MARKET RETURNS: Stock and bond markets both rallied to start the year in a welcome departure from 2022’s declines. Last year’s relative performance trends continued across global equity regions. International developed markets outperformed thanks to a combination of U.S. dollar weakness, a mild winter, and different composition within sectors. U.S. stocks were close behind, led by large growth companies that took steps to reposition their businesses for a higher interest rate environment. Emerging markets underperformed as geopolitical uncertainty lingered, but still posted healthy gains. Style trends within stock markets displayed a dramatic reversal as growth and quality stocks outperformed their value and low volatility peers and beat-up technology stocks led the rally while 2022’s top sector energy finished the quarter negative. Fixed income generated strong returns as intermediate-term interest rates fell, with foreign bonds also experiencing currency appreciation. The impact of higher short-term interest rates was apparent in cash approaching two-thirds of its full-year 2022 return after a single quarter.
Perception vs. Performance: The Q1 returns in the first section may come as a surprise to those that haven’t been following day-to-day market gyrations. Such strong performance seems at odds with news headlines related to layoffs, bank failures, the debt ceiling, extreme weather, and even a spy balloon floating over the United States. Survey data mostly reflects a corresponding dour mood among consumers, business leaders, and investors.
We see three potential explanations for the apparent disconnect. First, the impressive first quarter rebound must be taken in the context of 2022 returns. Most markets still have much territory to recover before regaining prior peaks. Second, an economic downturn has been widely anticipated and reflected in asset prices, even if some of the specific drivers have come as a surprise. Third, volatility works in both directions and the market’s best and worst days often occur in close proximity. We expect ongoing fluctuations as the economic picture becomes clearer.
Fed Moves Fast and Breaks Things: The current interest rate hiking cycle has been the swiftest since the early 1980s. Many commentators warned that the economy would be unable to absorb such a shock without some sort of accident, though few were clear on specifics. Now we’ve had one in the form of bank failures, including Silicon Valley Bank here in the Bay Area.
The fallout appears contained at this point, with limited risk of additional failures. There are several distinctions versus other periods of bank stress, such as the role of technology in expediting deposit flight and vulnerability caused by an interest rate mismatch between assets and liabilities rather than loose credit underwriting. Yet these were ultimately classic bank runs driven by herding behavior. Longer term, this episode raises questions regarding moral hazard and the role of policymakers in the economy.
End of an Era? U.S. stocks have dominated global equity markets for over a decade. They have consistently outperformed their foreign counterparts since the end of the financial crisis and now represent about 60% of global stock market capitalization. However, there are signs that the tide has begun to turn. J.P. Morgan recently declared a regime change in favor of international stocks, reflecting a peak in U.S. cumulative outperformance not reached again in the subsequent 12 months. The accompanying chart shows MSCI EAFE (Europe, Australasia, and Far East) beginning to outperform the U.S.
The conditions for such a shift have been in place for several years and now appear to have found a catalyst in the form of dollar depreciation. Foreign stocks have long had more attractive valuations and higher dividend yields. Their sector mix, once a headwind, may work in the region’s favor going forward with less technology and more financials and industrials. While the Fed appears to be nearing the end of its rate hiking cycle, the European Central Bank and Bank of England are still playing catch-up and the Bank of Japan is only beginning to tighten. This dynamic could benefit foreign currencies relative to the dollar as investors no longer need to buy U.S. assets to generate yield, providing an impetus for foreign stock leadership.
Conclusion: The return of diversification should be a key investment theme for 2023. Often considered the proverbial “free lunch” of investing, diversification can help to reduce portfolio risk without a meaningful decrease in expected return. However, many investors began to question its benefits during the 2010s as bond yields remained stubbornly low and stock market leadership became increasingly concentrated in a handful of large U.S. technology companies. Last year’s simultaneous declines for both stocks and bonds also raised uncertainty about whether their historical inverse relationship would continue to hold longer-term. We believe that the painful reset of 2022 sets markets up for a return to normal, with a constructive outlook for bonds and international stocks, as well as alternative investments. These asset classes now seem positioned to play an increased role as return generators within portfolios, potentially benefitting investors with a disciplined approach to constructing balanced portfolios.
S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks. Returns reflect the reinvestment of dividends.
The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding those from the U.S. and Canada. Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks. Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The Bloomberg Barclays U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollar-denominated bonds. Returns reflect the reinvestment of interest.
The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered a proxy for cash.
Benchmarks are unmanaged and provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be indicative of future results.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. All opinions expressed herein constitute the judgment of the author(s) as of the date of the report and are subject to change without notice. The material has been gathered from sources believed to be reliable, however Opes cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. This information may contain certain statements that may be deemed forward looking. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed. Opes does not provide tax or legal advice, and nothing contained in these materials should be taken as such. As always please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Opes and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Opes unless a client service agreement is in place.