The first quarter of 2023 proved to be a tumultuous period in the financial markets as investors closely monitored the Federal Reserve’s stance on inflation and interest rates. However, the interpretation of data by investors was often perplexing. Positive economic indicators sometimes led to higher yields and lower bond prices, due to fears of a more hawkish Fed, while weaker economic data brought optimism of a more accommodative Fed. In essence, good news was seen as bad, and bad news was seen as good. Market returns followed this pattern, seesawing as January brought hopes of a Fed rate hike pause, only to be followed by “higher for longer” expectations in February, and then slightly disappointing data and banking system turmoil in March.

Despite the volatility, stock and bond markets generally posted positive returns in the quarter, and commodities were the only segment to experience negative returns. This marked a reversal from the market environment of 2022, with growth stocks outperforming value stocks, large cap stocks outperforming small cap stocks, technology outperforming energy and Bitcoin outperforming traditional asset classes. The bond market also showed a turnaround, with bond prices rising and rates falling, even as the Fed implemented additional rate hikes.

Looking ahead, Mutual of America anticipates that market volatility will remain elevated throughout 2023, as short-term data and policymakers’ comments continue to drive market sentiment. The key issues we’re closely monitoring include the Fed’s ability to manage inflation and avoid a recession, job market conditions, corporate earnings and the overall health of the financial sector.

Equity Markets Rebound

During the first quarter, all major equity indexes posted gains, with the S&P 500^® Index rising by 7.5%, the Dow Jones Industrial Average up 0.9% and the Nasdaq composite jumping 17.1%. Notably, the technology-heavy Nasdaq outperformed the Dow by the widest margin since 2001. Mega-cap growth stocks, which have strong balance sheets and consistent revenue streams, benefited from lower interest rates and safe-haven characteristics, making them leaders in the first quarter amidst a low-growth economic environment. Interestingly, the 50 largest stocks in the S&P 500, known as the “Nifty 50,” returned 11.6%, while the remaining 450 companies returned only 2.3%.

The Nasdaq 100, consisting of the largest 100 companies in the Nasdaq Index, experienced a 20.8% surge in the quarter. The year-to-date gain in the Nasdaq 100 added more than $2.4 trillion to its market capitalization, bringing the total to $15.5 trillion, although still below its late-2021 peak of $20 trillion. Notable achievements included Apple and Microsoft regaining their $2 trillion market capitalizations, ending at $2.6 trillion and $2.0 trillion, respectively, by the end of the quarter. The biggest gainer on both the Nasdaq and the S&P 500 was Nvidia Corporation, with a staggering 90% increase, its largest quarterly gain since 2001. This rise reflects investor interest in artificial intelligence (AI), as Nvidia chips are utilized in various applications, such as chatbots and other technologies.

Over the six-month period ending March 31, 2023, equities experienced a significant rally, with the S&P 500 rising 15.6%, the Dow up 17.1% and the Nasdaq composite up 16.1%. Interestingly, this period started with the peak in the 10-year Treasury yield back in October.

Who Said Bonds Were Boring?

Bond market investors experienced a turbulent ride in the first quarter of 2023, with significant fluctuations in various indexes. In January, the Bloomberg U.S. Aggregate Index showed a positive return of 3.1%, but in February, it dipped to –2.6%. However, in March, it rebounded with a gain of 2.5%. Overall, the Bloomberg U.S. Aggregate Index posted a 3.0% return for the quarter, marking its best performance since the first quarter of 2020, when the COVID-19 pandemic prompted a flight to safe-haven assets.

Despite the Fed’s two increases of short-term rates by 0.25% during the quarter, yields for treasuries reached their lowest levels of the year in March, particularly for shorter-dated securities. Notably, the 10-year U.S. Treasury yield swung between a low of 3.30% and a high of 4.05% before settling at 3.47%. The 2-year Treasury, which is closely tied to expectations of Fed policy, also experienced significant fluctuations, ranging from a high of 5.07% to a low of 3.78%, and moving by at least 20 basis points on nine different days. In fact, the bond market exhibited greater volatility in the first quarter than the stock market, surpassing levels not seen since the global financial crisis of 2008–09.

In 2023, the 10-year Treasury yield declined by 41 basis points, to 3.47%, from its finish of 3.88% in 2022, resulting in rising bond prices. During the same period, the 10-year Treasury posted a positive return of 3.7%, the 30-year Treasury returned 6.0%, the Bloomberg U.S. Corporate Bond Index rose 3.5%, and the Bloomberg U.S. Aggregate Index returned 3.0%.

