Market update – period ending 31 May 2023

Key Themes

•             Markets got off to a strong start in January as investors became more optimistic about the prospects of slowing inflation.
•             In contrast, the tight labour market theme was in the spotlight with the release in February of a strong January US employment report which was the trigger for a meaningful jump in bond yields.
•             The path of least resistance for stocks was lower throughout much of February driven by the velocity of interest rate repricing.
•             The US banking sector turmoil grabbed the headlines in March with an intense focus on funding/liquidity pressures for regional banks and deposit flight into larger banks while in Europe, the Swiss regulator pushed through UBS' takeover of Credit Suisse.
•             The turbulence in the banking sector drove a meaningful interest rate reprieve in March. The US policymakers’ response to the banking turmoil helped to underpin the broader equity market and provided an outsized tailwind for large-cap tech stocks.
•             Trading was fairly muted in April despite a lot of moving pieces. Markets were supported by better-than-feared regional bank results and consumer resilience via healthy household spending along with better trends around cost controls, inventories and supply chain normalisation.
•             Analysts continue to flag the risks around the growing gap between markets and the Central Bank rate path outlook, a scenario that could see the Fed restarting hikes later this year if the economy continues to perform well and inflation doesn't recede. On the flip side, following the banking turmoil, recession fears persist as banks have tightened their lending standards and the possibility of higher interest rates for longer impact financial conditions.
•             May saw a narrow, tech-focused leadership with the mega-large cap FANMAGs (Facebook, Amazon, Netflix, Microsoft, Apple, Google) broadly higher and semi-conductor and semi-conductor manufacturing equipment companies riding a wave of AI (Artificial Intelligence) optimism.
•             From a glass half-empty perspective, financial conditions have tightened following the recent banking turmoil as banks have tightened their lending standards. Key downside risks include weak market breadth, narrow stock leadership, softening of labour markets, eroding household excess savings cushion, a downturn in the commercial real estate sector and geopolitics.
•             From a glass half-full (optimistic) note, the consumer has continued to stay resilient to-date, Q1 earnings season has been better than expected prompt measures by policymakers to maintain stability in the banking system have diminished hard-landing concerns, the debt-ceiling resolution has come about averting potential default by the US on its debt, supply chain pressures have dampened and long-term inflation expectations are well-anchored.
•             Volatility and illiquidity are creating opportunities for active managers to buy high quality assets. Ensuring your portfolio is well diversified remains essential.

Context

A volatile March quarter:

•             Markets got off to a strong start in January supported by increased confidence that inflation has peaked and will fall over the coming months, positive macro-economic data surprise momentum, expectations for an accelerated China reopening following the COVID pivot by Chinese policy makers late last year and warmer weather in Europe which helped prevent an energy crisis.
•             The US Federal Reserve also slowed the pace of rate hikes with a 25bp increase at the February FOMC meeting, while Chair J Powell acknowledged that the pace of increase in inflation had slowed and did not strongly push back against the loosening of financial conditions. However, he flagged the need to do more work, with “higher rates-for-longer” to combat ongoing inflation pressures – citing the tight labour market leading to wage increases.
•             A strong January employment report was the trigger for a meaningful jump higher for bond yields and led to a repricing of the peak in the Federal Funds rate higher by ~50bp over February. Additionally, headline inflation data globally showed that while the pace of inflation was slowing, inflation is likely to remain elevated for longer than hoped.
•             At the March 7th US congressional testimony Fed Chair J Powell said that the Fed was prepared to accelerate the pace of rate hikes if necessary. Markets focused on the risk of higher interest rates, the potential recession resulting in a deeply inverted yield curve, a sharp fall in the growth of money supply due to central bank quantitative tightening and the downside risk to consensus earnings estimates.
•             Interestingly in May, Chair Powell made a meaningful change to forward guidance suggesting the US Fed is at or near the end of its hiking campaign, while stressing that future moves would be dependent on the totality of the incoming data. While June rate-hike expectations dropped in the wake of the meeting, the minutes of the May FOMC meeting highlighted the fact that there remains a divide within the voting-member panel.

