Q1 2023: Something Has to Give

A row of electrical towers with the sunset behind them

Jessica Skolnick, CFA, Director of Investments
Adam Bernstein, ESG Analyst

Macro Update

The dust has now settled on a frustrating quarter for managers positioned defensively, as we are. We began the year with many more bears to keep us company than was the case a year ago. The consensus was that the Federal Reserve would hike rates to the point of triggering either a hard or soft landing, with rate cuts to follow only if something broke. Inflation remained elevated. The job market continued to see demand outpace supply. Market expectations for future Federal Reserve policy began to move more in line with the Fed’s own communications. A sharp rally in risk assets in January was followed by risk off sentiment in February and the market looked for something to break. 

A series of regional bank failures in the US and UBS’s takeover of failing Credit Suisse in March could have been the “something breaking” moment we have been looking for. The issues at the regional banks were directly related to the rising rate environment created by the Fed’s rate hikes while the direct cause of the failure of Credit Suisse remains murky. The policy response from both US and Swiss authorities, however, seems to have been enough to prevent a broader crisis for the moment. Despite Fed Chair Jay Powell’s insistence at the March FOMC meeting that rate cuts were not the base case for 2023, the market responded to this banking mini crisis by lowering the expected terminal rate and pricing in rate cuts at every FOMC meeting in 2023 beginning in June.

Following the pattern of the last 18 months or so, the stock market heard the good news (no more rate hikes!) and ignored the bad. If the Fed winds up cutting rates in the second half of the year contrary to their own guidance, it will be because something has gone wrong, which surely won’t be good for risk-on assets like stocks. We’ve covered this pattern before so won’t belabor the point other than to say the stock market should be careful what it wishes for. 

Even if something doesn’t ultimately break, something will have to give. Wherever we look in the economy, we find situations that are unsustainable or incompatible with other economic realities. The following are just a few examples: 

  1. Housing Market: Mortgage rates have risen from a February 2021 low of 2.8% to 6.8% at quarter end. Meanwhile home prices have risen 22% over roughly the same timeframe, pushing up monthly mortgage payments on new home purchases. The mortgage/income ratio has spiked from roughly 21% in early 2021 to nearly 40% today, eclipsing the pre-2008 peak of 35%. Ultimately, either rates or prices will have to decline or housing costs will be so high that consumers will need to curtail spending in other sectors significantly. 
  2. Corporate Profit Margins: A recent study by the Kansas City Fed found that roughly half of recent inflation can be explained by companies increasing their markup on goods sold and not by rising wages, which have actually declined on real basis. This is a classic tragedy of the commons situation. It benefits each individual company and its shareholders to improve margins but the aggregate effect is upward pressure on inflation, which then forces the Fed to raise rates. Further, if wages are not keeping pace with inflation, consumers will either cut their discretionary spending or rely more heavily on credit, creating more instabilities. 
  3. Commercial Real Estate: The Covid pandemic accelerated the trend towards remote work and, despite periodic pushes for workers to return to downtown offices, the reality that office demand is structurally lower has begun to sink in. Office vacancy rates are rising, especially in New York and California, as long-term office leases begin to expire. Nearly $400 billion in office debt will come due and need to be refinanced at much higher rates in 2023 alone, with an additional $500 billion next year. Multifamily properties are facing similar refinancing struggles and owners may not be able to increase rents as much as they had thought. National average asking rent dropped year-over-year in March for the first time since 2020.

If none of the above adjust first, a sustained period of higher rates alone could be enough to catalyze a downturn. Corporations which have grown used to borrowing in a very low-rate environment will eventually have to refinance their debt at higher rates. Those without strong financials may not be able to absorb the higher interest expense. If the market’s expected rate cuts fail to materialize, it could result in increased stress for so-called “zombie companies”.

A major cataclysm shouldn’t be necessary since markets respond to changes at the margin. The crisis of 2008 began with only a small percentage of the mortgage market defaulting and grew to impact practically every financial institution and country in the world due to leverage and interconnectedness. This moment in history, so far, appears to be entirely opposite. We have experienced major shifts in economic patterns since 2020. Interest rates have increased dramatically, live-and-work patterns have been altered by the pandemic and remote work, and globalization trends have stalled or reversed. Yet markets have apparently taken this in stride. Why? 

