March 2023 Stonemark Market Commentary

The month of March exhibited substantial volatility, bearing witness to the second and third largest bank collapses in United States’ history, exceptional swings in the U.S. treasury market, and the S&P 500 rising over 3.5% despite widespread uncertainty. A significant divergence within equity markets emerged in the month of March – a rotation from the winning sectors of 2022 into large and mega-cap technology companies. One driving factor for this divergence came from the turbulence in the U.S. and global banking system. Starting on March 8, the effects of over 400 basis points of rate hikes in a single year from the Federal Reserve materialized in the collapse of Silicon Valley Bank (SVB) and subsequently Signature Bank of New York (SBNY).

The headline story for March was the chaos in the banking sector, with Silicon Valley Bank and Signature Bank of New York collapsing in mid-March. Additionally, European giant Credit Suisse was forced to merge with long-term rival UBS, following Credit Suisse’s effective collapse shortly after SVB and SBNY. In short, mass withdrawals from the banks’ customers spawned a rapid bank-run after customers became worried about the solvency of both SVB and SBNY.

Concerns surrounding SVB’s solvency stemmed from a multitude of factors, with the largest being SVB’s exceptionally high uninsured-to-insured deposits ratio, substantial unrealized losses on Held-to-Maturity securities, and a highly focused client base (primarily start-up and fledging growth companies). Similarly, SBNY had substantial involvement in cryptocurrencies which faced a substantial drawdown in 2022 after a major boom throughout the pandemic. These fears culminated in the seizure of both banks by regulators, thus spawning the second and third largest bank failures in U.S. history.

The result of SVB and SBNY’s collapse was a widespread sell-off in regional bank stocks, fears of contagion, and drastic measures from the Federal Reserve and FDIC (Federal Deposit Insurance Corporation) to backstop deposits and reassure investors and depositors alike. Conversely, investors sought safety in large and mega-cap technology companies like Apple and Microsoft, while depositors quickly moved money from regional banks to large money center banks like J.P. Morgan and Citi National. The tech-heavy Nasdaq index had its best quarter since 2020, despite markedly different market and economic environments. 2020 was characterized by loose monetary policy, Quantitative Easing, and stimulus, versus 2023 with tightening well-underway, significantly higher interest rates, elevated inflation, and ongoing layoffs. This difference in environments does not discount the Nasdaq’s strong performance, but it does warrant caution in declaring victory on inflation early and returning to the bull market trends of the recent past.

In the aftermath of the banking turmoil, regulators and government officials have been calling for heightened regulation of the small and regional banks. Money center banks like J.P. Morgan, Wells Fargo, and Citi National are already stringently regulated. Smaller and regional banks, however, are not regulated to the same extent due to a multitude of factors. Regardless of one’s position on increased regulations, officials have been deliberate in their calls for bolstering regulations, and this is likely to impact the profitability of small and regional banks. Compliance with new and elevated rules is costly, and lending from these regional banks is likely to slow as an indirect result of this.

The Federal Open Markets Committee (FOMC) raised the Federal Funds Rate by 25 basis points on March 22, continuing the Federal Reserve’s fight against inflation. Prior to this decision, there was much debate surrounding the Fed’s appropriate course of action in the fallout of the banking crisis. Chairman Powell echoed the resiliency of the banking sector and highlighted the actions taken by the Federal Reserve to provide liquidity to banks and security to depositors. He also reiterated the Federal Reserve’s base case of there being no rate cuts in 2023, which was reinforced by the release of the FOMC’s dot plot following the meeting. The dot plots also imply one more 25 basis point rate hike in 2023, which markets are tentatively pricing to occur at the next FOMC meeting in May.

In response to the collapse of SVB and SBNY, the Federal Reserve created the Bank Term Funding Program (BTFP), which was specifically designed to prevent banks from having to realize losses due to interest rate hikes over 2022 on their Held-to-Maturity securities. Under the BTFP, banks are able to receive loans of up to a year in length by pledging treasuries, agency debt, and mortgage-backed securities as collateral valued at par. The significance of this is that it allows banks and other financial institutions to pledge treasuries and other securities that are classified as “Held-to-Maturity” and thus, not marked to market, as collateral for additional funding. This means the Federal Reserve is effectively taking on bank securities at a loss in exchange for providing liquidity and stability within the banking industry. The BTFP program is working in conjunction with the FDIC to ensure that deposits are safe and secure, but likely at the expense of higher inflation for a longer period.