A noteworthy observation is that, despite the Fed having raised rates four times over the last six months, amounting to a total increase of 1.75%—from a range of 3.00% to 3.25% to a range of 4.75% to 5.00%—the Bloomberg Aggregate Index still managed to achieve a return of 4.89%. Additionally, the 10-year Treasury yield reached its peak at 4.23% in October, but declined by 76 basis points to 3.47% by the end of March.

Inflation’s Second Anniversary Above 2%

Inflation remains a persistent challenge in the United States, with multiple factors contributing to its continued rise. Global commodities prices have increased, consumer demand remains strong, employers face wage pressures, and supply-chain issues persist. Recent readings from three well-known inflation gauges consistently show levels above the Fed’s average target of 2.0%.

During the first quarter, the Bureau of Economic Analysis’ Core Personal Consumption Expenditures (PCE) Index, which is the Fed’s preferred inflation gauge and excludes food and energy prices, fell by about 1%, but still remains elevated at 4.6%. The Producer Price Index (PPI), which is sometimes considered a predictor of consumer prices, rose 2.7%. And the widely recognized Consumer Price Index (CPI) increased by 5.0%. The CPI measures the average change in prices for a fixed-market basket of consumer goods and services. Notably, the March CPI report marked the 24th consecutive month that inflation remained above the Fed’s target rate.

Although there are indications that inflation may be moderating, the Core PCE Index remains elevated. This underscores the persistent message from the Fed that more efforts are needed to address inflationary pressures. The variety of factors contributing to inflation, coupled with the prolonged period of inflation above target, highlight the ongoing challenges in managing inflation in the U.S. economy. 

Rates Are Starting to Slow the Economy

In an effort to combat inflation, the Fed began aggressively raising interest rates one year ago in March 2022. So far, it has implemented a total increase of 4.75%, and the effects of these rate hikes are starting to impact the economy. However, it is important to note that interest rate policy is a blunt tool with long and uneven lags.

One area where the impact is most evident is in the housing market, as higher mortgage rates are starting to cause sluggishness. In 2022, the 30-year fixed mortgage rate began at 3.1% and peaked in November at 7.1%. By the end of March 2023, the rate was sitting at 6.3%.

Another key indicator of the state of the economy is the ISM Manufacturing Index, also known as the Purchasing Managers’ Index. The first reading in 2022 was 58.8, but by March 2023, it had significantly weakened, contracting by almost 12.5 points to 46.3, indicating a decline in ordering activity at the nation’s factories.

Gross Domestic Product (GDP) growth also showed signs of slowing down, with the fourth quarter of 2022 ending at 2.6%, down from 3.2% in the third quarter. The Atlanta Fed’s predictive model, GDPNow, is forecasting GDP growth of 2.5% in the first quarter, but consensus estimates predict the economy will slow in the second, third and fourth quarters of the year, with projections for a 0.2% increase, a 0.6% decrease and a 0.2% increase, respectively. 

Equity Valuations

When looking at equities, there has been a shift in the narrative from last year’s “multiple compression” story to concerns about a potential growth slowdown or even a growth recession for corporate earnings. In the fourth quarter of 2022, overall earnings for the S&P 500 declined 3.2%, and it is expected that they will drop by 4.6% in the first quarter of 2023. One factor contributing to this decline is the decrease in profit margins, which have fallen for six consecutive quarters. Despite healthy top-line revenue growth, rising costs have put pressure on margins, creating a squeeze.

Adding to the concerns, the price/earnings ratio for the S&P 500, as reported by FactSet, is currently at about 17.8 times, which is higher than the beginning of the year at 16.7 times and above the 25-year historic average of 16.8 times. This suggests that stocks are not cheap at the moment. The first quarter of 2023 has been a contrasting market environment compared to 2022, with notable reversals, such as Bitcoin’s 70% return and meme stocks like AMC and GameStop rising by 23% and 25%, respectively.

Banking Crisis Catches Investors Off Guard

Just three months ago, the idea of three major regional U.S. banks failing would have been unthinkable to most investors. However, the unexpected downfall of Silicon Valley Bank, the largest of the three, marked the second-largest bank failure in U.S. history. The other two banks, Silvergate and Signature Bank, were lesser known and had significant deposits in cryptocurrencies. All three banks failed because they ineffectively managed their interest rate and liquidity risks, which led to a “run” on deposits that needed to be funded with investments that had become “underwater” due to the rapid rise in interest rates. This was yet another unintended consequence of the Federal Reserve’s aggressive interest rate hikes. In addition, First Republic was essentially rescued by its U.S. competitors after facing significant liquidity issues, and UBS took over failing rival Credit Suisse.

