The first quarter of 2023 ended with gains across the board while stock and bond markets continued to exhibit heightened volatility. Positive results occurred despite continued tightening of short-term interest rates by the Federal Reserve Open Market Committee (FOMC) and the failure of a few high profile banks, most notably Silicon Valley Bank. Corporate earnings were lower for the 4th quarter, but came in mostly in line with or slightly ahead of expectation. Profit outlooks were slightly improved as a mild winter resulted in a less severe economic impact on European markets than anticipated due to falling commodity prices. In addition, resurgent demand from China materialized as a result of the reversal of their zero-tolerance COVID policy and the continued reopening that followed. The S&P 500 rose 7.50% for the quarter. International stocks—as measured by the MSCI EAFE—added 8.47% in the first quarter.

The FOMC continues to target inflation as the number one issue concerning the economy. The short-term fed funds rate was raised twice in the quarter, February 1st and March 22nd, and is now at a range of 4.75 to 5%. The final rate hike was made following the collapse of Silicon Valley Bank (SVB) further emphasizing the FOMC’s resolve to defeat inflation. It may also indicate their belief that the situation at SVB, and the few others, were idiosyncratic. The result of poor management and not reflective of systemic banking weakness. Expectations for economic growth have declined as a result of potential tightening of credit standards by lending institutions, but so far most economic indicators point to a resilient US economy.

Interest rates rose to start the quarter. The 10-year US Treasury yield peaked at 4.07% on March 2nd, but fell following the SVB turmoil as market participants anticipate the end of FOMC tightening will be sooner than previously thought. The 10-Year closed the quarter at 3.49%. This led to positive results for bond investors. The total return for the Barcap Aggregate Bond Index added 2.96%. The yield curve remains inverted with short-term interest rates yielding more than long-term. The 6-month US T-Bill yields 4.94% while the 5- and 10-year notes yield 3.60% and 3.48% respectively.

The anticipated recession following the FOMC hiking cycle has not yet materialized, and though the consensus on the street still expects one to occur, the potential timing and severity vary considerably. Multiple factors are considered by the National Bureau of Economic Research (NBER), the organization responsible for determining a recession. These include real personal income and unemployment rates, both of which have shown continued strength so far in the teeth of the tightening. Many point to the collapse of SVB as the first sign of cracks in the US economy. Future economic readings will be needed before we know for certain.

Looking Forward

Stock and bond markets will continue to experience elevated bouts of volatility as participants wrestle with near term questions regarding inflation, future FOMC policy changes, and the outlook for a recession and its severity. Inflation has shown signs of cooling, but perhaps not enough to convince the FOMC that their campaign should come to an end. Current expectations point to a 50% probability of another 25 point hike, followed by cuts later in the year. In our view, barring any serious economic deterioration in the coming few months, cuts will likely occur much further in the future as we believe the FOMC is willing to keep rate levels in place through a mild recession if it means putting inflation worries to bed. The institution’s integrity is at issue and only time will tell if they have the resolve to stand firm against mounting political pressure.

The conflict in Ukraine continues. Though much of the economic fallout is behind us and Europe seems to have been fortunate thanks to some help from Mother Nature, it is wise to remember that future events in times of conflict are unpredictable and can have short- and long-term impacts on markets. China continues to re-open following years of restrictions which is likely to have positive benefits on global economic growth and earnings reports for many multi-national companies.

We remain optimistic that markets will look past near-term recession risks and focus on the inevitable recovery. Valuations remain reasonable and we are maintaining an overweight exposure to stocks, but will be looking for opportunities to rebalance risk as the market rallies now that yields for bonds are much more attractive than one year ago.

Bond portfolios remain invested to a relatively short-duration compared to the market on average. We are content maintaining that shortened stance in the current environment as near-term risks of stickier inflation and persistent FOMC tightening favor higher long-term rates and potential price deterioration for bonds with longer maturities. Cash, in the form of money market funds, continues to be an additive to portfolios. Current yields on these money market funds now match levels seen in late 2007. As a result, we are holding higher levels than normal which can be used to fund our customers’ distribution needs or be easily deployed when opportunities arise in the market, which, as history has shown us, is a matter of when, not if.

Thank you for allowing us to serve you, it is an honor we do not take for granted. We are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

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