Q1 2023 Market Commentary & Outlook

Recap of Q1 2023: Size Mattered

Stocks saw major dispersion in the first quarter of 2023, with the Nasdaq rallying 17.1% for its best quarter since 2020.  Meanwhile, Large Value lagged (+1.0%), primarily due to underperformance in Financials, which were down (-5.6%). Small Caps (+2.7%) also lagged, as Financials make up a larger percentage of the Russell 2000 Index versus the S&P 500. Overall, the S&P 500 finished the quarter up 7.5%.  As shown below, five of the best seven performing stocks in the S&P 500 were in the Tech sector, while six of the seven worst performing stocks were in the Financial sector.  

Historically a strong first quarter bodes well for the remainder of the year.  Since 1950, when the S&P 500 gained over 7% in the first quarter, the full year has never been negative.  

The Story of Q1 2023: Banking Crisis

It’s not unusual for a Tightening Cycle to result in a Financial Crisis.  In response, the Fed has historically either Eased or Paused.  In some instances, a Recession was avoided (i.e. 1984 Failure of Continental Illinois), while other times a Recession quickly followed (i.e. Global Financial Crisis).  In the past, a financial shock/crisis has never ended until the Fed paused or cut rates.

The Fed’s response to the recent Banking Crisis is highly unusual, as the Fed hiked rates 25 basis points in March and continued Quantitative Tightening.  Prior to the Banking Crisis, markets were pricing in a 50 basis point hike, but financial stability took precedence over price stability. The Fed continues to be in a difficult position of trying to battle high inflation while also managing a crisis in the Regional Banking system. Dynasty believes the Fed is nearing the end of its tightening cycle, especially with a deep inversion of the yield curve.

Major Takeaways from the Banking Crisis

  • Most Banks don’t have the level of uninsured deposits as a SVB, or the crypto exposure of a Signature Bank.  
  • It’s important to note the government guaranteed all deposits for SVB and Signature Bank because they were in receivership and deemed a “systematic risk exception.”
  • Over the past two weeks, Banks have seen their deposits decline by a record $300 Billion.  After SVB went under, some deposits that left Small Banks went into Large Banks.  Other deposits moved to higher yielding Money Market Funds, with a record $5.2 Trillion in these funds (see Chart #1).
  • To improve liquidity and stability, Banks utilized the Fed’s Discount Window and the Fed’s newly established Bank Term Funding Program (BTFP).  Both allow Banks to borrow short-term loans from the Fed by providing collateral (i.e. Government Bonds) at Face Value, regardless of market price.  This resulted in the biggest surge in borrowing using the Discount Window since 2008 (see Chart #2).
  • Usage of the Fed’s Facilities resulted in a jump in the Fed’s Balance Sheet by $300 Million, despite QT.
  • The Dodd-Frank Act tried to reduce concentration among Banks, but we expect further consolidation now.
  • According to Apollo, tighter financial conditions and lending standards equates to an additional 150 basis points in the Fed Funds Rate.  Already, Bank Lending has plummeted (see Chart #3).

Financial Crises are Part of Tightening Cycles

It’s not unusual for a Tightening Cycle to result in a Financial Crisis. In response, the Fed has historically either Eased or Paused. In some instances, a Recession was avoided (i.e. 1984 Failure of Continental Illinois), while other times a Recession quickly followed (i.e. Global Financial Crisis). In the past, a financial shock/crisis has never ended until the Fed paused or cut rates.

The Fed’s response to the recent Banking Crisis is highly unusual, as the Fed hiked rates 25 basis points in March and continued Quantitative Tightening. Prior to the Banking Crisis, markets were pricing in a 50 basis point hike, but financial stability took precedence over price stability. The Fed continues to be in a difficult position of trying to battle high inflation while also managing a crisis in the Regional Banking system. Dynasty believes the Fed is nearing the end of its tightening cycle, especially with a deep inversion of the yield curve.

Equities Historically Rally After the Last Fed Hike

In March, the Fed raised rates to a range of 4.75-5.00% and released its updated “Dot Plot,” which showed a majority of FOMC participants forecasting just one additional rate hike in 2023.  The market continues to price in a much different outlook for rates, with expectations of multiple rate cuts in the second half of 2023. 

In looking at the past 30 years (going back to 1994), there have been five prior rate hiking cycles – including the current cycle.  In the prior four cycles, equities rallied after the last rate hike except in 2000 during the Tech Bubble.  The end of the current rate hiking cycle could be bullish for equities. 

The Bond Market Continues to Signal Warning Signs

In March, the Fed raised rates to a range of 4.75-5.00% and released its updated “Dot Plot,” which showed a majority of FOMC participants forecasting just one additional rate hike in 2023.  The market continues to price in a much different outlook for rates, with expectations of multiple rate cuts in the second half of 2023. 

In looking at the past 30 years (going back to 1994), there have been five prior rate hiking cycles – including the current cycle.  In the prior four cycles, equities rallied after the last rate hike except in 2000 during the Tech Bubble.  The end of the current rate hiking cycle could be bullish for equities. 

Markets were previously pricing in a peak Fed Funds Rate above 5.50% on March 8th.  After the collapse of Silicon Valley Bank, the market quickly shifted to expecting multiple rate cuts.  To end the quarter, the market now expects rates to finish 2023 at 4.25%.  

Short-Term Yields also plunged in response to the Banking Crisis.  At one point in mid-March, the 2-year yield sank over 100 basis points in less than two weeks.  

The 10yr-3month curve is at its most inverted level (-160 bps) since the early 1980s.  Historically if there is a Recession, it is preceded by the steepening of a yield curve that was deeply inverted.   

Major Takeaway

The Equity and Fixed Income markets continue to price in radically different outlooks. Equity markets have largely shrugged off the Banking Crisis to finish Q1 up 7.5%, which historically is bullish for the remainder of the calendar year. Seasonality Trends and a Third Year of a Presidential Cycle are also bullish for equities. The Fixed Income market, however, continues to flash warning signs of a Recession, from collapsing Treasury yields to severely inverted yield curves.

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