused massive infrastructure destruction and human tragedy. Instead, both sides are gearing up for spring counteroffensive fighting. Unfortunately, President Putin didn't anticipate the resilience of the Ukrainians to defend their territory or the support they would receive from the US and EU.
So far, the Western allies' support for Ukraine has topped 65 billion euros ($70 billion), and with no peace in sight, they continue to pledge their support. Based on an article from AP, the US is providing $2.6B in military aid to Ukraine. This latest support contains short-term and long-term assistance, showing the US commitment to the long haul. However, this support creates political tension between the US and Russia.
Russia's actions have aided in strengthening Europe and NATO collaboration and unification. It has also helped in persuading Sweden and Finland to seek NATO membership. As a result, Finland formally joined the alliance on Tuesday, April 4, 2023, doubling NATO's border with Russia. (see map).
Instead of claiming defeat, President Putin will continue to drag this conflict for as long as needed to weaken the support to Ukraine and discourage the troops. The Ukrainians must maintain control of Kyiv to persuade Putin into potential negotiations. But, for now, the conflict continues with no end in sight. Investors should be aware of geopolitical instability's risks and opportunities and maintain a diversification that aligns with their goals. Short-term volatility will be present and most likely elevated until this is resolved. The question is, when? Which no one knows.
There have been changes in trends; many sectors that struggled in 2022 seemed to have made a comeback earlier in the year. Unfortunately, many returns were quickly turned down when Silicon Valley's collapse was announced. The banking sector had the most significant impact, followed by the Real Estate sector. As a result, Corinthians immediately acted and divested from any highly concentrated banking positions.
Our views on the market have not changed and remain the same. Although there have been some shifts in trends on the equity side, we have agreed to take a more conservative approach and watch where we invest more carefully. As Goldman Sachs stated in their Market Know-How for Q2 2023: "Recessionary downside risk, combined with recent financial system stability concerns, remains significant, while additional upside corresponding to sustained recovery is limited. Accordingly, managing risk over return is as important as ever." Our primary focus has been to protect the principal and reduce risk. As the markets continue to experience uncertainty and volatility, we have been positioning ourselves in ways to mitigate the current troubles of the market. We continue to favor short-term US treasuries and Certificates of Deposits (CDs) over longer-duration bonds as the likelihood of another interest rate hike remains. We may be in the early stages of a recession, so we proceed cautiously as to what trends we decide to participate in.
Advisory services offered through Corinthian Wealth Management INC. an SEC Registered Investment Advisor.
Smialek, Jeanna. 3/7/2023. “Fed Chair Opens Door to Faster Rate Moves and a Higher Peak”. The New York Times. https://www.nytimes.com/2023/03/07/business/economy/fed-powell-interest-rates.html
Goldman Sachs. March 24th Market Monitor. https://www.gsam.com/content/gsam/us/en/advisors/market-insights/market-strategy/global-market-monitor/2023/market_monitor_032423.html
Goldman Sachs Market Know-How Q2 2023. https://www.gsam.com/content/gsam/us/en/advisors/market-insights/market-strategy/market-know-how/2023/market-know-how-edition2.html