By Ellen Hazen, CFA®, Chief Market Strategist

January Takeaways:

• After 2022’s 18% decline, US equity markets appreciated markedly, with the S&P500 returning 6.3%
  • In a reversal of the 2022 trend, Growth outperformed Value. The Russell 1000 Growth Index appreciated by 8.3%, handily outpacing the Russell 1000 Value Index 5.2% return
  • International outperformed the US, with the EAFE index returning 8.1%. Emerging markets also outperformed the US (although underperformed EAFE), with the MSCI Emerging Markets Index appreciating by 7.9%. Fundamentals outside the US are improving more rapidly than domestically, and when combined with inexpensive valuations, international stocks are looking more attractive – watch this space
• Interest rates declined, leading to bond appreciation. The 10-year Treasury bond yield declined by 46 basis points to 3.41%, while the Bloomberg Intermediate Government/Credit Index appreciated by 1.8%
• Inflation continued to ease. The December Consumer Price Index (CPI) was reported at 6.5%, down from 7.1% in November. Wage inflation also moderated: Average Hourly Earnings growth decelerated to 5.0% from 5.5% in November, while the Employment Cost Index for the fourth quarter of 2022 decelerated to 1.0%, down from 1.2% in the third quarter
• Jobs indicators remained strong. Unemployment of 3.5% continues to match multi-decade lows, and new jobs in December of 223,000 remained above 200,000
• The Federal Reserve (Fed) increased the Federal Funds Rate on February 1 from 4.50% to 4.75% (upper bound). Currently, markets are pricing in an additional one-to-two 25-basis point increases at the March and May meetings, with the rate peaking at 4.9%
• Companies have started to report Q4 2022 and yearend 2022 earnings. Just over one-third of the S&P500 companies have reported so far, with 71% beating earnings estimates. This is marginally higher than the 70% we saw for the third quarter of 2022, but is declining as more companies report – a week ago, this was 73%

What We Are Watching in February

• Earnings season will continue. Watch for guidance reductions and continued negative operating leverage
• CPI on February 14 will provide additional data on whether inflation continues to abate or if it reaccelerates

January 2023 was a month for the history books. The S&P500’s 6.3% return was the second highest in the last thirty years and was particularly noteworthy given that it occurred in the context of continued declines in both earnings estimates and broader economic growth forecasts.

We will be watching the Fed minutes (released on February 22) to gain further insight regarding the ultimate terminal rate and timing of any anticipated rate declines. Recent datapoints that confirm inflation softening may give the Fed cover to pause raising interest rates fairly soon. Right now, the markets are forecasting that the Fed will reach peak rates in May of this year, followed by a rate cut shortly thereafter. We think the Fed may keep rates at this level for longer.

Update on Q4 2022 Earnings

Thus far, just over one-third of companies have reported Q4 results. Average sales growth has been just under 7%, while earnings growth has been 3.5%. Seventy-one percent of companies have beat estimates, with the most positive surprises in the more predictable and less economically sensitive utilities and real estate sectors. The Communications sector – home of Google parent Alphabet and Facebook parent Meta, as well as media and telecom companies – has had the fewest positive surprises. Again, this is consistent with a slowing economy.

Earnings Estimates Have Declined – Is It Enough?

We have been arguing for some months that corporate earnings estimates for 2023 are too high. We expect that the combination of decelerating revenue due to slower GDP and cost inflation would lead to negative operating leverage, i.e., companies growing profit less than revenue.

The chart below illustrates corporate earnings estimates six months ago and today. On the left you can see that earnings growth expectations for the overall S&P500 have sharply declined, from expectations of 7.4% in July of 2022 to only 0.1% today. The right-hand portion of the chart breaks this down by sector. The traditionally highest-growth sectors, Consumer Discretionary and Information Technology, have seen the sharpest declines in growth expectations over this time period. This is as should be expected and gives us confidence that the estimate declines are increasingly reflecting reality. Earnings growth expectations for 2024 have simultaneously increased, albeit modestly. This, too, is consistent with our view of a slower economy in 2023, reaccelerating into 2024.

Historically, during recessions, earnings decline for more than a single quarter. The chart below shows quarterly earnings per share for the S&P500 over the past thirty years. One can see that in recessions (1991, 2001, 2008), typically earnings decline sequentially for 4-6 quarters before reaccelerating. Today, earnings have been down for two quarters and are forecasted to decline for only one more quarter, before bouncing back starting in Q2 2023. Given the strength of the labor market, we believe this is consistent with our expectation of either a mild recession or no recession. All in all, we believe that earnings estimates are approaching levels that adequately reflect the softening economic conditions.

A Word About the Debt Ceiling

A number of clients have asked whether they should be concerned about the US hitting the debt ceiling. Let’s start with some definitions. Congress controls all three key variables related to this potential breach: taxes (cash inflows), spending (cash outflows), and debt issuance (to cover the difference between inflows and outflows). Congress has already approved the taxes and the spending; logically, one would think Congress should agree to authorize Treasury to issue bonds to cover the variance between the already-approved taxes and the already-approved spending. Theoretically, any debate regarding deficit size should occur before approving the taxes and the spending, rather than over the mechanics of how that already-approved spending will be funded. There have been “crises” several times over the past three decades, most notably in 2011, when Congress did not resolve the debt ceiling until the 11^th hour. In that case, S&P famously downgraded the US sovereign credit rating from AAA to AA+. Equity markets promptly weakened, but a rapid recovery followed shortly thereafter: the S&P500 ended the year 2011 with a 2% increase after having suffered a 17% decline mid-year. Bonds actually appreciated in the near-term, under the expectation that a debt ceiling breach would result in spending cuts, meaning lower longer-term economic growth and therefore lower interest rates.

Will Congress take the US near to the brink again? Perhaps. We believe it is unlikely that the Treasury will actually run out of cash; we expect Congress to negotiate a deal before that occurs. How exactly this will play out becomes a political analysis: Which side will blink first? What concessions will the right wing of the Republican Party extract from the moderate wing and/or the Democratic Party in order to avoid a default? Rather than attempt to predict each side’s specific negotiating tactics, we believe that in the end, Congress will come to a resolution to cover expenses. We believe that attempting to trade around twists and turns that are likely to be unpredictable is a fruitless exercise; rather, we keep our investment focus squarely on the longer-term horizon and on the prospects of the individual companies whose common stock and bonds we purchase on behalf of clients.

As we look to the rest of 2023, our view remains unchanged: we expect continued volatility, with inflation easing and the economy slowing. At some point this year, we expect to have increased visibility into a reaccelerating economy. The Fed will stop raising rates, GDP will reach a low for the year, and companies will find ways to mitigate negative operating leverage. Until then, keep the seat belts fastened and expect the unexpected.

Disclosures