If you had to guess how financial markets performed in the first quarter based solely on news headlines, what would you find?

Performance was likely quite poor, right?

Well, the truth is that markets held up quite well in the first quarter, but I wouldn’t blame you if you guessed that it was just another disappointing repeat of what we saw last year.

To be sure, after news of markets swooning back and forth on optimism and pessimism on central bank policy, stubbornly high inflation, the prospects of another banking crisis, and the ongoing talks about a recession, there certainly is a lot for the markets to be worries about these days.

Even so, market sentiment has remained buoyant even as a host of worries continue to capture news headlines.

So, given how resilient markets have been in the first quarter, the big question now is, “where do we go from here?” Indeed, could the positive start to the year be a sign of a sustained risk asset rally through the end of 2023?

Well, the short answer is, maybe.

You see, while markets have taken many of this year’s bad events in stride, history tells us that we’re likely not out of the woods yet as far as how outstanding negative events could dent market sentiment. Even so, it’s possible that investors could look past historic precedent on their way to a renewed rally after last year’s bear market sell off.

Inflation is What it’s All About

Now, truth be told, where the markets land by the end of the year is anyone’s guess. If I had a crystal ball and could tell you where the markets are headed with certainty, I’d likely be the richest man in the world. Even so, one factor likely to drive market direction either higher or lower this year is inflation.

And why’s that?

Well, that’s because inflation is affecting all of our lives in material ways. Certainly, weeks ago, we saw headlines about how basic staples like a dozen eggs and snack foods like a 7.5-ounce bag of your run-of-the-mill potato chips fetched as much as $7.00 each. And these anecdotes only point to the broader problem of housing affordability, the price of new and used cars, and how expensive many of the goods and services we depend upon have become over the past few years.

At this point, the key issue for the markets is that if policymakers demonstrate that they can’t get inflation under control, then we’ll likely have a new set of challenges to deal with.

Now, the truth is that inflation is a phenomenon that we’ve dealt with for time in memoriam. However, the reason that inflation is a concern right now is because when consumer expectations of inflation remain elevated, or what policymakers call “unanchored,” it has a lot of unintended economic and social consequences.

And while inflation has been slowing in recent months, according to the University of Michigan’s latest survey of households, individual expectations of inflation remains elevated. Indeed, in its February survey, data showed that consumers expect inflation to end around 4% in about a year from today. And while this expectation is an improvement from the near 5.5% level we saw last year, it remains well above the 2.5% figure we saw in the months just before the pandemic started.

At the same time, the Richmond Fed’s quarterly survey of CFOs shows that business leaders expect inflation to remain around 5% over the coming year. What this means is that the household and business expectation surveys are still way above the Fed’s 2% inflation target.

The point here is that the data show that the air has yet to entirely come out of the inflation bubble, especially when it comes to what people expect about inflation. And as we pointed out in previous reports, inflation tends to become a self-fulfilling prophecy, which is why officials are so keen to put it to bed.

What this means is that as long as the data show that inflation is still running hot, and workers and business owners alike are feeling it, then policy rates likely will need to remain higher for some time so that the US economy will eventually slow to the point where prices are less of a concern, and staying solvent is.

Boring Bonds Bring Down Banks

Now, the thing about the Fed pushing rates higher is that it has had knock-on effects across all aspects of the financial system, especially in the bond market. You see, in this sleepy corner of the market, when interest rates go up, the price of a bond goes down. And under normal circumstances, these price swings are par for the course when it comes to investing.

But, what’s different this time is that US banks hold a lot of Treasurys, or US government bonds, as assets on their balance sheets. Now, banks hold these assets for various reasons, but one of them is to ensure that they can absorb losses in the event of an economic downturn.

Typically, when the Federal Reserve tightens its policies, banks and other financial institutions are able to look past the falling value of their bond portfolios as interest rates move higher in a steady fashion. 

Now, that’s not what happened over the past year as officials raised rates aggressively, catching some banks flat-footed. Indeed, we learned in March that many US banks had become overly complacent with how they manage their otherwise boring bonds, contributing to the failure of several highly visible banks and sparking widespread worry that a financial crash was on the horizon.

