Q1 Market Review: Even with setbacks, the economy showed some signs of recovery

by Vittorio Ciccone | M.Sc | Investment Analyst at Ciccone McKay Financial Group

As 2023 dawned, many of us working in finance hoped the market volatility of the past two years would begin to ease. In January things looked hopeful. Equities were off to the races; the S&P 500 closed January up nearly 7%. As we entered February, the world’s central bankers signalled that the worst of the interest-rate hiking cycle was over. Markets took the view that an interest-rate cut might be forthcoming.

Unfortunately, February and March let such hopes down. The varying financial crosscurrents, including stress in the U.S. and European financial systems, put investors on edge. They feared that the collapse of Silicon Valley Bank and Signature Bank, along with issues at Credit Suisse, would spread contagion throughout the banking system.

However, proper backstops, that is, provisions of liquidity, prevented further such crises. And major stock indices held their gains, with international equities leading the way.

What happened with the banks?

It seems fitting to start this market commentary with a summary of just what happened in the financial banking sector. Here’s the timeline. On March 10, regulators took over Silicon Valley Bank (SVB). SVB became the largest bank since the Global Financial Crisis in 2008 (the second largest such crisis in U.S. history) to fail. On March 12, New York state regulators took control and closed Signature Bank. And on March 19, the Swiss National Bank facilitated the purchase of Credit Suisse by the Union Bank of Switzerland (UBS.)

From the start of the pandemic, SVB had been buying assets it considered safe: U.S. Treasury notes and government bank mortgage bonds. While these bonds don’t have much credit risk, they do have interest-rate risk. As interest rates began to rise, the assets lost value (when yields go up, prices go down).

According to the Wall Street Journal, the bank was sitting on US$17B in asset losses at the end of 2022. Additionally, to shore up its balance sheets, the bank began to sell its losing assets. As consumers began to worry, SVB faced a mountain of withdrawals requests – and were unable to raise cash for to cover the outflows. The resulting run on the bank caused regulators to step in.

It’s important to note that most of SVB’s deposits were larger than the Federal Deposit Insurance Corporation’s (FDIC) $250,000 limit (the FDIC is equivalent to the CDIC in Canada). At the end of last year SVB had roughly $150B of uninsured deposits.

The news of SVB scared Signature Bank’s customers, who also started withdrawing deposits. As with SVB, a large portion of Signature’s deposits were uninsured (the bank was also a large cryptocurrency firm). That’s when the FDIC, Treasury Department, Federal Reserve and President Joe Biden announced they would backstop these banks. As a result, customers could again access their deposits.

While this was happening, Credit Suisse, founded in 1856 and among the 30 banks known as globally systemically important (G-Sib), began to totter. According to its webpage, at the end of 2021 Credit Suisse employed over 50,000 people and had over $1.6 trillion in Swiss francs (apx. US$1.7 trillion) of assets. Well before the UBS takeover, scandals and management changes had plagued the bank. These sparked significant losses, forcing management to restructure its business model. This restructuring led to an investment by the Saudi National Bank.

However, after the SVB and Signature Bank failures, scrutiny of banks increased. As Credit Suisse came under pressure, the Saudi National Bank, now its largest investor, demurred at putting anything further into it. The Swiss National Bank stepped in to backstop Credit Suisse and push through its sale to UBS.

So far, no other banks have suffered the same fate as the three above. Central banks and federal governments around the world are now ensuring their respective countries’ banking-system stability with programs for accessing cash if necessary.
Still, banks are now cutting their lending, which stokes recession fears. Couple the lending slowdown with higher interest rates, and households and businesses will reduce their borrowing for consumption and investments. Economists are now predicting a recession of some sort to start in 2023.

Equity summary

Thanks to Mathieu Roy, Head of Equities at Louisbourg Investments, for providing the following information.

To kick off 2023, Canadian equities joined others in showing considerable strength. The S&P/TSX Composite returned +4.6%, despite the important energy sector having generated a negative return for the quarter. Oil prices dipped in late March – the exception, as strength was broad-based across the other 10 sectors with positive returns. Technology (+26%) performed the best, with fading long-term interest rates giving a valuation boost. Materials, consumer staples, utilities, industrials and real estate all generated returns of 6% to 8%.

Global equities extended their year-end momentum during the first quarter with solid returns. Volatility re-accelerated in March, resulting in some cracks to U.S. financial systems. But overall, U.S. equities had a strong rebound, up 7.4% in Canadian dollars. On a sectorial basis, there was a clear reversion to what we observed last quarter, with the “growth”-oriented sectors back in favour as interest rates appeared less likely to move higher. The IT sector (+24%), communication services (+20%) led by digital advertisers and entertainment, and consumer discretionary (+16%) led by Amazon and Tesla, drove most of the return. By contrast, health care (-4%), utilities (-3%), and financials (-3%) were the laggards. Energy (-5%) also lagged, weighed down by concerns about a slowing economy.