Despite this crisis, we believe that the overall condition of the banking system is better than it was during the 2008 financial crisis and should be able to withstand the impact. However, we anticipate some immediate consequences, including increased regulations on small and regional banks, tightened lending standards and a decrease in the total number of loans. In fact, in just two weeks ending on March 29, lending activity dropped by a staggering $105 billion, marking the largest decline in loan activity since 1973. While these changes were not planned by the Fed, they are expected to have a significant impact on lending activity, which will ultimately slow the economy. When combined with interest rate hikes and reductions in quantitative easing, we anticipate that economic activity will be significantly affected in the coming months.

Cost of Servicing Debt

The rise in interest rates has resulted in several repercussions, including increased borrowing costs for companies and governments. This is particularly evident for companies that heavily rely on financing to sustain their operations, such as a majority of U.S. companies and the U.S. government itself. The U.S. government, for instance, currently bears a massive debt of $31 trillion, equivalent to 120% of the country’s GDP. With approximately $7 trillion of this debt maturing and needing to be reissued each year at higher interest rates, the burden of interest payments has surged. In 2021, the interest payments amounted to $352 billion; by 2022, these had spiked to $475 billion. Projections indicate that these will further escalate to $640 billion in 2023 due to the elevated reinvestment rates. In essence, the heightened interest rates are significantly driving up the U.S. national debt.

Labor Market Trends Are Slowing

The Fed is keenly focused on reducing inflation to meet its 2% target, which requires implementing tighter monetary policies to create more slack in the labor market. The nonfarm payroll report for March 2023 suggests that the labor market is cooling to some extent, although further efforts are needed. The change in nonfarm payrolls for March was 236,000, in line with consensus estimates, but lower than the 12-month average of 342,000. Fed officials were likely encouraged by the drop in average hourly earnings on an annual basis to 4.2%, from 4.6% at the end of 2022. On the other hand, the overall unemployment rate fell to 3.4% for January 2023, its lowest level since 1969, before ticking up to 3.5% for March.

However, despite the historic rate increases in 2022 and 2023, the Fed considers the labor market to still be too tight, necessitating continued interest rate hikes, albeit at a slower pace and with more modest increases compared to 2022. Quantitative tightening is also expected to proceed in 2023. Currently, there is a widespread prediction, with an 86% probability, that the Fed will raise rates again in May. While some economists anticipate that the Fed may eventually stop raising rates and even cut rates by the end of the year due to a potential significant weakening of the economy, the demand side of the labor market presents concerns.

The Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS) for February showed that the number of job openings nationwide was 9.9 million, the first time it has dipped below 10 million since May 2021. This indicates that, while there are more job opportunities than job seekers, the labor market remains tight. The Fed aims to avoid wage-price spiral inflation, wherein higher wages result in increased costs for companies, which may pass on the burden to consumers. Therefore, it is crucial for the Fed to cautiously slow the job market to tame inflation without causing a significant spike in the unemployment rate.

Outlook

The first quarter of 2023 was marked by volatility in the financial markets as investors closely monitored the Federal Reserve’s stance on inflation and interest rates. However, investors’ reactions to economic data were often puzzling, with good news sometimes leading to negative market reactions and vice versa. Despite this uncertainty, equity markets rallied, with major indexes like the S&P 500, Dow Jones Industrial Average and Nasdaq composite posting positive gains. Mega-cap growth stocks, particularly in the technology sector, performed well, benefiting from lower interest rates and their safe-haven characteristics.

On the other hand, the bond market also experienced volatility, but with a different trend compared to 2022. Bond prices rose as yields fell, despite the Fed’s two rate hikes during the quarter. The Bloomberg Aggregate, a bond market index, returned 3.0%, the best performance since the first quarter of 2020 when the COVID-19 pandemic triggered a flight to safety. However, yields for Treasuries reached their lowest levels of the year in March, with the 10-year U.S. Treasury yield ranging from 3.30% to 4.05% during the quarter. The bond market’s volatility exceeded that of the stock market, with the 10-year Treasury yield dropping 41 basis points to 3.47% in the first quarter of 2023.

Looking ahead, Mutual of America expects volatility to remain elevated in 2023 as markets continue to react to short-term data and policymakers’ comments. Key issues to watch include the Federal Reserve’s efforts to tame inflation and avoid a recession, the job market, corporate earnings and the health of the financial sector. Despite the uncertain market conditions, equity markets have rallied, particularly in the technology sector, while the bond market has seen increased volatility but with bond prices rising as yields fell. Investors will need to closely monitor economic data and policy decisions for further insights into market trends in the coming months.

Jamie Zendel is EVP, Head of Quantitative Strategies, and Erik Wennerstrum is VP, Quantitative Research, at Mutual of America Capital Management LLC.

Past performance is no guarantee of future results. The index returns discussed above are for illustrative purposes only and do not represent the performance of any investment or group of investments. Indexes are unmanaged and not subject to fees or expenses. The index returns above reflect the reinvestment of distributions. It is not possible to invest directly in an index.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

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