The Independent Market Observer

Looking Back at the Markets in Q1 and Ahead to Q2 2023

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 5, 2023 3:53:38 PM

and tagged Commentary

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Look Back and AheadAfter a weak February, markets rallied in March. U.S. markets were up by low single digits, while bond markets were in the same range. International markets also showed modest gains, with developed markets about the same as the U.S. and emerging markets doing slightly better. For the quarter as a whole, the Nasdaq did best and moved into a bull market by some measures, followed by developed international markets and the S&P 500. This was a stronger start to 2023 than most had expected, and it may signal how the rest of the year will play out.

Looking Back

The markets. The S&P 500 gained 3.67 percent in March, while the Dow Jones Industrial Average (DJIA) rose 2.08 percent. The Nasdaq Composite did the best of the three indices, with the technology-heavy index up 6.78 percent. For the quarter, the S&P 500, DJIA, and Nasdaq gained 7.50 percent, 0.93 percent, and 17.05 percent, respectively.

International markets also showed gains. The MSCI EAFE Index rose 2.48 percent in March, and the MSCI Emerging Markets Index had a 3.07 percent gain. For the quarter, the MSCI EAFE Index did best, gaining 8.47 percent, while the MSCI Emerging Markets Index gained 4.02 percent. Even fixed income did well, with the Bloomberg Aggregate Bond Index up 2.54 percent for the month and 2.96 percent for the quarter. The 10-year U.S. Treasury yield dropped from 4.01 percent at the start of the month to 3.48 percent at month-end.

Inflation. The progress on inflation drove the gains during the quarter. While it is still too high, it is well below where it started the year. With the Fed having hiked rates at a fast pace, markets are now convinced that inflation will come under control, as the benchmark yield on the 10-year U.S. Treasury dropped significantly in March.

The economy. While financial markets showed gains during the last month and quarter, the economy showed signs of slower growth. Labor market indicators, including job openings and hiring, continued to slow, while some measures of consumer confidence in present conditions ticked down. Business confidence indicators also declined. The manufacturing survey stayed in recessionary territory, while the service sector dropped from its previous strong level. While a recession is not likely in the immediate future, signs indicate that the economy is continuing to slow, and a recession may appear by year-end.

Looking Ahead

The banking crisis. The aftermath of the banking crisis may accelerate a potential recession. March saw the failure of four banks, which triggered worries about the banking system as a whole. While prompt government action stabilized the situation, banks are likely to slow lending growth, which will be a drag on both consumers and businesses. This drag, and the building effects of prior Fed rate hikes, may slow the economy throughout the rest of the year.

Lower rates. Despite the headwinds from slower growth and the possibility of a recession, there is some potential good news ahead. With inflation dropping—and likely to drop further as the economy slows—the Fed will have less incentive to raise rates further, and the current drop in longer-term rates reflects that. And while the current data shows that higher rates were needed to curb inflation, such increases may not be necessary. Lower interest rates typically mean higher stock and bond values, and that is just what we saw. Looking back, the drop in rates appears reasonable, given the slowing economy. Looking forward, that slowing may continue. While slower growth will be a headwind for the market, it could also mean lower rates, which would help support markets.

Earnings and valuations. Overall, while valuations are likely to be supported as rates decline, a slowing economy will put earnings growth at risk. We will get more color on this as market analysts update their estimates, but the signs show that expected earnings may come down. This means that markets could face more headwinds over the next couple of months.

In the short term, the economy may experience slower growth, and markets could struggle given increased risks to earnings growth. April may be tougher for markets than the start of the year. At the same time, as we look further forward, a strong first quarter has historically been a positive sign for the year as a whole. We can reasonably expect more volatility in the short term, but the longer-term picture remains more positive.

Political risks. Beyond the economic and policy angles, April could also face political challenges. The federal debt ceiling was hit again in January, and the Treasury is now using extraordinary measures to pay the bills. While this will be resolved, it will likely be at the last minute, as it has been before. Until then, the rising uncertainty will also weigh on markets. With the Ukraine war underway and China’s Covid-19 reopening still uncertain, there are multiple risks that could act as market headwinds this month.

The Bottom Line

The first quarter had good economic and market results. April and the second quarter will likely be more challenging. But even if they are, the prospects for the rest of the year continue to look positive. And that is the bottom line here. While we do have headwinds, the current economic slowdown and adjustment in interest rates should put the economy and markets in a better place. Over time, we could see that same kind of economic resilience as those improvements continue.

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