The above graphic, pulled directly from the Federal Reserve’s website, shows the total assets on the Federal Reserve’s balance sheet over the past year. Up until March of this year, there was a strong downward trend, indicative of Quantitative Tightening working throughout 2022 and into 2023. However, the BTFP has reversed this trend and caused a substantial portion of last year’s tightening to be undone in a matter of weeks as a necessary response to the banking crisis. The good news is that the rapid expansion of the Federal Reserve’s balance sheet seems to have currently halted in conjunction with easing fears in the banking sector. Nonetheless, the banking crisis and subsequent response from the Federal Reserve has ensured that the process of fighting inflation and quantitative tightening will continue for longer than initially expected.

March provided an additional month of economic data for markets to digest, showing the continuation of trends from prior months. Inflation remains sticky, the labor market is showing continued resiliency, and the money supply continues to contract.

First and foremost is inflation, with CPI (Consumer Price Index) coming in at 6.0% year-over-year and up 0.4% in the month of February. Core CPI, which excludes volatile food and energy prices, was 5.5% year-over-year and ticked up 0.5% in February. Headline CPI came in slightly below market expectations while Core CPI came in slightly above market expectations, showing a divergence in inflation driven largely by housing prices. Additionally, the Producer Price Index (PPI) came in 4.6% year-over-year and down 0.1% in February versus market expectations of being up 0.3% for the month.

The next major component of the macroeconomic environment is the labor market, which unexpectedly expanded in January as shown in the blowout jobs report from February. The highly anticipated jobs report for February was released on March 10, which showed a gain of 311k jobs versus the expected gain of 225k jobs. Additionally, unemployment ticked up to 3.6%, while average hourly earnings climbed less-than-expected by 4.6%. The jobs report came in above market expectations but was much less than the January report’s massive increase of over 500k new jobs. The gains in January and February are being driven by services and leisure, as consumers are continuing to spend on travel and hospitality as pent-up demand from Covid-era shutdowns remains strong.

M2 money supply is a measure of the total amount of money in the markets, aggregating cash, checking and savings accounts, certificates of deposit (CDs), and money market accounts. Since the start of the tightening cycle in early 2022, the M2 money supply has begun to decrease after years of rapid expansion. With the money supply contracting, it shows that the Federal Reserve’s tightening measures are working, albeit slowly, and a contracting money supply generally indicates a slowdown ahead.

Ultimately, inflation is no longer raging ahead as it was in 2022, but it is remaining sticky across the economy. The labor market is showing some signs of weakness in specific areas, such as the technology sector, but simultaneous strength in other areas, such as services and leisure. The economy is in a near-flux state, where continued leading indicators show that the economy is slowing significantly, and a recession is likely imminent. However, consumer spending remains robust, and unemployment is well below recessionary levels. The Federal Reserve is likely to remain largely consistent in their approach to this economy and inflation, with interest rates staying elevated and liquidity being less accessible.

The market is proving resilient despite continued challenges, from persistent inflation to banking turmoil to a decreasing money supply. Despite all of this, the S&P 500 gained over 7% for the first quarter of 2023. Recession-resilient sectors like healthcare, utilities, and consumer staples underperformed in the first quarter, while expansionary sectors like technology, communications, and consumer discretionary outperformed. Nonetheless, the macroeconomic data shows persistent trouble and a likely recession in the second half of 2023. Exceptional volatility in the treasury market lends credence to this, and many leading indicators show slowing economic activity in the U.S. economy.

We remain defensively positioned on a firm level, favoring companies with sound balance sheets, strong profitability, and high cash flows. We are increasing diversification, adding exposure to international and emerging markets through ETFs, and broadening our exposure beyond primarily large cap companies, as we add small and mid-cap exposure through ETFs. Fixed income remains an attractive sector of the market with yields higher across the board and the Federal Reserve signaling that we are likely near the top of the rate hiking cycle. Increasing exposure to fixed income will bring diversification in conjunction with increased income and may be an attractive fit for investors. We will continue to evaluate economic data and market developments as we forecast our positioning across each of our models.