April Fools’ Day is an annual custom consisting of practical jokes and hoaxes. The origins of this April 1st tradition are unknown, but several theories exist. One such association comes from Middle English poet Geoffrey Chaucer’s The Canterbury Tales, where in the “Nun Priest’s Tale” the protagonist, Chauntecleer, a rooster, is tricked by a cunning fox on April 1. Markets have enjoyed a decent rebound in 2023 after a difficult 2022, but is this sustainable or are we being tricked into a false sense of optimism as we enter April?
Equities were mostly higher in the first quarter, with the Nasdaq being the standout, enjoying its biggest rally since the second quarter of 2020. The S&P 500 gained for the second straight quarter. Bonds, especially Treasuries, were also stronger with yields falling in March. The strong start to the year is being attributed to positive macro-economic momentum and expectations for a soft landing in the economy. The Federal Reserve slowed the pace of rate hikes in the face of moderating, yet persistently elevated, inflation. However, the Fed also has signaled that further work needs to be done in the fight against inflation and they will not stop until it is near 2% on an annual basis. Labor markets continue to show strength and retail data sales data indicates consumers are willing to continue spending money.
Overhangs remain in the market with underwhelming earnings guidance while profit margins continue to be pressured by still elevated input costs, particularly from labor, and softening demand. Banking sector turmoil resulting from the Fed’s aggressive interest rate tightening cycle impacting investment portfolios grabbed headlines over the past month, but seemingly have faded into the background as the Fed has announced a new emergency liquidity facility to cover uninsured deposits. The turmoil still drove an increase in concerns over a hard landing given expectations for tighter credit conditions and risks of bank exposure to commercial real estate. Stress in the banking sector did lead to a meaningful reprieve of interest rates with yields plunging significantly, as well as aggressive expectations for a Fed pivot.
Not Fooling Around
With last week’s gains closing out March on a high note, the S&P 500 now sits where it did exactly two years ago, having dropped and rebounded in the interim. The index has been range-bound over the past six months and we are now at the upper end of that range, which we saw back in September and again in December. This time will the market be able to break through and continue a more sustained upward trajectory?
As is usually the case, sector returns have diverged and in some cases are very different than the broader market. Last year’s laggards – Technology, Communication Services, and Consumer Discretionary, have been the strongest performers this year with Financials, Energy, and Healthcare being laggards. The case for a sustained bull market includes moderating inflation and the possibility of nearing the end of the interest rate cycle, continued strength in the labor market and consumer spending, as well as banking stabilization. Arguments for a continued bear market are caution around stretched valuations, recession signaling from the yield curve inversion and concern about how long consumers can remain resilient given that wages are not keeping pace with inflation and savings rates are falling.
A strong case could be made that a mild recession has already been priced into the market. We remain cautiously optimistic that the Fed will be able to engineer a soft landing, however the likely outcomes are somewhat of a paradox. If the economy can avoid a recession, it is likely inflation will linger and the Fed will need to continue raising rates, putting pressure on both the stock and bond markets. If the Fed does not need to continue raising rates and can in fact pivot and begin to lower rates (which we do not think will occur until at least the last quarter of this year, barring any unanticipated events), it is likely the result of a slowing economy. This would likely also weigh on equities but would be bullish for bonds. The easiest prediction at this point is that the markets will continue to muddle through and may not move significantly in either direction over the next several months. Since the S&P 500 is already higher by 7% on the year and the Nasdaq has gained nearly 16%, many investors would even be quite content with those gains for the year.
The new quarter will be ushered in with the March jobs report on Friday. (As a side note, the markets will be closed on Friday in observance of Good Friday.) The jobs report is anticipated to show continued growth in the labor market and the unemployment rate holding steady at 3.6%. The Federal Reserve’s forecasts released in mid-March show unemployment rising to 4.5% by year-end. Investors continue to look for signs the turmoil in the banking sector is weighing on broader economic activity but impacts from tighter credit conditions are not likely to impact economic readings for at least another month. We may not know for several months if the banking crisis has been resolved or if it worsens. Regardless of the outcome, there tends to be no middle ground in a banking crisis, it either happens or does not. The bond market is likely pricing in too many rate cuts or not enough.
With the first quarter behind us, attention will turn to earnings in a couple of weeks with expectations already having been lowered. Valuations, which seemed to have been largely overlooked in the first quarter, are likely to again come into focus. We will also be watching oil prices after OPEC+ producers announced surprise output cuts, which is expected to cause an immediate rise in prices. After falling to their lowest levels in 15 months on concerns a global banking crisis would hit demand, oil prices have been rebounding as the crisis subsides, at least temporarily. Production cuts may accelerate the move higher and higher energy costs could contribute to higher inflation in the months ahead.
As we have experienced over the past year, markets remain highly unpredictable. Be sure the level of risk you are taking is commensurate with your risk tolerance and risk capacity. Do not let dramatic movements in the market fool you and sabotage your retirement. Please contact us if you would like to discuss your situation in detail or learn about the strategies we are implementing to protect against market downturns while participating in rebounds.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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