KCS Quarterly Market Review for Q1 2023
April 25, 2023
After a challenging 2022, 2023 has provided much-needed relief for investors, with markets solidly positive to date. Both equities and bonds have fared well, as gradually subsiding inflation and decent economic data provided support to asset prices.
Within equities, global stocks as measured by the MSCI ACWI finished the first quarter up +7.3%. The US slightly outperformed, with the S&P 500 index rising +7.5%. Gains in the US were largely driven by the tech-heavy NASDAQ, which surged by more than +20% during the quarter, as the largest tech companies, including Meta and Apple, lead the way. As a result, a market cap weighted index outperformed an equal weighted one by over 4.5%, with all this outperformance occurring during the last 3 weeks of March (see chart below).
Foreign developed stocks also performed well, returning +8.5%, boosted by double-digit gains in Europe. At the same time, emerging market equities lagged yet again, returning only +4.0% for the period, albeit with sizable differences across individual markets. For example, while the tech-heavy Chinese and Indian markets trailed the global benchmark, stocks in smaller countries such as Mexico and Greece shot up by more than +15%.
Among sectors, the theme has been simple: the winners so far in 2023 have mostly been the losers during 2022, and vice-versa. For example, energy, healthcare and financials, the best performers last year, are down year-to-date. Meanwhile, cyclicals and technology stocks are up by double digits.
Fixed income performance has also been good this quarter, a most welcome change from the last 2 years. The Bloomberg Barclays Global Aggregate Bond index rose by +3.0%, driven by cooling inflation and lower interest rates. The best performers were long duration and high yield bonds, but almost every area of fixed income rose in price.
KCS equity performance benefited from our individual stock selection, despite our being underweight technology. While we have generally been favoring value stocks, we do own several high-quality growth names, particularly in the mega cap tech space, which, after their steep drop in 2022, are starting to look more like value stocks.
Our fixed income performance benefitted from the higher yields our portfolio offers versus the indexes, but this was more than offset by our shorter duration positioning during a period of falling interest rates. Over the medium-term, we continue to select bonds with a belief that longer-term interest rates could rise more from here. A persistent 10-year treasury rate above 4% is possible if inflation remains stubborn.
Is the Fed Done?
After numerous Fed rate hikes since last January, short-term interest rates remain higher than long-term rates (i.e., the yield curve is “inverted”). Currently, the federal funds rate is a bit over 4.75%, while the 10-year Treasury yields only 3.5%. At these levels, we think the Fed is mostly done, with perhaps one more 25 bps hike before they pause. Given that inflation continues to moderate and the economy is far from overheated, there seems little benefit to rate hikes beyond that.
Furthermore, the Fed should be more concerned about a slowing economy than about inflation once interest rates reach 5%. We say this because the banking system appears to be particularly sensitive to rates above 5%. A few weeks ago, the 2-year treasury only briefly touched the 5% level before deposit flight became a real concern and several medium-sized banks got into trouble. When banks lose deposits, they have less money to lend; stingier bank lending will slow both the economy and inflation much more than further rate hikes. That also has important portfolio implications, which we’ll discuss later.
Is a Recession Imminent?
For some time now, investors have been expecting a recession sometime soon. And “sometime soon” keeps getting delayed.
To be fair, there are certainly several reasons to believe that a recession is coming, including:
- The Federal Reserve is raising interest rates. This makes it more expensive for consumers to spend and for businesses to borrow, weighing on economic activity. In the past, many Fed tightening cycles have been followed by recessions.
- The U.S. economy is already slowing down. The economy grew at an annual rate of just 0.9% in the fourth quarter of 2022, which was the slowest pace in 2 years.
- Inflation remains persistently high. Inflation strains household budgets and businesses’ bottom lines, and increases the likelihood that real (after inflation) GDP growth will turn negative.
That said, labor indicators remain very strong, and we don’t envision a severe recession when all the employment data points continue to signal economic strength.
