The quarter that felt like a decade

Debra Slabber

“There are decades where nothing happens, and there are weeks where decades happen" -Vladimir Ilyich Lenin

After a tough 2022, markets sighed in relief during the first quarter of 2023. The gains most certainly did not come in a straight line - from euphoria in January to fear in March, it has been a bumpy ride. During the last few weeks, worries about a banking crisis and continued interest rate speculation dominated headlines. 

The primary concern among many investors shifted from inflation to a liquidity crisis among US regional banks, which began with the collapse of Silicon Valley Bank. While it escalated quickly, investors seem convinced that central banks contained the problem, so much of the stock market was able to weather the storm and actually rallied in the aftermath. 

Underlying the back-and-forth sentiment in stock and bond markets were significant swings in expectations for central bank policy. We saw further interest rate rises in the quarter, albeit at a slowing rate, as investors started the year believing that inflation pressures were weakening. Economic surprises also continued, but mostly on stronger-than-expected data. Corporate earnings were a soft point in the reporting season, although investors appeared to take this mostly in their stride. 

At the sector level, the first quarter saw a reversal of the trends that dominated the market in 2022. Technology and communication services stocks carried the market higher. Meanwhile, energy and defensive sectors—generally the most buoyant names in 2022—lagged in the first quarter. Growth stocks more broadly staged a rebound, while value and dividend-paying stocks trailed. Developed-market stocks also outperformed emerging-market stocks, although both posted positive outcomes. 

Volatility in the bond market has remained at twice its historical level over the past four quarters, a notable occurrence for a market that most investors usually look to for stability. That said, bonds generally produced positive outcomes in the first quarter. Investors flocked to safety in U.S. Treasuries, while some bonds at the riskier end of the spectrum lagged. Longer-term government bonds—which are the most sensitive to changes in interest rates—performed particularly strongly, unwinding some of the losses from 2022. At its steepest point during the first quarter of 2023, the yield curve became the most inverted it had been since 1981. 

Currencies were volatile in the first quarter but weren’t overly influential. Commodities also gave mixed signals, with oil prices modestly lower. 

Local portfolios in perspective 

The Morningstar portfolios held up well over the quarter and continue to serve clients well over the long term. From a broad asset allocation perspective, most portfolio assets delivered positive returns over the quarter. Within SA Equities, industrials fared the best, although performance was partially offset by weaker returns in the resources sector. SA Bonds and SA Cash also had a positive quarter, adding to the performance of the local portfolios. From a global perspective, most markets ended in positive territory from an equity as well as a fixed income perspective. Clients benefited from both an asset allocation as well as a manager selection perspective over the quarter. 

We continue to maintain an on-weight position to risk assets that stems from our Global Aggregate for Risk framework. While valuations on domestic assets are cheap, we do not think investors are being compensated for taking on higher levels of risks in the current market environment. 

Portfolio Changes 

At the heart of our process is our valuation-driven asset allocation. This process continually seeks the most undervalued assets, and in turn, avoids what we consider to be expensive. With that in mind, the portfolio range has been refreshed to match our current thinking, but within the context of our long-term decision-making framework. While we aim to keep portfolio turnover low, as prices move and our asset class convictions change, we are active in our allocation to areas of high conviction. 

Here is a summary of some of our recent portfolio changes:

• Reduced the drift in local versus offshore allocations (following the rand depreciating by almost 20% to the US dollar over the last 12 months).
• Diversified the equity core towards more S.A. market beta through the introduction of an additional local equity-focused manager.
• Took profits from active share managers where appropriate.
• Included new fixed income managers. 

Looking Ahead 

As the second quarter gets underway, the question facing investors (and central banks) is whether the banking scare will reverberate through the global economy and trigger a recession. Obviously, this is difficult to predict and remains a genuine risk. What is clear is that investors and central banks are watching closely, with the risk of further bank failures (and undesirable knock-on effects) being weighed against a potentially friendlier-than-expected interest rate outlook. 

General sentiment remains bearish among investors on most measures. In some respects, this is cause for optimism, as it usually means asset prices are cheap. The negative sentiment expressed towards banks has been reminiscent of the second quarter of 2008 when market participants sought the next exposed financial institution following the troubles at the investment bank, Bear Sterns. 

The Global Financial Crisis has left an indelible mark on the minds of investors and so it is not surprising that this experience is influencing the perspective of investors. 

Looking beyond sentiment, the differences between the current situation and 2008 are more noticeable than the similarities. Regardless of the strength of a bank’s balance sheets, a loss of confidence in a bank can trigger a systemic shock that potentially includes a destructive ‘run’ at a particular bank and a sharp tightening of lending standards across the system. This environment is extremely complicated for policymaking at central banks and can be challenging for investors to navigate. 

Turning to investment opportunities, the collapse of SVB and Credit Suisse is yet to create an unusually good investment landscape, so caution is warranted. While some of the best investment opportunities could emerge among banks and broader financials, a greater ‘margin of safety’ is required given the near-term risks. 

In such an environment, we remain determined to balance opportunities against risks and are mindful of the potential for further surprises. With a contrarian mindset, we’ll look at this resourcefully. 

In conclusion 

At Morningstar, we believe that you don't have to outsmart the market if you can rely on a repeatable investment process to deliver superior risk-adjusted returns for clients. Cut through the confusion and noise and focus on what actually matters - a simple, consistent, diversified approach over the long term and remember: 

• Returns don’t happen in straight lines, and it seldom occurs when one expects them to.
• The long term is just a collection of short runs and having a long-term strategy does not excuse you from the short-term setbacks in markets and funds.
• It’s vital to separate emotion from an investment portfolio. Often the most beleaguered investments turn out to be a great opportunity for future returns, as investors can access these investments at a good price.
• Volatility creates opportunity and short-term underperformance can translate into solid, longer-term upside. 

We believe the Morningstar portfolios remain robust, well diversified and well-constructed to continue to deliver on clients’ expectations.