Key takeaways

  1. During the first quarter of 2023, US interest rates saw extreme volatility, rising in February and falling in March due to events affecting Silicon Valley Bank
  2. Returns diverged among sectors—with tech and telecom enjoying the strongest performances—while 4 of 11 sectors were negative
  3. Facet underweighted cyclical industry and was overweight tech, telecom and healthcare, benefitting performance overall
  4. Emerging markets finished the quarter down 5.5%, as investors shifted out of cyclical industries expected to be more vulnerable to economic slowdowns
  5. Facet is overweight high-margin companies and taking cautious stance on emerging markets going forward
  6. Looking further into 2023, a slowdown in lending may quell inflation or result in a recession; Facet portfolios are well positioned for either potential outcome.

The first quarter of 2023 felt like three very distinct periods for investors. 

In January, economic data supported the idea of a “soft landing.” This is where inflation recedes, but the economy avoids a recession. 

Both stocks and bonds produced strong returns during January. However, we saw inflation data rebound and employment data surge in February. 

People started talking about a “no landing” economy; that the economy would accelerate again and the Federal Reserve would need to hike rates even higher. 

This caused interest rates to lurch higher and stocks to give up most of their January gains. 

Then in March, the collapse of Silicon Valley Bank and Credit Suisse completely changed the focus again. Fears of a banking crisis had people back talking about a “hard landing,” in other words, a recession.

Here is a look at how these cross-currents impacted Facet portfolios and our thoughts on how to sort through all of this looking forward.

Model portfolio performance as of March 31, 2023

Facet model portfolio performance as of March 31, 2023

(The portfolios listed above, Facet Equity and Facet Bonds, represent the equity and fixed income portions of the models a member may invest in but are not necessarily stand alone portfolios. For example, if a member were in a portfolio that was balanced 70/30 between equity and fixed income, the Facet Equity model return would be the return for that portion of the overall model only).

A wild ride for interest rates

There has seldom been as rapid of a shift in Fed expectations as occurred during March 2023. 

On Wednesday, March 8, the day before the market became aware of Silicon Valley Bank’s troubles, futures markets indicated that the Fed’s target rate would be at 5.5% at the end of 2023. That weekend Silicon Valley Bank (SVB) was shut down.

When markets opened on Monday, year-end Fed target expectations had fallen all the way to 3.75%. That same day the 2-year Treasury yield fell by 0.60%—the largest single-day change in that yield since 1982.  

Bond Market Volatility

Bond market volatility chart

This sudden shift following the collapse of SVB erased a significant move higher in yields in February. This meant that interest rates finished the quarter only mildly lower, with the 10-year Treasury falling from 3.88% to 3.47%. 

Still, this was enough for the bond market broadly to enjoy its second quarter in a row of solidly positive returns. The Morningstar Core Bond index, a board measure of US high-quality bonds, was up 2.93% for the quarter.

Facet’s standard bond allocation for tax-deferred accounts was up 3.54%, 0.61% better than the core bond index. The strategy benefited from being overweight corporate bonds and being positioned to generally benefit from falling interest rates. 

Facet’s bond allocation for tax-paying accounts returned 2.76%, which was 0.17% behind the Core Bond index. This was due to municipal bonds lagging slightly behind taxable bonds during the period. However, for tax-paying members, the benefit of earnings interest that is tax-exempt was greater than the 0.17% difference in returns.

Technology and telecom dominate returns

The first quarter was an unusually divergent period for stock returns. 

The telecommunications and technology sectors returned more than 20% for the quarter, pacing all other sectors. 

Consumer discretionary was also strong, returning just over 15%. However, no other major sector returned more than 4% after those three, and 4 of the 11 major sectors were negative.

2023 Q1 S&P 500 Performance by Sector

2023 first quarter S&P 500 performance by sector

Tech and telecom enjoyed strong performance to start the year, which seemed to coincide with generally falling interest rates in January. Both sectors performed poorly during 2022, in no small part because of rapidly rising interest rates. (Investors generally value faster-growing companies more when interest rates are low.)

However, it wasn’t just about interest rates this quarter. Technology outperformed the broader S&P 500 each month during this period. 

Even as interest rates rose sharply in February, tech was still an outperformer. Compare that to a traditionally cyclical industry (a sector especially sensitive to economic growth) like Materials.