A complex system like our economy is like an expensive race car that is incredibly fast and powerful but also vulnerable to breakdowns in a way that a used Camry isn’t. Policymakers at central banks and in governments have been doing their utmost to prevent the breakdown through Covid stimulus, bank rescues, etc., but change is inevitable. There will be winners and losers and a lot of uncertainty along the way. We’re comfortable staying defensive against this unpredictable backdrop, believing it is well worth trading some upside in exchange for downside protection. 

Market Update

Global markets rallied in the first quarter as investors shrugged off reports of higher-than-expected inflation, a Fed in tightening mode, slowing economic growth, an increasingly tight labor market and a banking crisis. The market action was more reminiscent of the days following the Covid stimulus and eventual reopening than a world where global central banks are committed to tightening financial conditions and where recession risks are rising.

Large Cap Growth/Technology Rally

Sectors that underperformed throughout 2022 took the lead in Q1 2023.  The Technology and Communication Services sectors were the main drivers of return, particularly among the mega cap tech firms like Apple (+27%), Nvidia (90%), Meta (+76%) and Alphabet (+18%). One year performance of the tech and communication services sectors were still weak at +2.4% and -10.0% respectively despite the sharp Q1 rebound and the average tech stock in the S&P 500 remains down about 50% from its peak. The tech company rally was attributed to year-end portfolio rebalances, valuation resets and a focus on cost reduction in the form of layoffs. In just the first quarter of 2023, the tech industry laid off 166,044 workers compared to 164,411 for the full year of 2022 and both sectors saw double digit margin expansion year-over-year as a result.

Commodity/Banking Selloff

As investors shifted their focus to growth to start the year, value and defensive sectors struggled.  Energy (-4.4%), Financials (-5.6%), Healthcare (-4.3%) and Utilities (-3.3%) were the worst performing sectors in the first quarter. 

Energy companies underperformed as oil and gas prices moved lower. Crude prices dropped below $70/barrel compared to an average price of $90/barrel in 2022. The outlook may be for higher energy prices on the horizon, which would be good news for energy companies but bad news for inflation. OPEC+ recently announced a 1.16 million barrel per day production cut through the end of the year and President Biden’s options are more limited now that the Strategic Petroleum Reserve has been largely depleted. 

Given the March failures of Silvergate, Silicon Valley Bank and Signature Bank, Financials were the worst performer. These banks found themselves under pressure from depositor withdrawals that were first caused by weakness in the VC and crypto industries and then exacerbated by panic-driven bank runs. Most of the deposits at these banks were above the FDIC insurance limit and depositors were reasonably concerned they could lose access to cash. The FDIC, Treasury and the Federal Reserve issued a joint statement on March 12th detailing a plan to limit contagion to other regional banks. Depositors at the failed banks were made whole above and beyond the FDIC insurance limits. A new facility was created that would allow other banks to borrow from the Fed to meet withdrawals rather than be forced bond sellers and risk falling into a similar spiral.  As a result, over $100 billion of deposits moved from regional banks and community banks to the large banks, money market funds or T-bills paying higher rates during the turmoil.

International Stock Markets Outperform

The MSCI EAFE Index gained 8.6% in Q1, surpassing the S&P 500’s gain of 7.5% and the MSCI Emerging Markets Index’s 4.1% return, driven by stronger economic data, moderating energy prices in Europe and China’s reopening, which benefitted European exporting economies. Fears of a winter energy crisis in Europe never materialized, due mostly to warmer weather, and the dollar finally weakened against most developed currencies following a period of sustained strength. The relative underperformance of Emerging Markets is what one would expect given tightening monetary conditions and lower commodity prices. 

