Endowus Q1 2023 Market Update and Outlook — Markets Rally: Is A Recession Priced In Already?

Markets on a rollercoaster ride but ending higher in Q1

If we review the weekly returns of markets, out of the 12 weeks in the quarter, 10 of those weeks moved by more than 1%; more than half of them by more than 2%. It was a real rollercoaster ride — up, then down, then up again. It is understandable considering the major shocks of a bank run and bank closures in the US, the Credit Suisse debacle, and constant talk of recession and sticky inflation. 

But at the end of it all, the MSCI All Country World Index (ACWI) ended the quarter up — yes, up — by more than 7%. This goes to show that sometimes, investors focus too much on the short-term volatility driven by the latest news and events. Imagine if we were watching markets’ daily moves, or even worse, intra-day moves. It’s time to break that bad habit as we learn from history and empirical evidence instead. 

To reduce market volatility, diversify and extend the time horizon

Markets are, by definition, volatile. When we talk about risk in investing or financial markets, it means that we are taking that risk of volatility and are expecting to be compensated over the long term by higher returns. Risk and return always are positively correlated. 

However, we know that there are two things we can do to improve the risk-reward in our favour. One is to enjoy the benefits of diversification — so even if a single stock like Credit Suisse or Silicon Valley Bank blows up on you, it doesn’t blow up your whole portfolio. The other is to extend the time in the market, thereby reducing that volatility. The monthly return is less volatile than the weekly return, and the annual return is likely to be less volatile than monthly returns. If we invest for 10 years, then the volatility again is significantly reduced from the annual returns. We take market risk, but over the long term, there is a way to harvest good positive returns without the emotional rollercoaster ride.

Recession or resilience?

The International Monetary Fund (IMF) released a report this month, with a downward revision to its global growth forecast. The report also stressed that the risk of a hard landing had increased amid sticky inflation and global financial system vulnerabilities. The IMF has revised upwards their estimate for core inflation (ex energy and food) to 5.1% this year, by 0.6 percentage points since the January forecast. The growth outlook for both advanced and emerging economies were revised downwards for 2023 and 2024. 

Global growth is slowing and the risk of recession has increased — but markets are still up. As an investor, how do you make head or tail of the current economy and the markets? 

Historical returns show that it is very difficult to compare the market movements and track it directly to economic growth, so trying to trade the recession is an impossible thing to do as an investor. This is because recessions are normally called after the recession has occurred, due to the lagging nature of economic data. Therefore, trying to time the market or investing based on macroeconomic data is a hugely problematic thing to do when the data is always lagging and often revised from its original numbers. 

Studies show that there is virtually no predictability in economic data on financial markets. There is a reason why the financial markets are seen as leading indicators of the economy — the financial markets are much more efficient in pricing all available information and data.

How markets perform before, during, and after a recession

Of course, when there is an economic downturn and the growth or earnings of companies fall, then obviously markets will react to this in a negative way. During a downturn, the market would typically fall from a peak to trough of around 30%. We saw this in 2020 during the Covid-19 crisis (-34%) and again in 2022 (-26%). 

But more importantly, before and during the recession, the average return of markets throughout that period was virtually flat. Often markets go down, but sometimes they go up — on average, they are flat. But after a recession, markets typically rebound and continue to rise. So even if you were able to correctly forecast a recession, the best thing to do through a recession is to just stay invested. 

Imagine sleeping through a recession. If you did, you would have saved the emotional rollercoaster ride of seeing the markets fall and then rebound, as the chart above shows. One year after a recession, you would be up around 18%. After three years, you would be up about 35%. And after five years, you would be up some 52%.

Also, it’s important to remember that capturing all of the peak-to-trough fall is only achievable if you perfectly timed the top of markets to exit, and then buy at the absolute lows of the market — an impossible thing to do. Monitoring the peak to trough is not how most people view markets, and the worst intra-year falls are of course tough to watch, but what’s critical to note is that performance is typically bettered by the actual annual return of markets, as we can see above. For these reasons, staying invested, and possibly dollar cost averaging in a downturn, is the best way to reduce risk as well as ride out volatility and the uncertainty of recessions. 

Q1 2023 — the market rally

The good…

It all started with a bang. After ending December 2022 in mostly negative territory, the markets were off to the races in January, starting 2023 strong, and with China leading the pack. Buoyed by strong macro factors such as a lower-than-expected US consumer price index, higher-than-expected GDP growth, and a still strong job market — the markets, including fixed income, also saw a good run in January.

