From the CIO’s Corner- Q1’2023 Performance Review: Caught Between a Rock and a Hard Place

The first quarter of 2023, characterized by bank failures not seen since 2008 and a collapse in bond yields not seen since 1987, brought forth the specter of crisis past, leaving the US Federal Reserve in a quandary as to the path of its monetary policy. Just 2 days after Fed Chairman Jerome Powell had assured the markets that a 50-basis points rate hike was necessary to continue curtailing a stubborn inflation, the whole yield curve decided the Fed needed to pivot sooner, erasing months of gains in interest rates in a very short period. Many market participants were caught off-guard by this change of position, contributing to the short-cover rally in bond markets. The Bloomberg US Aggregate Bond Index ended the quarter gaining 2.96%.

Meanwhile, equity markets, which had one of the strongest starts of the year in January, quickly gave back some of these gains as regional banks faced a confidence crisis but rallied again to new highs for the year as the support from monetary authorities restored confidence in these banks. The S&P 500 TR Index finished the quarter up 7.89%.

Overall, this has been good news for the 60/40 portfolio which is bouncing back from a dismal 2022 and finishing the quarter up 4.73% (60% S&P 500 TR Index/40% Bloomberg US Aggregate Bond Index). However, and perhaps of concern to wealth advisors, the correlation between stocks and bonds is now at the highest level since 1997 (rolling 1-year correlation of monthly returns of the S&P 500 Index and the Bloomberg US Agg Bond Index).

The physical commodity sector struggled most of the quarter with the S&P GSCI TR Index down 2.28%, mostly on fears of a global economic slowdown.

On the inflation front, the PCE – one of the Fed’s favored measures of inflation – has been pulling back, a positive sign for the Fed. That still leaves inflation much above a comfortable level for the Fed. However, with the latest rate hike, the Fed Funds rate is now above the PCE, bringing real interest rates above the inflation rate.

The tug-of-war between the two goals of the Federal Reserve dual mandate brought little clarity as to the possible outcome of the four scenarios which looked probable at the beginning of the year:

• The “soft-landing” which the Fed is looking to engineer;

• A “hard landing” which would quickly bring a recession;

• “Stagflation” where inflation is persistent and causes the Fed to keep rates elevated at the cost of economic growth;

• The Fed tolerates higher inflation for a while to avoid sacrificing growth and full employment.

It is clear that there are enormous forces at work: (1) relentless consumers who continue fueling inflation, and (2) higher interest rates impacting institutions and companies that are sensitive to rates and challenging financial stability. These represent a dilemma for the Fed. 

What is interesting is that while the equity markets have taken in stride the recent banking sector turmoil and Fed Funds rate hikes, the bond market is flashing signals that a recession could be imminent: the US yield curve is now the most inverted it has been since 1980, causing many economists to claim a recession is already under way. Furthermore, the Fed Funds dot plot now assumes that the Fed will start easing rates later this year, possibly towards the end of the 3rd quarter. It seems unlikely that the Fed will lower rates so soon, unless it is getting signals that the economy has indeed entered into a recession.

All of this market activity was not keen to hedge funds, with some reports of firms shutting down. Macro and CTA strategies, which had spent the first two months of the year hovering around zero, were not exempt from the poor performance in March and ended up the quarter down 5.27% (SG CTA Index). Short-term traders fared better, capitalizing on the ability to quickly adjust their portfolios, ending the quarter down 2.31% (SG STTI Index).

In just the last three years, global markets have suffered a series of shocks: a pandemic causing an enormous fiscal & monetary stimulus, supply shocks leading to inflation, and rising geopolitical tensions culminating in war. Looking forward, together, these themes create an environment where macro and CTA strategies may thrive as these types of strategies tend to benefit from sustained levels of market volatility and the availability of many themes to place bets on.

As Nobel laureate Merton Miller famously used to say, “Diversification is your buddy.” Investors should take heed to his advice. A well-diversified portfolio which includes potentially risk-mitigating strategies like macro and CTA strategies may help navigate the current uncertainty as the Fed seems to feel caught between a rock and a hard place. 

IMPORTANT DISCLAIMERS:  The author’s point of view reflected in this article should not be construed as investment advice. The CTA strategies noted herein, some of which may be available on the Galaxy Plus platform, do not represent an endorsement of a particular CTA or strategy. The information presented is for illustrative purposes only and is based on the opinion of the author as a result of recent market conditions and does not represent the view of New Hyde Park Alternative Funds, LLC.