Treasury Yield Curve Slump

Following a dismal year for bonds in 2022, the bond market rebounded in the first quarter of this year, with most bond sectors experiencing positive returns.  In 2022, short duration bonds with lower credit quality outperformed and this remained the case through early March, as investors hunted for yield in the short end of the curve. Long duration bonds, which are more sensitive to interest rates, fell to start the year in response to rapid Fed rate hikes but rallied beginning in mid-March when the banking crisis caused a flight to safety and a rapid decline in future rate hike expectations. As a result of this shift, longer-duration bonds outperformed over the full quarter. If rate cuts do not materialize as quickly as the market now expects, longer-duration bonds would be more vulnerable to price loss but would likely provide downside protection when and if equity markets break to the downside. 

Climate and ESG Update

The last year and a half has revealed more insights into ESG and Climate than the combined learnings of the preceding decade, thanks in part to the increased attention and scrutiny.  The mainstreaming of ESG data into the investment processes of asset managers is well under way and regulatory agencies like the SEC in the US and ESAs in Europe have expanded their supervisory and compliance oversight. Over the past quarter there were some notable moments within sustainable finance that are worth mentioning: 

Recalibration of the ESG Fund Universe

  • US SIF (the Forum for Sustainable and Responsible Investment) slashed their estimates of the size of the US sustainable investing market from $17.1 trillion to $8.4 trillion, a 51% contraction citing changes in methodology used to calculate the universe to account for more modern greenwashing protections. 
  • ESIF is warning that the size of the EU sustainable fund market will drop by more than 50%. 
  • MSCI is set to strip hundreds of funds of their ESG rating and downgrade thousands more in a methodology shake-up to tighten up the criteria for what qualifies as an ESG-compliant fund.  The total effect of this re-rating is not yet published but FT is quoted stating “the number of European ETFs with a AAA ESG rating from MSCI is set to tumble from 1,120 to just 54, while the number with no rating will surge from 24 to 462.”

These actions are a direct response to greenwashing rules, enforcement, and enhanced disclosure rules that have been passed in Europe and the US to help investors better understand what they are investing in. Overall, this is a helpful move for the field as we are unlikely to achieve any of our environmental or societal outcome goals if every mutual fund can claim ESG integration and classify their AUM as “sustainable”. Europe took this process a step further this year with the final rollout of the SFDR regulation that categorizes funds into 3 categories: Article 6 (funds without sustainability scope), Article 8 (funds that promote environmental or social characteristics) and Article 9 (funds that have sustainable investment as their objective).  

IPCC Released its Synthesis Report of the Comprehensive Sixth Assessment Report of the State of Global Warming

This is the most comprehensive assessment of the status of the global climate ever produced and the findings were mixed.  The report unequivocally states that humans have permanently changed the planet and caused climate change that is killing people and reducing global prosperity.  Some negative highlights in the report include:

  • “Global emissions have not fallen but have continued to rise since the 1.5-degree target was established at the 2015 Paris Climate Accords, indeed hitting an all-time high in 2022.”
  • “If all fossil fuel infrastructure currently planned around the world is developed, there is an 83 percent likelihood of reaching irreversible levels of warming, defined as 2°C or more.”
  • “To avoid this, greenhouse gas emissions must be slashed to 40% of 2019 levels by 2035, a 60% reduction in 12 years.”

And yet there is still good news. The 1.5-degree warming target is still a viable option.  The solutions and technology needed to reach our goals already exist and the current solutions have already proven their ability to scale and be deployed rapidly while being economically viable.  Reaching the target will require the fastest energy system transformation in history to occur between now and 2035 but we have the tools to succeed. Some other positive highlights include:

  • “The Inflation Reduction Act has already spurred action and has the potential to lower emissions by up to 40%.”
  • “Europe now needs to offer similar incentives to remain competitive. This will set up another feedback loop.”
  • “The cheapest way to transform is massive investment in scaling up wind and solar and cutting wasteful methane emissions from coal, oil and gas.”
  • “Solar is now the cheapest form of electricity in history. This fact alone should spur rapid deployment.”
  • “For cities, which make up 70% of emissions, this means electric vehicles, public transport and more bike lanes.”
  • “For land and food, this means reducing meat consumption, healthy diets and reduced food waste.” 
  • If carbon was priced at $100 per tonne all the solutions outlined above are either cheaper than current fossil fuel burning solutions, or the cost is easily affordable with subsidies.

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