Markets are off to a strong start this year despite ongoing economic and geopolitical concerns. Looking solely at news headlines, it might be surprising to find that almost every asset class and market sector, with the exception of commodities, rose in the first quarter.
Geopolitical risk remains high, as the war in Ukraine lingers with no end in sight, China insists on escalating its military activities around a contested Taiwan, and alliances start to shift in the Middle East. At the same time, inflation remains a problem too. Although it has declined from a peak of 8.9% last June to 6% today, that is still three times the Federal Reserve's target rate of 2%. In response, they have continued raising interest rates this year, though at a pace far slower than last year. All of this makes a recession practically inevitable, especially when you consider that interest rate increases take time to fully impact the economy. The Fed has raised rates nine times over the past year, but most of those have yet to have their full effect, hence the call by many economists for a pause here.
In March, Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY) became early casualties of the Fed's tightening policy. The prices of most previously-issued bonds declined substantially over the past year as new bonds were available with much higher rates. Depositors began withdrawing massive amounts of money from SVB and SBNY when those institutions ran out of liquid assets and were forced to start selling their bond holdings at a loss to meet distribution requests. This led to a run on the banking system, particularly the smaller, regional banks, resulting in collapsing share prices across the sector, and ultimately government intervention. The Federal Reserve and the U.S. Treasury seem to have contained the situation for now by essentially pledging to provide unlimited amounts of FDIC insurance to depositors. Hopefully no further intervention will prove necessary.
In the meantime, investors and analysts actually seem pretty sanguine about the risk of a significant market downturn from here. Many are finding comfort in the view that the 2022 market declines may have already priced in a mild recession, and few analysts are predicting anything more substantial than that. Of course analysts are often overly-optimistic. The final pieces of this recession have yet to fall into place and it remains to be seen how high the unemployment rate will go before it's all said and done. At the moment, government spending, business investment, and consumer spending – the three-legged stool of the economy – are all facing headwinds.
A divided Congress has contributed to a steeper-than-expected decline in government spending, which was already falling as pandemic-era spending waned, and the current debt ceiling debate will almost certainly assure that trend continues. For businesses, revenues and capital spending have, so far, been quite stable on average, but rising labor and materials costs are squeezing profit margins. As a result, corporate earnings have declined over the past year, and according to research from JP Morgan, a drop in business investment has historically always followed. And finally, consumers, by far the largest contributor to the U.S. economy, are spending down their savings and carrying higher credit balances as they cope with rising costs and attempt to maintain the level of spending to which they have become accustomed. With wage growth still trailing inflation, as it has for the past 24 months, the present trend is unsustainable.
Speaking of inflation, investors and analysts are also finding comfort in the belief that the Federal Reserve will have that under control in rather short order. In fact, the bond market, along with most analysts, are assuming that interest rates will start to fall again relatively soon, possibly even by the end of this year, according to some. While that would turn a headwind into a tailwind, it is unlikely, historically speaking. According to an analysis by Research Affiliates, whenever inflation has surpassed 8%, as it did in February of 2022, it has taken between 6 and 16 years to drop back below 3%. The Fed has been fairly aggressive in its response this time around, so perhaps it will be different this time, but valuations today do not seem to account for the possibility of an extended period of inflation.
As always, we will continue looking at ways to navigate this unique and uncertain economic environment as best we can.
The information above represents the opinion of financial advisor Travis Rus, and is not necessarily that of Raymond James. It is not a complete summary of all available data necessary for making an investment decision and does not constitute a recommendation, nor is it a complete description of the securities, markets, or developments referred to herein. Opinions are subject to change without notice. Information has been obtained from sources considered reliable, but we cannot guarantee that it is accurate or complete. Investing involves risk and you may incur a profit or a loss. Past performance does not guarantee future results. Investment products are, in most cases, not FDIC-insured. Raymond James is not affiliated with SVB and SBNY.
