Global stock markets experienced positive returns in the first quarter of 2023, with the MSCI All Country World Index delivering a 4.5% return for investors using sterling. Bond markets also saw gains since the beginning of the year, as investors anticipated an upcoming end to the period of increasing interest rates.
Despite negative headlines concerning the banking sector, equities managed to gain momentum in March. The collapse of Silicon Valley Bank (SVB) and the government-brokered takeover of Credit Suisse by UBS caused some short-term volatility. However, the avoidance of a broader fallout provided reassurance to investors, at least for the time being.
While the rise in interest rates played a role in the downfall of SVB and Credit Suisse, their specific issues, such as interest rate risk mismanagement and poor performance, were more significant factors than indicative of systemic weakness. The insolvency of SVB and troubles faced by other US regional banks met the expectations that the Federal Reserve (Fed) would continue raising rates until an event occurred.
Although the Fed raised rates following SVB's insolvency, expectations for further increases have diminished, with derivatives markets now pricing in rate cuts before the year ends. Since the Fed began its cycle of raising interest rates just over a year ago, they have increased the funds rate from 0.25% to 5.00%. The full impact of this rapid increase is yet to be fully realized in the broader economy due to the lag in monetary policy, and while recent economic resilience has been positive, there may be potential weakness ahead.
Bond markets started the year strongly but experienced a decline in February due to consistently robust economic data. The recent turmoil in the banking sector renewed calls for an imminent end to central bank rate hikes, resulting in higher bond prices and intermittent volatility in equity markets.
The market-implied year-end fed funds rate now stands at around 4%, down from a peak of 5.5% in early March. This has influenced the US Treasury market, with the two-year yield down nearly 100 basis points and the 10-year yield approximately 50 basis points lower from their March highs. These diversification dynamics, absent for much of the previous year, have been observed and demonstrate the benefits of holding bonds alongside equities in a portfolio.
Fixed interest markets are indicating a greater risk of recession compared to six weeks ago, but stocks have remained relatively unaffected by this prospect. Whether a hard or soft landing awaits is still uncertain, but it seems increasingly likely that some form of landing will occur. The ideal scenario, where inflation returns to target and the economy continues to perform well without any landing disruption, appears to be a long shot at best.
US tech indices have benefitted from falling bond yields in 2023, with benchmarks outperforming broader US indices in local currency terms. Despite the anticipation of weak earnings this year, investors are looking forward to a recovery in 2024 supported by lower bond yields. However, it is worth noting that weaker growth, even with falling interest rates, can present challenges for risk assets based on historical patterns.
Financials have been among the worst-performing sectors due to recent banking headlines. However, the consensus view is that the banking system is in a much stronger position than during the 2007-2009 crisis, and current share valuations already reflect a considerable amount of negative news.
US regional banks are expected to face tighter regulatory scrutiny, which, combined with recent issues, will lead to credit tightening. Reports indicate large withdrawals from banks with capital flowing into money market funds. If this trend continues, it will further tighten financial conditions, weigh on economic activity, and weaken banks. Larger US and European banks currently seem to be in relatively better shape, with significantly larger capital buffers compared to 15 years ago.
The recent weakness in financial stocks has affected UK benchmarks, with large-cap indices returning to positive territory for the year by the end of March. Falling oil prices have also had a negative impact on UK indices, with Brent crude reaching its lowest level in over a year before rebounding due to OPEC+ production cuts, trading in the mid-$80s at the start of April.
While price pressures decreased in most areas during the first quarter, there are indications that high inflation may persist longer than expected. The UK's consumer price index recorded a 10.4% annual increase for the sixth consecutive time. The core reading, at 6.2%, remained the same as last May, suggesting that disinflation has not yet begun in earnest. This poses a challenge for the Bank of England, which recently raised interest rates for the 11th consecutive time, bringing the base rate to 4.25%. Sterling has benefited from the overall weakness of the US dollar, trading around the 1.24 level and just below its peak for the year.
Inflationary pressures are currently more prominent in services than in goods, primarily driven by higher wages rather than elevated commodity prices. However, soaring food costs remain a concern. Europe demonstrates this trend, as the gap between headline and core inflation closes, with the latest headline figure reaching a one-year low while the core equivalent reaches a new eurozone high of 5.7%. Continental European stock benchmarks have outperformed their US and UK counterparts year-to-date, with an increase of just under 10%.