And while policymakers were able to quickly avert a widespread crisis following the collapse of Silicon Valley Bank, the event itself has sparked greater caution across the broader banking system. 

For example, financial institutions, on the whole, are now tightening lending standards and granting fewer loans. What’s more, many of these organizations have announced layoffs across various lending groups, including mortgage and auto lending, and are increasing their loan loss reserves in anticipation of borrowers simply giving up on their expensive loan payments. 

Now, on the surface, a decline in lending activity is generally bad for the economy. That’s because when it’s more challenging for a business to obtain financing to keep its operations going, managers tend to lay off employees to free up working cash flows. And when households are facing potential job losses and the prospects of lower available credit lines when banks tighten lending standards, consumer spending tends to slow.

The silver lining is that falling bank lending, slower business and consumer spending, and slowing economic activity, in general, can have a more significant effect on curbing inflation than a central bank solely pulling the lever on higher interest rates. 

What this means is that if banks aren’t lending as freely as they were because they’re now worried about a recession, then businesses and consumers alike are likely to spend less on goods and services, which could cause the rate of inflation to slow further in the months ahead.

What it All Means for Your Investments

So, where does all of this leave us in terms of the market outlook for the coming quarter? Well, market participants so far have been able to look through all of the worries about the banking sector which is evidenced in the positive performance we saw in risk assets in the first quarter.

Even so, inflation continues to remain the dominant catalyst for whether the markets manage to move higher throughout the second quarter of the year and beyond. That’s because investors are primarily focused on what the Fed will do next, and taming inflation remains the Fed’s number one priority for the year.

Now, some may argue that inflation is, in fact, coming down, but the reality is that it’s not falling as fast as policymakers would like. And that’s one reason why so many Fed officials remain vocal about the central bank’s need to continue raising interest rates this year.

Nevertheless, many investors are looking past what the Fed will do in anticipation that tightening bank lending standards and the potential for lower spending amidst recession worries could give the Fed less of a reason to continue raising interest rates later this year. And when the Fed stops raising rates and finally signals that it’s ready to ease its grip on a tight monetary policy, that likely will be the moment when investors begin to breathe a sigh of relief, and risk assets subsequently take off.

With that said, history has shown that sustained market rallies generally do not take place until the Fed begins cutting its key policy rate. And, again, based on what we’ve been hearing from various Fed officials in recent weeks, rates hikes are still on the table.

So then, where does this leave the markets? Well, you’ll recall that markets are often considered to be discounting mechanisms because they incorporate all available information and, more importantly, expectations about future events into current asset prices.

In other words, market participants use all available information to make informed decisions about the value of a particular asset, and these decisions are reflected in the market prices.

So, then, from this perspective, we can argue that risk asset prices have been moving higher in recent months because investors anticipate an eventual rate cut by the end of the year. Now, whether inflation is tame enough by year-end to warrant rate cuts is hard to say. That’s because few things about how the economy functions have been standard textbook over the past few years.

Either way, market participants are likely now betting that a credit crunch and the prospect of an economic recession could be enough to cause policymakers to finally pivot to rate cuts, confirming investors’ expectations and supporting the current market rally through the end of the year.

So, what does this mean for your investments?

Well, a great deal of uncertainty remains about the timing of the change to Fed policy. Remember, markets have been betting that the Fed would “pivot” and cut rates for nearly a year now. And every time they were wrong, risk assets sold off sharply as a result.

Indeed, what last year’s market experience taught us is that even the brightest and most talented professional investors got many of their bets wrong. Therefore, if you’re trying to time your way into and out of the markets, it will likely cost you more than you will gain over the long term.

At the same time, what this outlook means to you is that it’s essential to stay invested for the long term and avoid the temptation to hide in cash. To be sure, while concerns about a broader banking collapse and the prospect of recession are warranted, it’s worth remembering that we’ve been through worse over the past few years, and markets have nevertheless charged higher.

