Market Outlook

March 31, 2023

The macroeconomic environment shifted sharply in the first quarter of 2023. Entering the quarter, the market’s and investors’ primary concerns were how long inflation would remain high, and how fast the Federal Reserve (Fed) would continue to increase interest rates. The Q4 2022 GDP of 2.6%, which showed continued economic strength, and the January and February readings of CPI of 6.4% and 6.0%, which showed still-elevated inflation, suggested that the Fed would increase the overnight rate to over 5%, perhaps as high as 5.25%, and stay there for at least several months. The yield curve remained inverted, and the key question was whether or not there would be a recession.

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Macroeconomic Outlook

The Silicon Valley Bank failure changed the prevailing narrative and with that, the prevailing concerns. The bank failed quickly, although as many have noted, the unrealized losses in the held-to-maturity bond portfolio had been there for all to see, in the company’s 10-Q and 10-K SEC filings for several quarters. The first public sign of distress was on Wednesday, March 8, when the bank announced both a realized loss of $1.8 billion and an intended $2.25 billion equity raise. Depositors panicked, and two days later, the FDIC took over the bank. It has since been sold to First Citizens, now a top-20 bank.

Fears of financial contagion surfaced, because a few other banks either also failed (Signature Bank, Silvergate Bank), or had similar mark-to-market loss problems (First Republic). Markets rapidly shifted from worrying about a 5.25% or higher terminal rate to anticipating cuts to avoid contagion.

We do not believe contagion is the most likely outcome. Many investors are haunted by the memory of 2008, when multiple large banks failed over several weeks. The fundamental differences between 2023 and 2008 are in 2008, the underlying credit was bad, and the entire system was significantly leveraged. In 2023, the underwater Treasury securities, if held to maturity, do not represent credit problems. And the leverage in the system is significantly lower than in 2008. Nonetheless, any fractional reserve banking system depends upon faith to stay solvent, and we are seeing that faith be tested.

Signs that the economy is slowing are accumulating: so-called soft economic data (e.g., surveys) has shown that companies’ and individuals’ expectations of future economic growth has deteriorated over the past several months. This is not yet showing up in so-called hard economic data (e.g., GDP, unemployment), but may be serving as an early warning signal. Similarly, financial conditions are tightening as banks rein in lending, partially in response to the Silicon Valley Bank failure and to get ahead of any regulatory-driven increases in capital requirements. These tightening financial conditions may reinforce economic slowing that was already occurring.

In 2022, we had taken several steps to inoculate client portfolios against a slowing economy; some of these were exiting high yield bond exposure and reducing equity exposure. In the first quarter of 2023, we took further steps to reduce credit exposure, the most significant of which was to eliminate leveraged loan exposure within the fixed income allocation, most of which is below investment grade. This is not because we fear a credit problem, but rather because spreads have remained narrow and thus we are not being adequately compensated for the risk inherent in this sub-asset class. We also increased exposure to international equities.

We believe that equities outside the US are increasingly attractive. The valuations have been significantly below those of the US equities for many years. What has changed is the relative earnings growth

growth, as can be seen in the chart below. European and other developed countries are positively exposed to China’s re-opening, and we see that reflected in earnings estimates.

As we look forward to the rest of 2023, we expect continued volatility across asset classes, but do not expect a full-blown recession. Because markets are forward-looking, we expect that as we move toward the end of 2023 and have increased visibility into 2024, securities across most asset classes will reflect expectations for a reaccelerating economy.


Fixed Income

After a challenging 2022, the fixed income asset class has started 2023 on a positive note. In the first quarter, the Bloomberg Intermediate US Gov’t/Credit Index returned 2.33%, its second consecutive quarter of positive returns. The pretext for these returns has been declining interest rates and tighter credit spreads as market sentiment improved. After peaking at 4.32% (intraday October 21, 2022), the 10-Year US Treasury yield has been on a choppy but downward trend and ended the first quarter at 3.47%. High Yield credit spreads, where an elevated spread indicates increased market stress, were at 5.52% (552 basis points) on October 1, 2022.1 Since then, this spread has fallen to 4.55%, signaling improved sentiment and a smoother outlook for the US economy. Additional reasons for market optimism include gradually decreasing inflation and a Fed that seems near the end of its rate-hiking campaign.

