The stock market is often a place of strange bedfellows filled with contradictory forces. But even by that standard, the market’s rally in the opening months of 2023 was unexpected. Ornery inflation and nagging recession fears — not to mention a sudden banking scare — don’t normally provide fertile ground for equities. At a minimum, the improbable advance points up the unpredictability of short-term price swings and how futile it can be to time the market. Beyond that, it shows how garbled the signals from the financial world have become lately.

Equities rallied at the start of the year amid hints of lighter inflation. Stocks reversed course after that as the central bank warned that a taut job market and beefy wage growth might force more aggressive interest rate hikes. Then Silicon Valley Bank abruptly collapsed — and the calculus was scrambled yet again. The Fed eventually settled on a quarter-point hike out of fear that a more-emphatic move could induce a full-blown banking crisis.

Perhaps counterintuitively, stocks wafted upward on the belief that the banking furor could handcuff the Fed and prevent a more-assertive rate campaign. The end result was a 7.5% first-quarter advance for the S&P 500. The rally was fired in part by a rebound in technology following Big Tech’s drubbing last year. Tech benefited from an emphasis on cost containment, a drop in interest rates and a burst of enthusiasm for artificial intelligence.

Stocks continued to be leavened by many of the forces that drove them in recent years. The jaunty labor market is propelling strong wage growth and — at least to this point — relatively shatterproof consumer spending. The news from abroad has been encouraging. The outlook in China has improved following the government’s recission of its zero-Covid mandate. The European economy has been surprisingly resilient thanks to a blend of lower energy prices, mild winter weather and government subsidies to consumers and businesses.

Overall, market bulls cling to the belief that modest economic slowing and gradually decelerating inflation will coax the Fed to pull back from rate hikes. For the moment, the banking tumult has played into that narrative. The angst that followed the demise of two U.S. banks and shudders at several others has quieted, raising hope that the blowups were due to idiosyncratic circumstances and poor management rather than to an industrywide ailment.

The economy is facing key hurdles.

However, contagion remains a risk. Past crises have shown that financial implosions emerge intermittently.

The September 2008 demise of Lehman Brothers, for example, struck a full six months after the Bear Stearns meltdown. At a minimum, the banking tremors are likely to bring increased regulation of regional institutions and tighter lending standards as banks themselves seek to preserve capital and hunker down in the face of a possible recession.

Inflation remains a big question mark. The Fed is walking a tightrope as it tries to steady the banking system while preventing a reacceleration of inflation that could be much harder to root out later. Consumer prices rose 5% year-over-year rise in March, the lowest rate in nearly two years. But core prices edged up and pressure remains high in service-oriented industries as Americans flock to malls and airports. And there are still a hefty 1.7 open positions for every job seeker.

Despite the U.S. resilience to this point, many Capital Group economists believe a slowdown and a potentially mild recession remain likely. The index of leading economic indicators has turned negative, suggesting an elevated risk of contraction in the next six months. Earnings expectations have come down, and could be hemmed in further as the Fed’s nine rate hikes filter through to the corporate world. The unresolved dispute over raising the federal debt ceiling poses another complication.

Portfolio managers are picking up select companies on weakness.

Regardless of the near-term clouds, the longer-term outlook appears favorable. In fact, bond and global stock valuations are better than they've been in some time. Our investment team has sought to take advantage of last year’s market selloff to acquire promising companies at favorable prices.

For instance, the jitters weighing on banks extended to shares of unrelated financial companies such as insurance companies. Capital Group portfolio managers have increased holdings in insurance brokers, which sell policies but are not on the hook for paying claims in natural disasters and other emergencies. Managers also have raised exposure to the luxury goods sector as China’s brightening outlook raises the prospects for leading businesses.

Our investment team also added to positions in the technology, consumer discretionary and communication services sectors, all of which were hit hard during last year’s selloff in Big Tech. The blaze of attention-grabbing headlines surrounding ChatGPT has stoked enthusiasm that artificial intelligence could usher in a new tech growth phase.

Fixed income returned to its traditional role as a safe haven.

Bonds also had a whirlwind quarter marked by notable gyrations. Yields climbed when it looked like the Fed would impose stiffer rate hikes — only to drop sharply when the banking upheaval raised the odds of recession while decreasing the likelihood of extended rate hikes.

Given the heightened risk of a downturn, Capital Group fixed income portfolio managers continue to favor high-quality bonds and are being very selective about credit risk. Though the premium offered by corporates and other higher yielding bonds has increased, our investment professionals have generally decided that the increased risk wasn't worth the larger payouts in most portfolios.

One area where many members of our fixed income team see opportunity is housing bonds. Demand is expected to hold up for many parts of this sector, especially state housing agencies that serve first-time, middle-to-lower income home buyers. The agencies help borrowers secure attractively priced mortgages and assist with down payments. Some of these bonds also benefit from guarantees by government-sponsored enterprises on the underlying mortgages.

The near-term outlook for bonds is foggy given the uncertainty over the economy and interest rates, as well as the debt ceiling showdown. But after the acute pain that bonds suffered during the Fed’s rapid-fire rate hikes last year, fixed income returned to historical form in the first quarter and is expected to offer much-needed diversification during periodic bouts of weakness in stocks.