Markets showed their resilience in the first quarter, despite being rocked by shock waves that few anticipated. Investors began the year feeling largely upbeat. Inflation appeared to be subsiding, and many bet that would lead the Federal Reserve to switch quickly from raising interest rates to cutting them. Then economic data started coming in hot. Stocks and bond prices slid, hit by worries that the Fed would likely have to keep rates higher for longer. The biggest shock of the quarter came in March, when Silicon Valley Bank and Signature Bank collapsed. Bank stocks tumbled. Credit Suisse Group AG came to the brink of failure, forcing rival bank UBS Group AG to arrange a hasty takeover. The biggest U.S. banks scrambled to shore up First Republic Bank to stop growing panic from taking down more lenders.

 

Equity markets proved to be more buoyant than many investors thought possible. The S&P 500 has risen over 7.4% in the first quarter, while the S&P/TSX is up over 4.6%. The NASDAQ Composite soared. The technology-heavy index has jumped over 17%, on pace to outperform the Dow industrials by the widest margin since 2001. Meanwhile, bond prices climbed. The yield on the 10-year Government of Canada bonds, which influences everything from mortgage rates to student loans, has fallen to below 3% from over 3.5% just a month ago.

So, what explains the relative calm in markets? Perhaps one can argue that things have been better than many feared. A widely anticipated recession has failed to materialize, at least so far. The labor market has remained robust, even with a pickup in layoffs in the technology sector in recent months. And inflation, while still high, has continued to ease. Data showed consumer prices rose 6% from a year earlier in February, the smallest annual gain since September 2021. That combination of factors has helped investors to stay somewhat optimistic.

 

It must be said that we are not out of the woods just yet. It is logical to wonder how well the economy will hold up under the strain of higher interest rates and tighter financial conditions. Recent stress in the US and European banking industry has resulted in renewed investor concerns around the economic growth outlook, and increased volatility in risk assets. While the price action stress has somewhat stabilized, potential for reduced credit availability is likely to pose a growth headwind. Hence it is logical to position in the more defensive pockets of the markets.

 

Against this backdrop, we have focused on identifying stocks with certain quality characteristics that should position them well across market environments. While there can be many ways to define quality, experience has taught us that a track record of strong financial returns and robust free cash flow generation, are important indicators. Healthy free cash generation provides company management with financial flexibility to adapt capital priorities to the market environment (e.g., return capital to shareholders, pay down debt, invest for growth or preserve cash). To reduce bias, we enter the metrics we seek into a stock screen and then work to own and/or hold the names generated. A great methodology to confirm whether existing positions still hold merit while generating a list of potential new holdings that are worthy of closer look. A quote from one of my favorite investment gurus comes to mind, “Investment success doesn’t come from buying good things, but rather from buying things well.” - Howard Marks, Co-Chairman & Founder Oaktree Capital Management