Unfortunately, market signals have been mixed, and a couple are flashing warning signs. Most recently, the re-steepening of the yield curve could be signaling that an economic downturn is looming. By now, many are familiar with the concept of an inverted yield curve and how it can precede a recession, which then occurs at an uncertain point in the future. While this is a useful indicator, it is actually the re-steepening of the yield curve that offers more precise timing and indicates that a recession is imminent. The yield spread between the 2-Year Treasury and the 10-Year Treasury is the most common measure of yield curve steepness, and this measure plunged to -1.08% (108 basis points) in early March, the sharpest curve inversion in over 40 years. Since then, this spread has re-steepened to -0.54%, led by the 2-Year Treasury, which decreased a full percentage point in the last few weeks of the quarter. A re-steepening curve due to declining short-term yields implies that the Fed will need to cut rates soon to stabilize the economy. The market-implied path for the Federal Funds Rate also affirms this view. In early March, the market expected the Fed to increase rates by another 0.75% by the end of 2023. The Federal Open Market Committee (FOMC) did increase rates by 0.25% at its March meeting, but now the market expects 0.50% in interest rate cuts for the remainder of the year. The catalyst for this reversal has been the failures of Silicon Valley Bank and Signature Bank—and this is our second warning signal for the market. We believe that banking turmoil will accelerate tighter lending standards and credit conditions, a trend that was underway even before the recent bank failures.

Corporate credit markets have proven durable, as indicated by resilient High Yield and Investment Grade bond spreads. Despite this, there are early signs of fundamental weakness at the aggregate issuer level. Overall, financial leverage has increased, and interest coverage has weakened over the last few quarters. Even though issuers spent years refinancing debt at lower rates and fortifying balance sheets, company fundamentals will continue to deteriorate if interest rates stay elevated. We are particularly vigilant to the risks in the Leveraged Loan market, which has been the preferred spot for weaker companies to fund themselves over the last several years. In many ways, trends in this market are symptomatic of years of low rates and easy monetary conditions. Specifically, the asset class grew as weaker issuers increased issuance, the loans themselves had fewer covenants to protect creditors, and weak companies were able to survive in a low interest rate environment. Given the inherent risk presented by higher interest rates, we eliminated our allocation to Leveraged Loans in the quarter.

The less volatile municipal bond market has acted as a safe-haven asset class during the market’s recent bout of volatility.  In the first quarter, the Bloomberg Municipal 5-Year index returned 1.93%, which ranks among the index’s best first quarter returns in the past twenty years. Fundamentally, state and local finances are strong, flush from fiscal stimulus and buoyed by stable property and sales tax revenues. According to Pew Research, 43 out of 50 states increased their rainy-day fund balance in Fiscal Year 2022, with an average increase of 10.4%. When compared to taxable bonds, we view the municipal bond sector as fairly valued, but are attracted to its lower volatility and valuable tax-exemption.

As we have cautioned in previous communications, we expect continued volatility in 2023. The outlook for the US economy is increasingly uncertain and fixed income markets are focused on the interplay between inflation, Federal Reserve action, and the ensuing economic effects. In fixed income portfolios, we remain defensively positioned with a neutral duration and a healthy allocation to high-quality corporate and government bonds. Despite anticipated headwinds headwinds, a continued silver lining is that fixed income yields are significantly higher than previous years. Going forward, this should dramatically improve the ability of fixed income securities to provide solid returns and diversification benefits.


Equity Income Market

When we published our 2023 equity market outlook at the beginning of the year, we were expecting short-term volatility that would create long-term investment opportunities. The first quarter of the year did not disappoint by this measure as the S&P 500 posted a 7.5% total return in the quarter while experiencing significant volatility along the way as bank failures increased economic uncertainty. After this eventful quarter, our conviction in our 2023 outlook remains intact – we still expect ongoing volatility, but the stock market is likely to be in recovery mode by the end of the year.

While risk of an economic recession remains elevated by many measures, the economy has proven surprisingly resilient and our expectations for both a downturn and recovery were being slowly pushed further into the future prior to the collapse of Silicon Valley Bank.  Since that time, financial conditions have likely tightened and brought timelines back in line with our original expectations. This view seems to be shared by the Fed, which dialed back expectations for additional interest rate increases after suggesting that a return to half percentage point increases might be looming after both inflation and employment readings came in above expectations earlier in the quarter.

It is hard to overstate the importance of monetary policy in the valuation of financial assets.  The end of the Fed interest rate increase cycle has often (but not always) been followed by elevated equity returns as shown in the chart below.  In the past 40 years, the S&P 500 has returned an average of 18.9% in the 12 months and 14.3% annually in the 3 years following the peak Federal Funds interest rate for the cycle. There have, however, been important exceptions: after peak Federal Funds rates in 2000 and 2006, equities struggled for years. Those past two recessions have included dramatic drops in economic activity and corporate earnings as systemic risks in financial markets were revealed. There is little evidence so far of these types of systemic risks in this cycle and credit markets have been reasonably stable despite turmoil in the banking sector, which seems inconsistent with an imminent replay of these past severe downturns.  As a result, the events of the first quarter seem unlikely to significantly alter the magnitude and duration of the modest economic downturn that appears to be developing, but there are significant implications for corporate earnings.