Sector Returns Relative to S&P 500 Q1 2023

Sector Returns Relative to S&P 500 Q1 2023

Materials outperformed in January when economic optimism was high but underperformed in February and March as investors began worrying more about a recession.

This is a great example of a theme we have discussed for several months now. In 2022, inflation and Fed rate hikes were the dominant factors in markets. We have been arguing that in 2023 there will be some degree of economic slowdown. Given this, investors will be more focused on how different companies will weather this slowdown. 

To this end, last quarter, Facet reduced its exposure to cyclical industries, including materials, real estate, financials, energy, and industrials. We increased our exposure to tech, telecom, and healthcare.

So far, in 2023, this shift is working. The pattern in the chart above regarding materials would look similar if we used any of the other cyclical sectors we reduced last quarter. 

While we don’t know if there will be a recession in the coming quarters, we know that inflation won’t subside until the economy slows at least some amount. Therefore we think it likely that the performance of various stocks and bonds will partly reflect how well different companies will handle a slower growth environment.

A “low-quality” rally

One thing that did not work well for Facet’s allocation was our lean into higher profit margin stocks, as some of the best performers in the first quarter were unprofitable companies. 

According to Bloomberg data, 77% of all US-listed companies were profitable over the last year. However, of companies that returned 20% or more during the first quarter, 48% were unprofitable. 

Of the companies returning 40% or more, 71% were unprofitable. On Wall Street, they call this a “low-quality” rally, where some of the best performers aren’t actually such great companies.

These low-quality rallies often happen when a set of stocks were especially beaten up in a prior period. This time is no different. 

In 2022, high-growth companies with low-current profitability suffered significant declines. A prime example is the Q1 2022 performance of the 100 best-performing stocks, down an average of 44%. 

Since Facet was underweight these kinds of companies, that was a bit of a drag on our relative returns for the quarter. However, historically low-quality rallies don’t tend to last long. This is particularly true when the rally is really just “bottom fishing,” when investors are looking for companies that have just been beaten up too much.

European stocks lead as international outperforms

International stocks broadly outperformed, led by continental Europe. 

A year ago, the Russian invasion of Ukraine caused food and energy prices to soar all over Europe, mainly since Russian natural gas was such a large percentage of European electricity generation. 

As a result, most thought consumers would be forced to spend an excessive amount of their income on their energy bill, which would contract spending on everything else.

However, a combination of favorable weather, imports of natural gas from the US, and shifting power generation to other sources, has caused power prices in Europe to return to normal. In fact, natural gas prices in Europe have fallen by almost 50% from before the Russian invasion.

European Natural Gas Prices

European natural gas prices

The surprise surge in growth has resulted in strong returns for European stocks in recent months. According to Morningstar data, stocks in the Eurozone were up just over 13% in the first quarter and over 40% in the last six months.

Returns for emerging markets (EM) were not as strong, advancing just 3.58% in the first quarter. In January, Chinese stocks surged after the government ended its “zero COVID” policy and reopened the economy. However, trouble in the property sector continues to weigh on the Chinese economy, and Chinese stocks erased most of their January gains by the end of the quarter.

Meanwhile, reports that one of India’s largest companies, the Adani Group, had been engaged in widespread accounting fraud and stock manipulation sent stocks in India plunging, ending the quarter down 5.5%. 

In early January, Facet lowered its weighting to EM stocks. While many emerging countries have good long-term prospects, EM economies tend to struggle anytime US growth slows since numerous EM economies rely on exports to rich nations to fuel their growth. 

As a result, EM has historically underperformed during US slowdowns, even those that didn’t turn into a full-blown recession, such as in 2011, 2016, and 2018.

Since we believe some degree of economic slowing in the US is very likely, we felt that put EM stocks at risk of lagging. So far in Q1, this decision has benefited Facet portfolio performance.

Looking forward

When the Fed keeps hiking interest rates, economists say it usually continues until something breaks. 

The fall of Silicon Valley Bank may just be the thing that broke. While we think a full-blown banking crisis is unlikely, we do expect there to be a material impact on the economy. That impact will come from a slower pace of bank lending.

According to the Investment Company Institute, investors have poured over $300 billion into money market funds since March 8—the fastest increase since the onset of COVID. 

