How to Invest in the Second Quarter of 2023

With recent event many people are left wondering what will happen in the second quarter and the rest of the year. First I want to give a brief recap of what happened in the first quarter that drastically changed the outlook for 2023.

Quarter one recap

We started the year with another wonderful rally. January’s monthly performance was only topped by last July’s massive move. Markets moved so much in January that they blew past most analyst targets for the end of the year, making some investors think that the markets have returned everything they will return for the year… in month one.

Those dreams were quickly crushed by better than expected data on housing and employment showing the strength in the economy, leading to higher inflation forecasts and higher interest rates. We saw markets move lower in February based on this data.

Then the icing on the cake came on March 8th-March 13th. Between those 5 days we saw two of the largest bank failures in US history, and the failure of Silvergate Capital. Silicon Valley Bank and Signature Bank opened the eyes of the investor community by showing the severity of the fastest rate hike cycle in history and what it has done to the system. Stock and bond markets each rallied… on a banking crisis. This is because investors broadly saw this as the end of the hiking cycle and the possibility of rate cuts. Banking crises are generally deflationary too.

All that brings us here.

Quarter two outlook

On the tops of everyone’s minds is inflation and interest rates. Have each of those peaked. I believe they have.

Inflation has steadily been coming down from its 9.1% peak in June to 6% today. But the concerns are really focused on shelter inflation. But the Fed uses owners equivalent rent which is a lagged variable, but more real time data suggests that the shelter component of CPI has come down drastically.

Inflation should also ease on the backs of a banking crisis. What happens when you restrict the flow of capital throughout an economy is reduce the purchasing ability of people and businesses. Businesses can no longer finance working capital with debt therefor they don’t hire, and then people don’t spend as much with their paycheck. Without new working capital businesses just don’t flat out spend either. So with that inflation should meaningfully contract on the back of a banking crisis.

Interest rates are the reason we have a banking crisis. Rapid rate increases led bank balance sheets to unrealize a massive loss leading to loss of faith in the system. When that occurred people started wiring out causing the bank to realize those losses and have a liquidity crisis.

The rates caused the bank run, the bank run causes inflation to come down (at the expense of the economy), and the Fed has to cut rates and inject some liquidity back into the system.

What does that mean for stocks and bonds for the rest of the year.

As I am writing this the Nasdaq 100 is up 17% on the year. An annualized return of 68% if the trend continues exactly as it has. But the real appreciation should be in the bonds.

Companies make up the stock market and the economy, but the stock market is not the economy. Companies will feel the pressure from restricted capital on the face of the banking failures. Bonds on the other hand, especially government bonds, will be the flight to safety (which is something we are currently seeing).

As far as stocks go, defense is what we are calling for. Healthcare and industrials are heading into an investment super cycle based on the COVID-19 revenues and 2022 farm and commodity incomes. These could be outperforming sectors in the coming months and years.

The other thing to watch for is dividends. I’m not talking about 14% yielding mortgage REITs, those are bad for a number of reasons, I’m talking about strong and stable dividend payers. If the stock markets are only return 3-7% annually over the next 5 years dividends, even at 2%, will help enhance returns.

And lastly international investing is being heavily watched, by us and our peers, as a trade for 2023. If the Fed cuts rates and other nations wait/don’t the dollar trade is on. When the dollar weakens, the cost to do business internationally (as an international company) decreases adding to margin expansion and revenue growth. A falling dollar also creates more international buyers of US goods, so it’s good for the US as well. The bonus with the dollar trade is a lot of international companies are financials, industrials, energy, and healthcare companies. The companies are either paying nice dividends or moving into an investment super cycle as mentioned before.

While there is a lot to be alarmed about there is equal parts of things to be excited about. Stay nimble and flexible as we navigate these abnormal markets.