By Dr. Robert Votruba
Investors were eager to put 2022 behind them as the clock struck midnight on December 31. After all, it was the worst year for stocks since 2008 and the worst year for bonds - ever. Yet, there was little cause for optimism as it seemed, and still does, that 2023 would not offer a reprieve from the challenges that faced the economy and financial markets last year. Namely - inflation, rising interest rates, and a looming recession. Add to that mix the largest bank failure since 2008, and one would assume that the losses would have extended through this year’s first three months. However, in the world of financial markets, sometimes bad news is good news.
While markets have a long way to go to reach their previous highs from early 2022, most major indexes ended the first quarter in positive territory. The S&P 500, which tracks the largest 500 companies in America, advanced 7% through March 31, while the broadest measure of the bond market climbed 3%. Much like in 2022, all eyes have been on The Federal Reserve (“the Fed”), led by Chairman Jerome Powell. The challenges we face today can all be traced back to the Fed’s efforts to avert financial disaster during the early days of the pandemic. Simply put, the Fed, and the U.S. government, pumped trillions of dollars into the economy to help people who were unable to work and businesses that had to close their doors, some never to reopen.
With 20/20 hindsight, many pundits blame the Fed, and the federal government, for being too generous with stimulus for too long, which ultimately ignited inflation to levels not seen in 40 years. Like a fire truck arriving at the scene of a blazing home, the Fed took all measures necessary during the pandemic to put out an economic fire, the likes of which had never been seen before. And, to that extent, they were successful. But saving a house in a firefight sometimes has consequences like broken windows and ruined furniture. In the case of the economy, the consequence of avoiding another Great Depression was inflation.
Today’s major headwinds can all be traced back to the Fed’s fight with inflation. Though inflation has been more persistent than most thought (for a while, the Fed called it “transitory”), its high point seems to be behind us. While overstimulating the economy is surely the main culprit in determining the cause of elevated inflation, supply chain issues created by the pandemic played a role too. Those backlogs, and the higher prices associated with them, have eased considerably. For instance, shipping container delivery costs are down 85% from their 2021 highs and have returned to pre-pandemic levels.
The most effective way to combat inflation is by increasing interest rates. Higher interest rates make borrowing more expensive, so companies might be less likely to build a new factory or hire more workers. Homeowners might be unable to afford a larger home, which means new appliances aren’t needed. In theory, higher interest rates slow spending, which controls rising prices. While the fight against inflation is far from over, it seems to have peaked last June and has been trending lower since. J.P. Morgan’s Chief Global Strategist sees inflation falling below 5% by year-end and nearing the Fed’s target of 2% by December 2024. The following graph illustrates inflation’s trend over the past 50 years.
In 2022 the Fed increased interest rates at a historic pace and continued these efforts into 2023, albeit at a slower pace. In addition to cooling off an economy, rising interest rates often put downward pressure on both stock and bond prices, explaining why bonds had their worst year on record in 2022. But context is important when discussing the combined 4.75% rate hike over the last year. Remember, interest rates were at or near zero for the better part of the last decade. The Fed first drove rates into the basement to combat The Great Recession of 2008, and just when the Fed started to raise them back up, Covid struck. Low rates have the opposite effect of high rates, stimulating the economy and encouraging spending. The point is that an advanced economics degree is unnecessary to understand that “zero” percent interest rates are not normal and unsustainable. Interest rates had to come back up and now hover near their 50-year average. The Fed announced that they believe rates could rise another .50% near term, while the market expects that the Fed will have to cut rates later this year. Either way, it’s clear that the “heavy lifting” is behind us.
Large interest rate increases have a way of exposing risk-taking. Increasing rates preceded the bear market of 2000-2002 and the financial crisis of 2008, even if other factors played a role. This recent round of rate hikes has been no different. One casualty was Silicon Valley Bank (SVB). A classic bank run occurred when depositors sought to pull out their money when they learned of large losses in SVB’s bond holdings. Remember, due to rising interest rates, bonds had their worst year ever in 2022. It made no difference that most of those bonds were among the safest in the world and backed by the U.S. government.
While SVB was promised to be paid in full at maturity, the bonds they held matured years down the road. Until then, their values can, and did, fall. To meet their customers’ withdrawal requests, SVB had to sell those bonds at a loss causing the bank to fail and be bailed out by the FDIC, which covered deposits in excess of $250,000 to avert a larger crisis. Signature Bank in NY, which had exposure to the cryptocurrency industry, was soon to follow, as were the headlines: “Banking Crisis.” Comparisons to 2008 were made. In 2008 banks held riskier, less liquid assets on their books and were not as well capitalized as they are today – especially the big banks. Today, banks hold safer assets (remember, SVB owned mostly government bonds) and have far more in “Tier 1 capital” (a way to measure a bank’s financial strength), as shown below. Simply put, the comparisons to 2008 seem misplaced, even if new risks exist.
In addition to being criticized for not raising rates soon enough, some pundits now believe that the Fed may have increased rates too much and, as a result, predict a recession. Many economists have been calling for a recession for the past year, even though the economy has remained stubbornly strong (sometimes, good news is bad news). A survey by the Federal Reserve Bank of Philadelphia put the probability of recession in the next year at 40%, while economists polled by Bloomberg see a 65% chance of a slump. Of course, economists have been terrible at predicting recessions for years, giving birth to the joke, “Economists have predicted nine of the last five recessions.” In some ways, a short and shallow recession may be the final tool needed to stamp out inflation. And with tighter lending standards at banks (because of what happened to SVB), inflation might have finally met its match.
Financial markets hate surprises even more than recessions, and, in many ways, the market seems to be expecting a recession. So, a mild recession would not be a surprise. As for the banking “crisis,” while additional regional banks face some of the same challenges that took down SVB, financial markets encounter and react to crises regularly. One is left to wonder, could the absence of a crisis be classified as a crisis? In all cases, long-term investors who rode out major crises in the past were rewarded, sometimes in as little as a year but always within five years, using the examples below.
After last year’s 19% drop in the S&P 500, many major money managers have increased their forward-looking return assumptions. Yes, asset values were higher last January, but many argue that future returns (which are not guaranteed) will be higher. Given the rise in interest rates, bonds are arguably more attractive than they have been since 2007. If the Fed is near the end of its rate hike campaign, and if the past is any indication, the future looks promising for investors (see below). And that’s why bad news is sometimes good news.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. National Financial Network is not an affiliate or subsidiary of PAS or
Guardian. CA Insurance License Number - 0D23495. Data and rates used were indicative of market conditions as of the date shown. Opinions, estimates, forecasts and statements of financial market trends are based on current market conditions and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security. Past performance is not a guarantee of future results. S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market. Indices are unmanaged, and one cannot invest directly in an index. Past performance is not a guarantee of future results.