As shown in the chart below, S&P 500 earnings per share are declining relative to a year ago.  In prior updates to our market outlook, we’ve noted that S&P 500 earnings were likely to decline modestly in 2023, and consensus estimates have finally dropped to reflect the same expectation. These more reasonable earnings estimates and relatively attractive valuations have supported the overall market despite turmoil in the banking sector in 2023, but it will be difficult for equities to make consistent progress over time until corporate profits are rising once again.

In addition to the market volatility caused by shifting earnings expectations for equities overall, a dramatic market rotation has been ongoing under the surface. Last year it was growth-oriented companies that led the overall market lower as the S&P 500 Growth Index returned a stunning -29.4%, while other areas with more attractive valuations held up reasonably well. Those roles were reversed in the first quarter of 2023 as the S&P 500 Growth Index returned 9.6% and more attractively priced areas such as the S&P 500 Value Index and the Russell 2000 Index of smaller companies returned 5.1% and 2.7% respectively. Growth may be more highly prized when it becomes scarce, but we continue to view growth potential as one of many factors worth consideration in the management of diversified equity portfolios. In addition, these violent shifts and relatively narrow market leadership continue to reinforce that markets are still unsettled and adjusting to a rapidly evolving economic environment.

We continue to expect that this year’s volatility is not over, but the markets are adapting to a new economic environment and will generate attractive long-term investment opportunities along the way.  As markets churn through this adjustment process, we remain patient and focused on our discipline of investing in high quality equities that are likely to thrive throughout the economic cycle.


Sustainable Investing: Opportunity in Change

In our last quarterly letter, we touched on the idea of investing in ESG improvers and environmental transitions. These are companies that are starting from a place that many sustainable investors may not be entirely comfortable with. These companies generally have lower ESG scores or are in businesses without significant exposure to environmental solutions. The idea, backed up by research, is that positive change can be rewarding, making this type of analysis an increasingly important consideration.

With opportunity comes risk, the risk that lower-rated companies may be more volatile and the risk that companies may not be serious about transition plans. There’s also the risk that investment in improvers or transitions may be viewed as greenwashing. We believe carefully researched improvers and transitions deserve a place in sustainable strategies and believe investors broadly will come around to this idea as emerging regulations and market-based incentive programs like the Inflation Reduction Act accelerate the shift to a more sustainable future.

To start, ESG analysis is about assessing material environmental, social, and governance risks at an industry level and evaluating the management of these risks at the company level within each industry.  ESG scores from firms like MSCI do not pick good or bad industries, though they do help investors assess the quality of risk management across companies within each industry. Thematic targeting starts with research into a changing world to identify pressing challenges and potential solutions.  Investors use thematic analysis to identify companies with products or services that are likely to benefit as solutions scale, consumer preferences shift, or regulations develop. Within the sustainable investing landscape, investors have historically focused on companies with well-managed ESG risks and/or companies with clear and significant leverage to thematic growth drivers.

As sustainable investing in all its forms has become more mainstream, it is increasingly clear that focusing only on high scoring ESG companies or fully aligned thematic opportunities is incongruent with the broader journey toward a more sustainable future. Companies actively working to improve ESG risk management or shifting business models toward environmental solutions may present opportunities to add value in portfolios.

As noted last quarter, ESG Rating Score Revisions and Stock Returns, an academic paper published in April of 2022, explored the effects of ratings changes on stock returns over medium-term holding periods of six months. Among many interesting conclusions, the authors found a 3-percentage point spread between upgraded and downgraded stocks, and they noted that downgraded stocks experience a drop in return on assets relative to upgraded stocks after a revision.  The takeaway is that changes in ESG ratings can positively contribute to relative performance as investors assess the information content of revisions.

In contrast to changes at the margin around ESG risk ratings, transition opportunities are more about a shifting business model or product/service mix. Recent research from Morgan Stanley identified businesses that are transitioning toward more environmentally beneficial products or services. One notable conclusion from the report was the relative performance spread between utility companies that are actively shifting from a higher carbon intensity toward a lower carbon profile and those that have already lowered their carbon footprints. From the end of 2014 through mid-2022, Morgan Stanley’s “Active Rate of Change” basket outperformed the lower carbon intensity utility basket by about 8% per year. In this case, shifting from higher-cost coal generation to lower-carbon and lower-cost sources of generation has been beneficial both environmentally and economically.