Either way, the big takeaway here is that there’s reason to remain optimistic about the markets in the year ahead. But until we get clarity on the path of inflation, and hence Fed policy, trying to get cute in the markets likely will cost you more than it’s worth.

Financial Planning Housekeeping Items for the Quarter

Now, as we wrap up our outlook for the quarter, let’s quickly cover some financial planning topics that will set you up for success into the remainder of the year.

Rebalance Your Investments

To start, take a moment to review your investment and retirement portfolio. You know, the recent positive market performance has offered a unique opportunity to rebalance as asset prices have moved higher this year. So, if you haven’t done so already, take a moment to consider your current holdings versus your target allocations and sell positions that have done well, and add to those that are underallocated.

Now, why would you want to do this? Well, remember that over time, the performance of different asset classes can vary, causing your portfolio to deviate from its target allocation. And with many risk assets rallying into the start of the year, now may be the time to check whether your current holdings, especially in your employer-sponsored retirement accounts, reflect your long-term asset allocation strategy.

Make Your Quarterly Tax Payment

The next planning topic to consider is your estimated quarterly tax payments. Now, with tax season largely behind us, now is a great time to ensure that you’re prepared to make your estimated quarterly tax payment for the month of April if you haven’t done so already.

And why is this important?

Well, making estimated quarterly tax payments to the IRS can help you avoid any penalties for underpayment of taxes, help you better manage your cash flows, and stay organized with your finances.

And by making regular payments, you can track your tax liability and avoid any surprises at tax time, as well as spread out your tax payments throughout the year to avoid a large, unexpected tax bill next April.

Manage Your RSUs

Next, if you have RSUs (restricted stock units) that have vested in the first quarter, now may be a great time to consider your options for your holdings. And if you need pointers on understanding or managing your equity award, be sure to check out the resources we published last quarter about managing this critical component of your overall compensation.

Either way, the recent runup in risk assets may provide you with a great opportunity to lock in your company stock price at a higher level, given that we anticipate increased levels of market volatility into the rest of the year.

Check Your Cash Reserves

Finally, with market and economic volatility likely to remain elevated in the months ahead, given the prospects of a credit-induced recession this year, it’s crucial now more than ever to have an adequate cash buffer that you can rely upon.

Why?

Well, picture this: you run into an emergency, like a medical bill, your furnace needs replacing, or you’re dealing with an untimely car repair. 

How are you going to pay for these expenses?

And in a recession, job loss or reduced income can happen to anyone, and it’s not fun. But guess what? With a cash buffer, you’ve got some breathing room. You can cover your living expenses while you search for a new job or adjust your budget, all without the stress of piling on more debt.

And here’s another thing: having that cash buffer means you won’t need to rely so heavily on credit. With tighter lending standards already underway, getting credit becomes more difficult anyway. So, by having your own financial cushion, you’re taking control of your financial life, and that’s something to be proud of.

Inflation, Banking Crises, and Recession: Position Your Money for Success

Taken together, the first quarter of 2023 demonstrated that markets can, at times, remain resilient despite ongoing challenges, such as high inflation, bank crises, and a potential recession looming in the background. That’s why as we move forward into the rest of the year, it’s essential to keep a close eye on these factors and remain vigilant in monitoring how they may impact your finances.

Now, despite the uncertainty, it’s essential to maintain a long-term perspective and avoid knee-jerk reactions based on short-term market fluctuations. Indeed, by focusing on a holistic financial planning approach, you can prepare yourself for both the ups and downs of the market and ultimately, build a secure financial future.

This approach includes revisiting your investment portfolio to ensure it aligns with your long-term goals, making timely quarterly tax payments, managing your RSUs wisely, and checking in on your cash reserves. And by addressing these financial planning housekeeping items, you can optimize your finances and navigate the potential market and economic volatility ahead with greater confidence and peace of mind.

In the end, while the markets may continue to test your nerves with its unpredictable twists and turns, a well-rounded financial plan, coupled with a steadfast commitment to long-term goals, can help see you through even the most challenging of times, but more importantly, take you one step closer to becoming the master of your financial independence journey.