The Pinnacle: March 2023

April 14, 2023 TallRock Capital

M A R C H 2 0 2 3 • I S S U E 2 8

First Quarter 2023 Market Review

Over the first quarter of 2023 growth has been better than expected across the globe. Lower energy prices have certainly played a role in boosting sentiment along with China’s return to normal economic activity. However, the period has not been without its challenges with trouble in the banking sector as well as geopolitical tensions casting a shadow over the year so far.

In the US, the Federal Reserve (Fed) raised rates in both February and March, by 25 basis points on each occasion. While the Fed stayed on course during the quarter, inflation continued to fall, with the latest numbers coming in at 5% year on year (YoY) for March, down from 6% a month earlier.

The Fed was unmoved on its path of rate hikes despite trouble in the banking sector, which kicked off on Friday, the 10th of March, with the collapse of Silicon Valley Bank (SVB). This led to further turbulence in the banking sector with trouble at First Republic Bank, as well as Signature Bank going under. While the industry is certainly not out of trouble, the banking sector has returned to a more tranquil normality. Despite the banking sector distress, the S&P 500 rose in the first quarter, driven to a large extent by a comeback in the Technology Sector.

The UK economy performed better than expected in the first quarter of 2023. The Bank of England (BoE) raised rates by 50 basis points in February, followed by a 25 basis point hike in March. Inflation has been sticky and rose to 10.4% annually for February from 10.1% previously. The BoE does remain focused on bringing down rates, this stronger inflation can be put down partly to the resilience of the UK economy. While UK equities underperformed globally over the quarter, they still finished in positive territory. Economically sensitive sectors outperformed, indicating increased positivity in the market that the BoE will be successful in bringing inflation to lower levels.

Just as in the UK, the Eurozone and Europe at large, also performed better than expected in the first quarter of the year. The region was unable to avoid the turbulence of the banking sector with the notable event of UBS buying Credit Suisse as part of emergency measures brokered by the Swiss government. Despite this, Europe maintained a certain degree of economic positivity with the composite PMI (Purchasing Manager’s Index) reaching 53.7 in March, indicating an improvement in economic activity. This positivity was partly down to the continued lower energy prices during the quarter. The European Central Bank (ECB) raised rates by 50 basis points in both February and March, staying on course. Inflation fell to a one-year low of 6.9% in March, down from 8.5% previously. The better-than-expected performance extended into the stock market, with the STOXX 600 index posting an increase for the first quarter.

In China, equities had a strong start to the year. This was mostly due to the country resuming economic activity after abandoning its Zero-Covid Policy. However, the strong performance was also aided by supportive property market measures as well as easing its regulatory crackdown on its Technology Sector. Challenges for China and Asian Emerging Markets at large came as renewed tensions between China and the US gained momentum as well as fears of market contagion following the collapse of SVB in the US. Asian emerging markets followed the global trend with a pullback in February, with countries such as Thailand and Malaysia were hit especially hard, while equities came back strongly in March.

Despite better-than-expected performance in economies globally, the first quarter of 2023 has still provided a certain amount of turbulence. Some of the key factors for investors to watch going forward continue to be inflation levels, the actions of central banks, and the developments in the banking crisis.

Effects of the Banking Crisis

At the beginning of the year, market participants and economists voiced hope that the global economy may not slow down as much as they had anticipated. The reopening of China, resiliency in major economies, and a decline in energy costs were all positive developments. However, the banking crisis that surfaced last month has altered the equation.

Following the March bankruptcies of Silicon Valley Bank and Signature Bank, two local US institutions and the sale of much bigger Credit Suisse (CS) to competitor UBS in a government-backed rescue transaction, another US institution, First Republic Bank, edged on the verge of failure for which an agreement was reached with a consortium of American lenders to deposit tens of billions of dollars in cash into First Republic to stop the bleeding.

The International Monetary Fund revised downward its estimates for the world economy, citing "the recent rise in financial market volatility." The IMF now anticipates a slowdown in economic growth from 3.4% in 2022 to 2.8% in 2023. It had projected 2.9% growth for this year in January. According to the organisation's most recent analysis, "uncertainty is high, and the balance of risks has shifted firmly to the downside so long as the financial sector remains unsettled."

Given that the bank sector has come under pressure last month and the weakening economy is projected to harm profitability, banks are likely to announce lower quarterly earnings and have a gloomy view for the rest of the year. Banks, which form part of the broader financial sector, generally stand to gain from interest rate hikes as banks make more money on borrowers' interest payments than they pay out to depositors. However, under the current conditions banks face the possibility of sluggish loan growth and soured credit due to tighter financial conditions and a declining economy. As a result, it is likely bank management will adopt more protective liquidity measures, which might result in a negative adjustment of net interest income and in turn, a lower EPS.