The bad…

And then came February. The economic data indicated that the fight against inflation was far from over, with January’s inflation data coming in higher than expected. The prospect of more sustained rate hikes in 2023 led to the returns of both equities and fixed income markets falling across the board.

And the ugly…?

The banking troubles unfolded in March, first with Silicon Valley Bank (SVB), spreading to Signature Bank and other US regional banks, and culminating in the acquisition of Credit Suisse by longtime rival, UBS. 

Yet for all the volatility and the whispers of a repeat of 2008, major markets closed March and the first quarter with positive returns. Timely support and reassurances from central banks and governments helped stem a possible contagion from the banking crisis. As banking stresses receded and volatility in the markets dropped, the US Federal Reserve approved another 25-basis-point rate hike in March. 

Global equities

The resilience of the equity markets has been impressive, given the dark clouds prevalent at the beginning of the quarter and the subsequent market shocks. Economists continued to worry about inflation, interest rate hikes, and potential recessions in major markets, although these fears somewhat subsided towards the end of the period. As if that wasn’t enough, the first major banking collapse since the Global Financial Crisis happened. Yet investors remained undeterred — most equity markets around the world posted positive returns in the first quarter. The MSCI All Country World Index, including both developed and emerging markets, rose by 7.44% in USD terms.

The volatility and uncertainty following the collapse of Silicon Valley Bank on 10 March 2023 caused widespread market turbulence. The Fed remained undeterred and raised interest rates twice, to the highest level in more than 15 years. The picture in Europe somewhat mirrored that in the US, highlighting how interconnected developed economies are. Consumer discretionary, communication services, and technology stocks gained the most, posting double-digit returns for the quarter. And despite the troubles around banks, financials as a whole remained largely stable. Investors did not deem the events to pose a systemic risk to the financial sector. The European Central Bank (ECB) raised interest rates even more than the Fed, but that didn't come as a surprise, and as a result, European stocks managed to outperform their US counterparts.

Emerging markets overall had positive performance too, but there was wide dispersion on a geographical basis due to idiosyncratic events. China, Korea, and Taiwan gained between 4% and 15% despite rising geopolitical tensions, while other geographies such as Turkey and India lagged. In Turkey, markets were suspended for a week after the huge earthquake on 6 February, subsequently recovering strongly but still closing lower than in December.

Global growth stocks continued to outpace value stocks in March, finishing Q1 with a strong lead of more than 12 percentage points in USD terms. In March, large-cap stocks outperformed small-cap stocks, reversing the trend in the earlier part of the quarter as investors sought safety in blue-chip and more stable names in the aftermath of the banking turmoil.

Global fixed income

Central banks kept battling higher core inflation throughout Q1, but investors' rate hike expectations were sent awry by the banking sector upheaval following the collapse of Silicon Valley Bank. Still, interest rates were raised in the US, Europe, Canada, and the UK, with Japan being the one notable exception. So far, the efforts have had mixed results, as consumer spending remains high and labour markets remain strong. As a result, the discussions on how many more rate increases there are to come, and how hard a recession will be if there is one, have not abated.  

The global fixed income markets, as represented by the Bloomberg Global Aggregate Index (USD), had a positive quarter, returning about 3%. Due to the enduring uncertainty, credit spreads have widened further, which negatively impacted the returns of high-yield bonds. Investors sought out quality names, sending prices for investment-grade and government bonds higher over the quarter, especially following the sharp yield falls in early March when the bank run news shocked markets.

The US dollar strengthened slightly against the Japanese yen, but weakened compared to most other major currencies.

Commodities and gold

Overall, commodities had a negative first quarter in 2023. Gold was an exception, with the S&P GSCI Gold Index posting an impressive 8% for the quarter.

With the immediate European energy crisis having been averted in the winter of 2022/2023, energy and energy-related commodity prices fell sharply throughout Q1, particularly for natural gas, oil, and coal. Natural gas, in particular, was affected by the successful efforts of many European countries to diversify their energy supply and mitigate their dependency on politically less dependable partners. Conversely, both precious and industrial metals gained broadly. The Russia-Ukraine war has also accelerated the transition towards renewable energies and modern energy storage solutions, and with it, a rising demand for the raw material needed for these solutions.

Agricultural commodity prices are more closely tied to consumer demand, which has remained high despite the ongoing fight against inflation. The S&P GSCI Agricultural and Livestock Index was about flat in Q1.

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