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A Positive Q1 2023 for Stocks and Bond Markets, but the Coast Isn’t Clear

The key variable for investors to weigh will be the impact of the banking crisis on the economy.

A Positive Q1 2023 for Stocks and Bond Markets, But The Coast Isn't Clear

Ivanna Hampton: The first quarter of 2023 took investors on a wild ride. sticky inflation, a banking crisis and rising interest rates fueled market volatility. Also, the bruised-up tech sector is rallying. Morningstar’s chief markets editor and Smart Investor newsletter editor Tom Lauricella is here to talk about it.

Hi, Tom.

Tom Lauricella: Hi there.

Hampton: Tom, it was definitely a quarter with lots of twists and turns. What were some of the highlights for investors from this wild ride?

Lauricella: A lot certainly happened in the first quarter, and in some ways it’s best to split the quarter up into two. The first part of the quarter was really continuation from where we left off at the end of 2022. Where the focus was squarely on inflation and what the Fed was going to do. We started off the year with investors thinking that inflation was coming under control that the Fed might be able to stop raising rates sooner rather than later, maybe even start cutting rates by the end of the year. But then as we got into February, the picture changed dramatically. We saw the data that showed that inflation actually was looking much stickier than most people had expected, including the Fed. And investors began to think that the Fed was going to have to take rates still higher, hold them there still longer, and so we had the markets beginning to react negatively to that outlook.

Then came the second part of the quarter really where the focus shifted dramatically, literally overnight to the banking sector with the collapse of Silicon Valley Bank. When that happened, the attention shifted over to the health of the banking sector, potential for a credit crunch. And now we have investors looking at the Fed cutting rates much sooner, potentially in the third quarter, just to help keep the economy stable, keep the banking sector stable. So really a dramatic change there over the course of the first quarter.

Hampton: And that’s certainly a lot to digest. How did all this end up when it came to returns by the end of the quarter for the stock and bond markets?

Lauricella: Despite all this back and forth and back and forth, it was actually not a bad quarter for both stocks and bonds. The stock market ended the first quarter up about 6%, so that’s the second quarter in a row with gains. Key thing here: We’re still very much in the bear market, still down about 18% from our bull market highs set at the beginning of last year. Nevertheless, the market does seem to be finding its footing at least a little bit, bouncing back and forth in range, but we’ve got some gains in our pocket. Similar story for the bond market. Bonds are up about 2%, 3% in the first quarter, so some decent returns there, but that follows a terrible, worst in history 2022. In the bond market, it depends a little bit about on where you are. Some parts of the bond market did very well by the end of the quarter: Long-term Treasuries, government bonds did quite well. So, all in all, not a bad quarter, not a bad way to start the year.

Hampton: Let’s take a look under the hood of the stock market. What were some of the key trends, and how did the first quarter compare to what we saw in 2022?

Lauricella: Actually this is where the story gets even more interesting because within the stock market, what we saw in the first quarter was a reversal of some of the big trends that dominated investors’ portfolios in 2022. The biggest story really was the bounce in technology stocks and in communication-services stocks. So, we’ve got stocks like Facebook parent Meta META up more than 70% since the start of the year. Nvidia NVDA up a lot, semiconductors are rallying, other Big Tech stocks putting up big gains. Technology stocks overall up about 17% in the first quarter. Communication services up about 16% in the first quarter. Big numbers there. However, it’s important to put things in the context. Tech stocks are still down some 12% from where they were a year ago. Communication-services stocks still down about 23% from a year ago. So, investors are still really underwater there.

On the other side of the story. The more defensive sectors that did very well last year like healthcare, utilities—those stocks have struggled this year. Healthcare stocks down about 5%, 6% this year. Dividend strategies also, they’re not doing so well. Value stocks in general have lagged behind growth. So, there’s a lot of movement under the surface, even though the numbers haven’t changed much overall, there is fair amount of rotation going on between the sectors.

Hampton: Now your team has published several articles about the bond market in recent weeks. What were the big stories for bond investors in the first quarter?

Lauricella: As we noted in some of our articles, investors tend to watch the stock market much more than they do the bond market. But when it comes to clues about where the economy might be headed in the medium to near term, the bond market is really the place to look. And that’s where things got very interesting and not all that great looking, to be honest, following the collapse of those banks in early March. What we see in the bond market is on the one hand, flight to safety, flight to quality, investors snapping up U.S. Treasuries. Investors thinking the Fed’s going to be easing, so interest rates fell fairly dramatically in the bond market. But however, it’s a different story for more credit-sensitive parts of the economy. This wasn’t much of an issue in 2022, that’s when interest rates really dominated. But now we’re seeing lower-quality bonds starting to struggle as investors worry that a credit crunch could make it harder for low-quality borrowers to pay back those debts.

Hampton: And this was really quite the start of 2023. What should investors be focusing on as we kick off the second quarter?

Lauricella: The big focus really at this point is what will be the impact of this banking crisis. Will it be contained? Will it be limited? There’s some hope that the moves made by the Federal Reserve to backstop these banks—although it’s a little controversial and the Fed is being criticized for missing this issue when it came up, the Fed did step in aggressively. And so perhaps the question is “Will this be limited?” We will see an impact. We’ve already seen lending start to slow down, lending standards tighten. So, there will be an impact. The question is just how much. So that’s going to be really, really critical. And then, of course, we do have to keep focused on inflation. We’ve gotten some inflation numbers that suggested that maybe things will be a little bit better as we start to move into the second half of the year. There’s some optimism that, in fact, the slower economy that results from any even modest credit crunch will help with the inflation situation. But those two variables will be the key things for investors to watch as we move into the second quarter.

Hampton: And that sounds like a lot of things for investors to consider, should they remain cautious?

Lauricella: At this point, there’s so much uncertainty out there. There are a lot of data points out there for investors to be considering. It’s very unclear, like I said, how the banking crisis will play out on the economy. What will that mean for corporate earnings? Do corporate earnings expectations still need to come down further, which would not be good for stocks? How much of a credit crunch will we have? It’s definitely time for investors to keep cautious, but as always, you know a long-term investor can continue to look for opportunities out there. Just remember that it could be very bumpy. And you know we might not make a lot of ground in the stock market, maybe a lot of back and forth, but for folks to just stay focused on their long-term strategies, even if it is a little bit of a rough ride for the next couple of quarters.

Hampton: Those are some good tips to give. Thanks, Tom, for your time today.

Lauricella: Glad to be here.

Hampton: Subscribe to the Smart Investor newsletter. You can catch up on the weekly rundown of Morningstar’s take on big market trends and investment opportunities. I’m Ivanna Hampton, senior multimedia editor at Morningstar.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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