There are some considerable differences between the current conditions and the 2008 financial crisis, such as banks in general now have more capital to withstand shocks and stricter regulation to curb risky lending. Yet, there are some similarities to the 1980s US savings and loan crisis, when trouble at smaller institutions hurt confidence in the broader financial system. The likelihood of a US recession occurring within the next 12 months has increased, according to Goldman Sachs. The probability that the American economy could experience a recession within a year has increased from 25% before the start of the banking sector crisis to 35% now, according to the bank.

The effects of high and ongoing inflation, the quick increase in interest rates to combat it, excessive debt levels, and Russia's conflict in Ukraine were already weighing heavily on the world economy. The concerns about the health of the banking industry have now joined the list.

In the upcoming months banks are expected to pay considerably more attention to borrowers' creditworthiness and the availability and cost of financing might increase. Policymakers must act decisively to maintain trust and further close gaps in banking surveillance, supervision, and regulation. Resolution regimes and deposit insurance programs could also bring relief. Central banks may need to increase financing support to both bank and nonbank entities in severe crisis management conditions. This should help maintain financial stability and allow monetary policy to continue to work on stabilising prices.

Fiscal Policy, Monetary Policy and Inflation

Fiscal and Monetary Policy are the two main tools at the disposal of governments and central banks used to influence macroeconomic outcomes. Fiscal policy relates to government spending and whether it runs a budget surplus or deficit. Monetary policy is used by central banks mainly by setting an interest rate for a country. It is essential to understand the building blocks of both when looking at the macroeconomic situation we find ourselves in.

Fiscal and Monetary Policy can be expansionary or contractionary. Expansionary fiscal policy means that the government is increasing its spending to drive forward economic growth often running a deficit to do so (meaning its spending more than it’s taking in as income through taxes). Contractionary fiscal policy means that the government is spending less and practising fiscal discipline (spending less than it earns and running a budget surplus).

Expansionary monetary policy means a central bank lowering interest rates to drive economic growth, even if it means allowing for some inflation. Contractionary monetary policy comes about when a central bank increases interest rates to try and slow the economy with the hope of bringing down inflation.

When countries around the world entered lockdowns due to Covid-19 in March 2020, expansionary monetary and fiscal policy was the name of the game, until the start of 2022. Governments around the world were spending billions to try and boost their economies, often in the form of stimulus payments. Central banks lowered interest rates to rock bottom levels, some even below 0% in real terms.

It has been estimated that the stimulus payments in response to the Covid-19 pandemic totalled $814 Billion in the US alone just to households. One may argue that this was necessary as the pandemic triggered one of the greatest jobs crises since the great depression with the ability to increase poverty and inequality drastically. Those of the other viewpoint may argue that the massive government spending may lead to unsustainable levels of inflation which would hurt the economy in the long run. While high inflation has certainly been seen in recent times, whether government spending went too far during the pandemic has been debated.

Monetary policy was equally expansionary in response to Covid-19 not only through extremely low-interest rates but also through quantitative easing. Quantitative easing is when a central bank decides to make a large-scale purchase of assets such as government bonds. This has the effect of increasing the money supply in the economy and ultimately helping to lower long-term interest rates. While this helps stimulate the economy it can also be at the cost of high inflation.

While the main responsibility of reducing inflation usually lies with central banks, the US government cut its budget deficit in half from $2.776 trillion to $1.375 trillion for the 2022 fiscal year. Additionally, the Inflation Reduction Act was passed in August of 2022 which aims to boost clean energy, reduce healthcare costs, and increase tax revenues.

Inflation peaked at 9.1% in the US in June of 2022. The US Federal Reserve (Fed) has raised rates nine times since the start of 2022 to try and bring inflation under control. Many believe central banks may be coming to the end of their hiking cycles despite the recent hikes of 0.25% by the Fed, 0.25% by the Bank of England (BoE), and 0.50% by the European Central Bank (ECB) in March. Whether the Fed acted soon enough and can control inflation remains to be seen. The labour market is a key factor to watch going forward as the Fed tries to bring down inflation while minimising damage to the economy.

Despite inflation having peaked it is still at persistently high levels. There is much debate as to when governments will start increasing their spending again and central banks will start lowering interest rates. In the US, the consensus is now that this will not happen before the end of the year with other economies likely to follow their lead. If one thing is for sure it will likely be some time before government spending and interest rates return to their pre Covid-19 levels.