By Ellen Hazen, CFA®, Chief Market Strategist

March Takeaways:

• Stocks rebounded in March:
• • March saw a continuation of equity market rotation into more pro-cyclical areas of the market (“risk-on”), as Growth significantly outperformed Value; and Technology outperformed all other sectors
  • At the same time, small-cap stocks significantly underperformed; this suggests that the move was not uniformly a risk-on. Small-cap stocks have more exposure to the tighter bank-lending standards that have come into play after the Silicon Valley Bank failure
  • International equity markets modestly underperformed US equity markets, with the MSCI World ex-US index up by 2.4% compared to the S&P500, which was up 3.7%

• Bonds rallied as the market priced in a slower economy and a more dovish Fed. The 10-Year Treasury rate dropped from 3.9% to 3.3% in just a few weeks. Rates dropped across the curve, with 2- and 3-year rates declining by nearly 100 bps in the same timeframe
• Inflation continued to ease, declining from 6.4% in January to 6.0% in February
• Jobs continued to surprise to the upside, with February report at 311,000, ahead of the expected value of 240,000. More recent jobs data, including the Jobs Openings report and the ADP Employment report, have shown that the jobs market may be loosening
• The Federal Reserve (Fed) raised rates by 25 basis points (bps) on March 22, in line with expectations, although that was reduced from an earlier expectation of 50 bps
• Earnings estimates for 2023 for domestic equities continued to slip a bit and now reflect a 2.2% decline in 2023 versus 2022

What We Are Watching in April

• Nonfarm payrolls will be reported April 7. Expectations are for 240,000 additional jobs, down from February’s 311,000. The strong labor market has been one of the key reasons we believe any recession is likely to be short and shallow
• Consumer Price Index (CPI) will be reported on April 12. Consensus currently calls for a continued decline to 5.2% from 6.0% in February. Inflation well above the Fed’s 2% target is why we believe that rates are likely to stay higher for longer
• Earnings for the first quarter of 2023 will be reported starting April 14. We expect guidance for Q2 and more broadly the rest of 2023 to be lower than the current consensus expectations of -6.2% and -2.2% respectively. We believe the equity market is currently too optimistic and not fully reflecting this possible decline
• No Fed meeting until May 2-3, although the minutes from the March 21-22 meeting will be released on April 12. We’ll be looking closely to see how much participants discussed whether the mark-to-market losses on the Treasury securities in banks’ held-to-maturity portfolios should have been better anticipated by Fed members

As we enter the second quarter of the year, our overall view of both the economy and markets remains fairly consistent. We expect that inflation will continue to ease but is unlikely to reach the Fed’s target 2% level during calendar 2023 (see above chart). Thus, although the Fed may push out further rate increases into later in the year, we believe they will still need to occur.

Prior to the bank failures, expectations were for not only a 50 bps increase in March, but also increases at subsequent meetings, with the peak forecasted to be in October 2023 at nearly 5.5%. The futures market now reflects the belief that the overnight rate will peak in May at only 5.0%, with cuts starting shortly thereafter.

Growth stocks again were the best-performing of the asset classes we follow: the Russell 1000 Growth Index appreciated by 6.8% in the month, capping off a very strong quarter with over 14% return.

Operating margins for the S&P500 are forecasted at 14.9%, down from 15.7% reported in 2022. This is a welcome change from just a few months ago, when operating margins were forecasted to increase in 2023 over 2022, because it reflects the underlying reality of higher costs. That increase did not make sense to us, given the combination of inflation-driven cost pressures and weakening demand. We still think 14.9% may be too high, but estimates are more realistic.

We expect continued volatility in both equity and fixed income markets as economic crosscurrents paint a mixed picture of the outlook for the remainder of the year.

March Came in Like a Lion and Went Out Like a Lamb

Just a few days into the month, several banks failed in rapid succession, including Silvergate, Signature Bank, and Silicon Valley Bank. In response, the S&P500 declined a quick 5%. Then, as the Fed, the FDIC, and the Treasury swiftly stepped in to reassure depositors and investigate (and presumably address) possible regulatory weaknesses, the equity market shrugged off the banking news. The S&P actually ended March above its level prior to the bank failures, up 3.7% for the month and up 7.8% year-to-date.

