Investment Outlook, March 2023

March 31, 2023

This quarter started with a focus on the size of the next interest rate hike and has ended with investors questioning the stability of the banking system. While the bank failures we have seen will likely have an impact on the economy, it may be no different than the effects of what the market anticipated from central bank rate hikes going into 2023. Now that markets have had time to assess the few institutions where problems appear to exist and digest the government’s response to the events, to our mind the likely economic slowdown has already been discounted in security prices, setting the stage for improving markets for the rest of 2023.

When the Federal Reserve speaks of “tightening financial conditions” regarding monetary policy objectives, they tend to focus on impacts to financial markets – stock prices, interest rate levels, credit spreads, etc. – which then filter through to the real economy. As Chair Powell discussed at his press conference last week, bank failures are a form of tightening that “helps” the Fed’s inflation objectives. Remaining banks become more selective as to who they lend to, making borrowing more expensive for consumers and businesses, and thus economic activity slows, eventually dragging prices down.

The Fed would rather not rely on small bank failures to accomplish these goals of course, but by backstopping and quarantining the problem areas while reassuring depositors elsewhere that their assets are safe, the central bank may have found itself a monetary gift– in the short run. Current markets reflect that investors believe financial conditions may now be restrictive enough that further rate hikes may be unnecessary. The market’s rebound at the end of this month also reflects a belief that the system is currently stable enough to provide ongoing liquidity. These are core tenets that set the stage for a market to move higher out of this month’s surprise bank shock.

It remains to be seen whether credit tightening across the banking system will send the economy into a full recession. We have been expecting a slow down or recession in 2023 all along, so recent events may reinforce that path. The bond market is certainly expecting policy easing to support the economy, as the spread between 3-month and 2-year Treasury yields (a proxy for the expectations of the path of the Fed Funds Rate) has inverted nearly 1% in the last month, with the 2-year bond suggesting rates might fall to 4% by the beginning of 2024. If the market is correct in predicting where the Fed may be going, then it confirms our ongoing belief that markets have already discounted a slowing economy for 2023.

The limited bank struggles of this past month have not changed our view of portfolios in a material way. Our core equity investments have been focused on quality companies with healthy balance sheets that can grow and thrive in a slow, then recovering, economy.  Our corporate bond purchases remain in high investment-grade companies, where we always focus on quality positions to hold to maturity. We still see plenty of opportunities to take advantage of the volatile fixed income markets, especially in investment-grade bonds with yields not seen in a decade. We will continue to monitor economic developments and position your portfolios for the opportunities we see.

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