While there isn’t enough official data yet to know for sure, it appears most of this flow is coming out of bank accounts. The ICI reports that equity and bond funds have only seen outflows of approximately $3 billion since March 8. 

This flow partly reflects the fact that the yield available on money market funds is now much higher than a typical bank deposit account. For this reason, Facet has introduced some new short-term investment options

It also reflects concern among investors about the safety of bank accounts in the wake of SVB’s collapse. Moving money to a money market fund or another kind of investment account insulates you from the risk of a bank failure.

Regardless of why money is moving out of the banking system, it will impact the broader economy. If banks have fewer deposits, they have less ability to make loans. If banks make fewer loans, that means less money available for businesses to expand, acquire new equipment, build new buildings, etc. Ultimately that will wind up in less hiring and lower consumer spending.

We can’t know right now how significant of a slowdown we will experience. But, overall, the economy is coming into this period very strong. It could be that some degree of slower lending is just what we need to finally quell inflation, and this period of mild bank stress turns out to be a good thing for markets. On the other hand, it could also end up more significant and push the economy into a recession.

Our approach is to position portfolios to perform reasonably well in various scenarios. If the economy does slow, even mildly, we think there will be a performance divergence within stocks, similar to what we saw this past quarter. 

Companies with more volatile businesses could suffer, while more stable companies would be poised to outperform. We think our overweight of companies with high-profit margins, low revenue variability, and low debt burdens, plus a cautious stance on emerging markets, could be a good combination looking forward.


1 Performance displayed is based on Facet’s base model portfolios for equity, tax-deferred fixed income and taxable fixed income. Actual client portfolio results may differ. See additional disclosures at the end of this article for more details.

2 Inception for Facet portfolios is 12/31/2018

3 Equity benchmark is the Morningstar Global Markets NR USD index, which is net of dividends. See additional disclosures at the end of this document.

4 Bond benchmark is the Morningstar U.S. Core Bond index. See additional disclosures at the end of this document.

5 Performance disclosure

Investment returns shown here are hypothetical intended for illustrative purposes only. All investments involve risk, including the potential for the loss of principal. The model portfolio performance of Facet models began in 2018. Performance was calculated using Facet’s most common recommended equity and fixed income ETF portfolios. At times when Facet changed a recommended ETF, the average transaction price of both buys and sells were used to update the portfolio. Otherwise the portfolio was rebalanced monthly. Calculations were performed using the Bloomberg Portfolio Analytics tool. This illustration is meant to most closely resemble what a common Facet client in a given asset allocation mix may have returned. It does not represent any actual client or group of clients. The benchmark used for equity allocations is the Morningstar Global Markets Net Dividends index, which measures the performance of the stocks located in the developed and emerging countries across the world. For fixed income allocation, the benchmark is the Morningstar US Core Bond index, which measures the performance of fixed-rate, investment-grade USD-denominated securities with maturities greater than one year. We believe the sources for this data to be reliable but cannot guarantee the accuracy or completeness of the information. No consideration was given to tax loss harvesting or other activities that occur during the ongoing management of investments nor does Facet assert an opinion on the impact of these actions on these returns. These hypothetical returns were calculated net of the fees associated with the underlying investments. Facet charges an annual planning fee based on the complexity of a client’s financial situation but does not charge a separate fee for investment management. The planning fee was not considered in the calculation of returns. Past performance is not indicative of future returns.

Benchmark disclosure

The Morningstar Global Markets Index NR USD and US Core Bond indices have been licensed for use for certain purposes by Facet. The services provided by Facet are not sponsored, endorsed, sold, or promoted by Morningstar, Inc. or any of its affiliated companies (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation regarding such services. All information is provided for informational purposes only. The Morningstar Entities do not guarantee the accuracy and/or the completeness of the Morningstar Indexes or any data included therein. The Morningstar Entities make no warranty, express or implied, as to the results to be obtained by the use of the Morningstar Indexes or any data included therein. The Morningstar Entities make no express or implied warranties, and expressly disclaim all warranties of merchantability or fitness for a particular purpose or use with respect to the Morningstar Indexes or any data included therein. Without limiting any of the foregoing, in no event shall the Morningstar Entities, or Morningstar’s third party content providers have any liability for any special, punitive, indirect or consequential damages (including lost profits), even if notified of the possibility of such damages.