Banking sector turmoil in March:

•             In early March, US banking sector turmoil grabbed the headlines with the focus on funding/liquidity pressures for smaller regional banks and the impact of the Fed's aggressive tightening cycle on investment portfolios leading to deposit flight to the sanctuary of larger banks. US financial authorities announced that uninsured deposits at two failed banks (SVB Bank and Signature Bank) would be protected and to combat stress in the banking sector, the Fed announced a new emergency liquidity facility to mitigate the risk of further contagion.
•             In Europe, in the weekend before markets opened on 20 March, the Swiss regulator averted an escalation of financial contagion by engineering a takeover of Credit Suisse by UBS. Further, EU regulators and officials acted swiftly to assure investors that the European banking system remained resilient by committing to protect deposits and pledge liquidity (if needed).
•             However, the turbulence in the banking sector also drove a meaningful interest rate reprieve in March as market expectations for an aggressive Fed pivot took hold.  Over 100 bp of cuts were priced in for 2023 at one point and Fed balance sheet re-expansion regained prominence as banks increasingly tapped the Fed's backstop facilities (though this tapered near quarter-end). While the Fed still raised rates by 25 bp in March, this was lower than the 50bp expectation prior to the bank issues. The two-year yield plunged an extraordinary ~130 bps from their 5%+ peak in just a couple of weeks.
•             The Fed/Treasury/FDIC response to the banking turmoil helped to underpin the broader equity market and the Fed interest rate pivot expectations provided an outsized tailwind for large-cap tech stocks (and some other growth/long duration companies) which in turn provided broader market support. This sharp move was exacerbated by hedge fund buying.
•             The ructions in the banking sector in March have however increased the risk of further tightening in credit, particularly in the commercial real estate (CRE) sector. 

March Quarter (Q1 2023) Earnings Season summary:

•             The Q1 2023 earnings season largely wrapped up in May, with results continuing to outpace pre-season forecasts. The proportion of these companies posting earnings and revenue beats has been above both one and five-year averages, with the magnitude of earnings beats also outstripping recent trends. Cost-cutting/efficiency efforts remained a major theme in the corporate commentary, with companies also highlighting some continued normalisation and waning inflation pressures, though the possibility of a second-half recession remains a wild card.

Timely resolution of US debt-ceiling issues:

•             The US federal debt ceiling crisis generated an enormous volume of headlines in May. Negotiations between the White House and US House of Congress Republican Speaker McCarthy were bumpy to say the least. With a potential default looming on the 5th of June, both sides announced an agreement on the 27th of May that would suspend the debt ceiling until January 2025 and hold non-defense discretionary spending roughly flat over the next two fiscal years. The deal has removed a key near-term source of uncertainty for the US Fed policy (and has also lessened the risk of a budget battle in September), though there were also concerns about liquidity headwinds from T-bill issuance to rebuild the US Treasury’s general account.

Domestic context and monetary policy:

•             The Reserve Bank of New Zealand increased the OCR in February from 4.25% to 4.75%, followed by a surprise 50bp hike in April to 5.25% and kept the door open for additional hikes, citing that “Inflation is still too high and persistent, and employment is beyond its maximum sustainable levels”.
•             Finance Minister Grant Robertson anticipates a price tag of as much as NZ$10 billion for cyclone relief that he said will be distributed over many years as the country rebuilds by tapping unspent emergency funds and consolidating its fiscal policy. The Government in their May Budget announced increased spending and borrowing, projected wider deficits and pushed out the return to surplus by a year to 2026. Economists said fiscal policy was looser than expected and could add to inflationary pressures.
•             New Zealand’s current account deficit widened to 8.9% of GDP (for 2022), the biggest deficit since the mid-1970s. Rating agency S&P has indicated that New Zealand’s credit rating may come under pressure as the latest data release was much wider than S&P had anticipated (S&P had forecasted the current account deficit would ease to 5.8% by mid-2023).
•             New Zealand saw a record inflow of migrants in a bid to alleviate worker shortages. Net immigration rose to 65,440 in the year ended March 31st, the biggest net annual gain since August 2020.
•             Towards the end of May, the RBNZ raised interest rates by a further 0.25% to 5.50% but unexpectedly signalled that no further policy tightening would be needed for now to tame inflation, sending the NZ dollar tumbling 3.7% over the ensuing week.

Source: BT Funds Management