Financial conditions – specifically lending standards – had been tightening for several quarters, according to the Senior Loan Officer Survey. Anecdotally (we won’t get updated loan officer survey data until later this week), this credit tightening accelerated in March, as banks reined in credit to strengthen their balance sheets. As credit conditions tightened, the market pivoted from being primarily concerned about high inflation to being primarily concerned about slowing. We observed this in the equity markets. As economic growth expectations slowed, the market increased what it was willing to pay for those stocks that can grow in a slower economy. Thus, growth stocks outperformed. Conversely, small-capitalization stocks performed quite poorly, with the Russell 2000 (small-cap) Index underperforming large-cap growth by over 11 percentage points.

Why did the market shrug off bank failures? We think there are a few reasons. First, this really does seem to be a duration event, rather than a credit event. The loans on Silicon Valley Bank’s balance did not go bad; the precipitating event was the interest rate exposure in safe Treasury bonds. Second, the system is not as indebted as it was in the Global Financial Crisis of 2008, so failures can remain isolated without spreading into the wider banking system. Finally, the regulators acted swiftly and in a coordinated fashion to head off perceived bank-run risk.

At the same time, given our view that earnings estimates may be too high, we are puzzled as to why the equity markets behaved so optimistically. We still expect volatility as we work through 2023.

Digging Into the Crosscurrents

Soft Data vs. Hard Data

Investors analyze a variety of measures when trying to predict economic and market outcomes. So-called soft data consists of surveys, such as the ISM Manufacturing and Services surveys, the Conference Board Consumer Confidence Survey, and the NFIB Small Business Sentiment Survey. These have reflected uniformly weak sentiment over the past few months. Hard data, by contrast, is based on what has actually happened: it is measured, more quantitative, and often seasonally adjusted. Hard data includes a variety of economic, industrial, and labor measures, such as GDP, inflation, unemployment, jobs growth, retail spending, and personal income. In general, these have remained strong, which has underpinned our optimism that any economic slowdown is likely to be shallow.

Historically, soft data sometimes leads hard data; this is why investors are concerned about the recent deterioration in consumer and business surveys. It can also be fickle, though; to cite one recent example, the ISM Services PMI declined from 55 in November 2022 to below 50 (values below 50 indicate contraction; above 50 indicate expansion) in December 2022, then immediately bounced back to 55 in January 2023. So while we are watching the soft data as a possible leading indicator for the hard data, it is not a fully reliable measure.

Equity Markets vs. Fixed Income Markets

The Treasury market is clearly forecasting that the Fed will cut interest rates in fairly short order, presumably in response to a recession, or at least a significant slowdown. Fixed income markets are not uniformly so bearish, though: credit spreads have remained only modestly above their longer-term medians, signaling a slowdown, but not a recession.

Equity markets seem fairly sanguine. Although earnings are not expected to grow in 2023, the S&P500 forward price-to-earnings multiple has actually expanded this year, from 17.2x in January to 18.7x today. Put differently, even though earnings estimates have declined, the amount that investors are willing to pay for those declining earnings has increased. We believe there is further to go with estimate declines and believe that equity valuations are not quite as attractive as they were at the beginning of the year.

Summary

As Warren Buffet famously said, “Only when the tide goes out do you learn who has been swimming naked.” Rising real interest rates over the past two years have been the equivalent of the tide going out for this market and this economy. The crosscurrents we’re seeing in the economy – a strong labor market coupled with slower manufacturing and GDP – are being mirrored in the financial markets. Equity markets are reflecting both risk-on (technology stocks) and risk-off (small-cap underperformance). Fixed income markets have the rates side of the house forecasting rapid rate cuts and possible recession, while the credit side of the house is still fairly comfortable with credit risk in corporate bonds, as reflected by still-moderate credit spreads. Merriam-Webster says that a crosscurrent is a current running counter to the general forward direction; this seems reasonable to us. The economy is generally healthy, although there are some countervailing forces reflecting negative trends. At the same time, Vocabulary.com notes that a synonym for crosscurrents is riptide; a dangerous localized current that can wreak damage to anything caught up in it. We do not expect that a classic riptide will sweep the economy into damaging territory, but it is a risk. Thus, we continue to invest in high-quality securities in both equity and fixed income asset classes, while carefully analyzing new data as it becomes available.

Disclosures