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Quarterly Update

Quarterly Update

April 21, 2023

The first quarter was a welcome reprieve from the carnage endured last year. Most major indices were positive, and the Nasdaq even entered a new bull market. Bitcoin soared over 70%.

But the quarter wasn’t without drama. Unexpected positive economic data rocked stocks in early February, only to be eclipsed by multiple banks failing in March. One of them was even “too big to fail.”

There is no reason to expect the rest of the year to get any easier for investors. As the Fed prepares a likely shift in policy, we could be entering one of the most crucial points in any economic cycle – the early innings of a recovery.

U.S. Economy

The Federal Reserve has a dual mandate - control inflation and maximize employment. The combination of these two should theoretically produce manageable growth, where consumers make more and spend more without inflation going haywire. Their primary tool to achieve such harmony is adjusting our access to money.

Right around 70% of the U.S. economy is fueled by consumer spending (add in business spending, and the number jumps to 88%)1. Therefore, if consumers and businesses spend money, the economy grows, and when they stop spending money, it shrinks.

Rarely do we pay for homes, cars, and other big-ticket items in cash. Instead, we take out loans and repay these debts over time. Since big purchases are mostly done on credit, interest rates drive the economy. That’s why the Fed has been raising rates over the last 12 months. They want to slow everything down.

But the Fed only pursues this dual mandate if they have financial stability. Once the system starts falling apart or showing signs of cracking, their dual mandate gets thrown out the window fast. That happened in March when the Fed’s interest rate policy caused three banks to fail. The Fed dropped an atomic bomb on that ant hill to stop the fissure from becoming a canyon.

This has left the Fed in a tough spot. They still want to act tough on inflation, but it’s unlikely they will risk financial stability to do so. Perhaps that’s why the market is now pricing in a 0.50% rate cut by the end of the year and another 1.25% lower by the end of 20242. That and expectations of a recession later this year forcing the Fed’s hand.

But if the market is right and a recession is in the cards, ample evidence suggests it will be mild and short-lived. The Fed caused this current slowdown, and they have the tools to quickly reverse it when they feel their job is done.

Furthermore, despite a few failed banks, the overall banking sector in the U.S. has never been stronger. The capital cushion combined with strict regulatory rules that prevent large banks from taking on too much risk has transformed the system into a fortress.  If anything, the turmoil facing smaller banks has only made the larger banks stronger. For example, Bank of America reportedly brought in $15 billion in new deposits in the two days after Silicon Valley Bank was shut down3.

Add in the strength of consumer and corporate balance sheets, and our country has arguably never been better prepared for a downturn.


The chart below shows that most major asset classes rebounded nicely during the first quarter. The Nasdaq is even back in bull market territory, defined as a rise of 20% or more from a bottom. The S&P 500 fell behind but still recorded a respectable 7.5% total return.

But it wasn’t an easy 7.5%. Not even close. Stocks sold off in early February as economic data incorrectly spooked investors and the Fed into thinking the economy was stronger than initially expected. Three major banks also went under here in the U.S., along with Credit Suisse in Europe, which was supposed to be “too big to fail.”

There are signs that the first quarter will be emblematic of what is to come. The returns in the early innings of a market recovery tend to be the most rewarding but also the hardest to realize. Not because stock picking is harder but rather because the stomach to endure volatility like this is hard to keep settled.

The bond market is boring, but it’s three times the size of the stock market and arguably more important to the global financial system and U.S. economy. After the worst year on record, the bond market ended the quarter up over 3% (blue line in the chart below).

That’s not to say that risk is gone but rather likely being replaced. Interest rates andinflation wreaked havoc on bonds last year, but now it will likely be credit risk that investors must manage.

Lastly, gold has not been the inflation hedge that so many expected but rather one for the U.S. dollar. The chart below shows that the dollar and gold are almost perfectly negatively correlated (the actual value is -0.90 for fellow math geeks). When the dollar rose in value, gold fell by almost the same amount, and vice versa.

Looking Ahead

I was reading a book to my daughter the other night, and there was a lizard character that could point one eye in one direction and the other eye in a different direction. It occurred to me that this is how investors should prepare themselves for the rest of the year.

Source: Daughter’s Storybook

Keep one eye on the economy because it could help determine the Fed’s next steps. But don’t lock both eyes because financial markets tend to anticipate the economy. Stocks do so by 6 to 9 months, so by the time the economy bottoms, it’s almost certain that stocks will have already begun pricing in the recovery. Hence, keep the other eye focused squarely on asset prices.

Doing so is critically important because the early innings of a stock market recovery tend to be measured in weeks or even days. Missing out here because both eyes are focused on the economy could risk falling behind because the math required to recover is daunting.

Making matters worse, another challenge with market recoveries is that they tend to be universally hated. Pundits scoff and call them just another bear market rally. Wall Street research will reprint the same old story that stocks are overbought and that they haven’t fully priced in the recession. Anytime the market falls a few points, queue in the “double dip” rhetoric.

Herein lies the paradox. Any recovery will almost certainly not feel like one. It especially won’t if both eyes are bloodshot from being fixated on the economy.

Regarding investment strategy, these competing forces make any dramatic move to cash even riskier today than a year ago. Factor in taxes and the impossible task of timing the recovery, and we continue to firmly believe the best course of action is to stay invested but also remain active.

Some recent examples include adjusting duration to prepare for a Fed pause, targeting stronger fundamentals and credit quality, and incorporating new asset classes to generate attractive return potential uncorrelated to interest rates.

The bottom line is that we should all do our best to act like lizards. The direction of the economy matters because the Fed is watching it closely, so keep one eye on leading indicators like retail sales and select inflation and employment data. But keep the other eye fixated on markets to try to get an idea of what will get priced in next and when.




1 The Federal Reserve




This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.