The focus of the financial markets during the first quarter of 2023 remained on the Federal Reserve Bank’s interest rate policy. In our view, the Fed erred in generating substantially more liquidity than the economy required during the first two pandemic years of 2020 and 2021. Much of this excess liquidity found its way into commercial bank deposits.
As this liquidity drove inflation higher in early 2022, the Fed embarked on a tightening program, raising rates seven times over the year. During the exceptionally low interest rate environment of the early pandemic years, many U.S. banks chose to invest surplus deposit capital into intermediate and long-term Treasury bonds. As rates shot higher, banks suffered sizable losses. The total return on ten and thirty year Treasuries during 2022 was negative 16.3% and 33.3% respectively.
When banks like Signature Bank and Silicon Valley Bank reported the magnitude of their losses on bonds and mortgages, and signaled their need for additional equity capital, the market response was dramatic. Over 80% of depositors in Signature and SVB held balances in excess of the FDIC’s $250,000 insured maximum, and these customers rushed to pull their cash out—causing the banks to fail in less than a week.
The Federal Reserve Bank remains in a very tough spot. The Fed raised rates again last month and has signaled that inflation remains a concern. But further rate hikes could drive the economy into a recession. Anticipating this outcome, bond market investors have driven down longer-term interest rates even as the Fed continues raising short-term rates. The resultant inverted yield curve (short-term rates higher than long-term rates) is at an extreme level not seen in roughly forty years.
During the first quarter, equity investors reverted back to a strategy that worked for a large part of the previous decade with capital flowing into mega-capitalization technology stocks. This drove returns on the S&P 500 up 7.5% for the quarter. Equity returns were quite concentrated in the largest and fastest growing U.S. companies. The Russell 1000 Growth index return of 14.4% for the quarter well exceeded the Russell 1000 Value index return of 1%.
We are mindful of the mixed messages sent by current financial markets. On the one hand, declining long-term interest rates usually lead to higher equity valuations, particularly among faster growing, more speculative securities. On the other hand, inverted yield curves have presaged recessions nearly 100% of recorded occurrences.
We are watching first quarter earnings carefully, as the combination of higher labor, transportation, energy and interest expenses will likely result in lower corporate profit margins. We are emphasizing balance sheet strength and strong cash flow generation across our portfolios as we expect a slowing economy as the year progresses.
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