International equities had another strong quarter, up 8.0% in Canadian dollars and slightly outperforming their North American peers. Currency movements had a negligible impact on performance. On a sectorial basis, the IT sector (+20%) was the clear winner after a more difficult 2022, helped by the pullback in interest rates. More defensive sectors like communication services (+10%), utilities (+8%) and consumer staples (+7%) also benefited from the rotation. Unsurprisingly, given the recent chain of events, real estate (-2%), and financials (+2%) were two of the worst-performing sectors. As with global equities, energy (+1%) lagged due to concerns about an economic slowdown.

Fixed income summary

Thanks to Heather Hurshman, Head of Fixed Income, for the following information.

The first quarter of 2023 has been atypical of the asset class. The quarter can be best described as “highly volatile.” Bond market volatility reached unprecedented levels, comparable in scale to the VIX (name given to the options on S&P 500 expected stock market to measure volatility), as two-year Canada bond yields traded in a 91-basis point range during the quarter’s last three weeks.

Several conflicting forces contributed to bond market volatility. Resurging employment and inflation data offset weakening economic data in January, leading to a strong start. A return to higher yields in February then virtually erased these gains.
However, February also saw stronger-than-expected data. Markets began to believe the rate hike cycle was nearly complete. Central banks in Canada and the U.S. focused on holding policy rates at restrictive levels until inflation could return to the 2% target range.

These positive feelings were dampened by rising instability in the global banking sector, due to concerns about bank solvency and liquidity challenges. The takeover of the two U.S. regional banks and the troubles of Credit Suisse, all described earlier, spread concern throughout the market. This fear in the banking system created uncertainty about the future path of monetary policy and economic growth. The result: extreme bond market volatility in the short end of the curve. The quarter ended with the bond market (futures market) starting to price in the potential for rate cuts by the end of 2023. And, with a flattening in the yield curve (less inverted), led by lower two- and five-year yields.

Q1 saw a notable divergence in the risk sentiment between the equity and bond markets. Equity market indices were generally higher at times when the bond market moved lower in yield. This divergence can largely be explained by the strength in personal consumption and tight demand conditions. Both contribute to earnings estimates and support equity valuations.

By contrast, bond markets are increasingly focused on the impact of a rapid tightening cycle, where policy rates remain longer at restrictive levels. As a result, growth slows. Also contributing to a slowdown of economic growth are banks’ tighter lending conditions. Banks have no choice but to tighten these conditions because of diminished liquidity, due to the outflow of deposits into higher yielding money market and bond funds.

In January, the Bank of Canada (BoC) increased rates by 25 basis points, resulting in an overnight policy rate of 4.50%. The BoC confirmed it will pause further rate hikes until the impact of rate hikes on inflation and the broader economy becomes clearer.

Inflation pressures remain stubbornly high, well above 2% target levels in the year-over-year Core Consumer Price Index (excluding food and energy). In Canada, the Index is at 4.9% (yr./yr. median); in the U.S., 5.5% (yr./yr.).

Labour markets also continue to remain tight, contributing to elevated price pressures. Canada’s unemployment is currently at 5.0%, resulting in an elevated yearly wage growth of 4.2%. First-quarter projected gross domestic product (GDP) growth in Canada has also been revised higher, to 2.5% annualized Q1 GDP, and overall 1% 2023 GDP.

Two-year Canada bond yields declined 32 basis points to 3.73%, while five-year yields declined 39 basis points to 3.02%. Ten-year Canada yields declined 40 basis points to 2.90%. Thirty-year yields were lower by 28 basis points, to 3.0 % over the same period.

What is happening in Canada?

This past quarter showed Canadian economic growth being more resilient than expected, despite the past year’s interest rate hikes. In January, output increased 0.30% and jobs surged (RBC, 2023). In March the Canadian economy gained 35,000 workers, adding 348,000 over the past six months (RBC, 2023). The unemployment rate stayed constant at 5%, still near record lows.

The labour market started out extraordinarily strong. The Bank of Canada is showing that labour shortages are easing. Remember that labour is a lagging indicator and that the BoC’s hikes over the last year continue to build.

The BoC was one of the first central banks to move to the sideline and hold rates, neither increasing nor decreasing them. However, the higher Canadian interest rates will continue to cut into Canadian consumers’ purchasing power. RBC economists are forecasting that our economy will enter recession territory over the middle of 2023.

To sum up

The year sure started with a bang! Though economists cautioned about a possible recession, equity and bond markets showed healthy signs of life.

The current macroeconomic situation is the perfect time to rethink your financial planning. Increased savings rates can go a long way to boost your future finances, as higher inflation eats away at your existing assets. If you do not have a financial plan, the current era could serve as a useful prompt for you to chat with a fiduciary. This professional advisor can better equip you with the tools you need to be properly situated, not just for when years like 2022 occur — but for all your future.

As always, for more information about Ciccone-McKay Financial Group, or if you want to chat with someone at the firm, we welcome your call: 604-688-5262.

Sources for the above article:

Vittorio Ciccone, M.Sc.
Analyst at Ciccone McKay Financial Group

Market Commentary