Make no mistake, the US will eventually experience a recession (maybe as soon as the third quarter of this year), but it will likely be a garden-variety slowdown, much milder than the steep economic declines we lived through in 2008 and 2020. And remember, recessions are temporary and are followed by expansions. The economy always recovers, and your investments, if they were to decline in value going into a recession, will rebound well before the recession ends.
How stocks will fare later this year if we do have a recession is anyone’s guess, as now investors are laser focused on the Fed and interest rates. We think that the Fed’s future actions will continue to have an outsized effect on the markets for the rest of this year, leading to continued volatility. The looming debt ceiling issue could also impact markets, especially if a default starts to seem possible (we think it highly unlikely, however).
Are Bonds Worth Owning Again?
Even though we are optimistic about the intermediate and long term, it’s clear that there are risks in the near term. Inflation, though coming down, is still high; the economy is slowing; many smaller banks are stressed; and the yield curve is now very inverted. In the past, an inverted yield curve has usually been followed by a recession within 12 to 18 months. You can see the relationship between an inverted yield curve (blue line below zero) and recessions (shaded in gray) in the chart below. Note, however, that the amount of yield curve inversion bears no relationship to the severity of the recession. And while the economy—and oftentimes stocks—can struggle after yield curve inversions, bonds tend to do well in such environments.
Two additional considerations further strengthen the case for owning bonds:
The first is valuation. Currently, short duration, AAA-rated bonds are yielding 5% to 7%. These are the safest of the safe, with very small price movements, and interest distributions far higher than just a year ago. This seems a very attractive place to invest in a world where the S&P 500 still trades at 18 times earnings (or a 5.6% earnings yield).
Second, we believe that the upper bound of risk in bonds has now been established. That is because the banking system seems to become stressed at yields around 5%, as evidenced by recent bank runs and failures. Thus, if 5% yields represent an upper bound (at least for this cycle), then the risk of further significant price declines in bonds becomes quite low.
Given this backdrop, we are shifting in our bond portfolios toward allocations that can thrive during a recession and bear market. We are accomplishing this primarily by lengthening durations in highly rated paper, as these bonds could appreciate significantly if the economy stalls and rates decline meaningfully. Whenever we find high-quality bonds yielding 4.5% or more, we are striving to lock in those rates.
Given the above, you might feel like we are bearish on stocks for the near term. While it is certainly possible that equities could struggle for the rest of this year and appreciate little from here, it’s also easy to forget that the US is not the only country or stock market in the world. Other locales have cheaper stocks and are at different stages of the economic cycle. Europe, for example, is likely to avoid a recession and has many excellent companies selling at compelling prices. And China is in the early stages of an expansion, having already emerged from a covid-induced recession. As a result, we expect non-US stocks will do rather well this year, even if the US stock market struggles.
We don’t for sure know that a recession will occur, when it might happen, and how significant the impact would be on our investments. However, there are steps we are taking today to prepare for that possibility and further insulate client portfolios while maintaining upside during the inevitable recovery. Here are a few things that we are doing with stock markets back near their highs for this year:
- Rebalancing our portfolios regularly. We are seizing the opportunity during this period of relative market strength to reduce overweight equity exposures and buy bonds to their target weight. This helps keep portfolio risks balanced and reduces their exposure to a market pullback.
- Lengthening duration and improving fixed income quality. With bond yields attractive across the board, we are choosing to reduce credit risk in favor of greater portfolio protection, with only a modest reduction in interest yield.
- Maintaining diversified portfolios. We continue to favor developed international stocks, as valuations are now almost 30% cheaper than in the US. We have also been adding selectively to small cap and emerging market names when we see attractive prices.
- Holding a bit more cash reserves. With cash equivalents now yielding over 4%, we think now is a good time to add some cash to the portfolios of clients that have regular monthly withdrawals.
As always, your KCS advisors are available if you want to discuss your personal portfolio.
The KCS Investment Team
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