When investing in companies with apparently weaker sustainability profiles, it is important to carefully assess risk.  With ESG improvers, the key is a deeper analysis beyond simple headline scores to develop a broader understanding of risk and where this might be missed by other investors, ratings agencies, or companies themselves. This type of analysis is a natural part of a good fundamental research process and something we take seriously at FLP. Similarly, with environmental transitions, the key is understanding the level of commitment to change, and magnitude implied by targets.  As with any good research process, both improvers and transitions require ongoing monitoring of details and targets to increase the chance of capturing successful change and reduce the risk of greenwashing.

From a big picture perspective, improvers and transitions represent active change toward a more sustainable future.  We have witnessed change in companies across sectors including industrials, materials, financials, and even traditional energy.  Change in these somewhat staid sectors may not be easy, though to meet longer-term global goals, it is increasingly important. From a portfolio construction perspective, opening the opportunity set to include improvers and transitions means more room to maneuver through cycles and periods when factors such as growth and value shift materially.  For all these reasons, we believe improvers and transition opportunities should be on the radar for sustainable investors.


Alternatives: Private Equity

As of early April, private strategies are nearing the final stages of their year-end audits. These audits will finalize the valuations for year-end 2022 and provide an early indication of the direction and magnitude of valuation trends that emerged with the start of the current Fed rate hike cycle. While it is simply too early to provide a summary of the first quarter with any precision, there are clear trends of winning and losing strategies, asset classes, and business models that we discuss below. Many of these trends were exacerbated at the end of the quarter given the accelerated withdrawal of liquidity following the failures of Silicon Valley Bank and Signature Bank.

While private markets revalue slowly, particularly compared to the increased level of volatility in the public markets, they cannot escape the fact that interest rate policies globally are putting pressure on valuations. As most private market strategies utilize a moderate or even high degree of leverage, the specific terms of the debt and maturity profile are critical factors in determining the magnitude of current stress. The table below provides a framework for thinking about the current valuation paradigm for leveraged assets:

While real estate and private equity fit cleanly into the examples above given generally leveraged capital structures and the very apparent change in interest rates globally, venture capital is subject to similar issues – which can be simplified into a need for capital. Venture capital businesses are typically cash-flow negative and require infusions of fresh equity capital every 18-36 months. As investors become more discerning, they are less willing to fund businesses that aren’t making clear progress on revenue and/or achieving a path to profitability.

Across all asset classes, there is increased dispersion between high quality and low-quality assets, growing and shrinking assets, and well-termed capital structures and weak capital structures. Transaction volumes have slowed materially across most asset classes as buyers and sellers fail to agree on fair valuations, and those with good assets and/or good capital structures are choosing to sit out this market. As an example, within the commercial real estate market, transaction volumes were down approximately 60% in the first quarter of 2023 relative to the first quarter of 2022.

To some degree, the limited price discovery (transaction volume) is a feature of illiquid strategies, as they allow fundamentals to play out over long periods. However, this same dynamic is a negative for businesses or assets that don’t have the benefit of time, as necessity of capital allows liquidity providers to capture meaningfully higher lending rates and/or lower valuations.

While higher interest rates are a broad macro factor weighing on valuations across the entire market, manager and asset selection are becoming more critical performance drivers than they were over the prior 10 years. We would argue that manager and asset selection were always crucial, but when interest rates were near zero, taking more risk was one clear path to outperformance. As noted in our 4Q22 Market Outlook, it remains a great time to have capital to deploy. Secondaries and stressed/distressed remain our primary investment themes.

  • Secondaries: Despite the wide gap between buyers and sellers, which caused almost half of secondaries transactions to fail last year, 2022 was the second largest year ever for secondary market transactions at $103 billion according to Evercore. (The record was set in 2021 at $134 billion). Industry anecdotes suggest that the volume of sellers requesting bids in the first quarter of 2023 was half as much as the total for 2022 – implying the potential for tremendous volumes for all of 2023. Funds in our target universe continue to focus on high quality assets and are trying to maximize the discount at which they can acquire those assets. As institutional investors remain constrained by the denominator effect we discussed last quarter, and financial sponsors seek ways to provide liquidity for Limited Partners, this theme is likely to persist.
  • Stressed/Distressed: The 4Q22 Market Outlook highlighted what we believe will be a long-term opportunity set in the corporate distressed segment. While this theme remains intact, the opportunity set is taking longer to emerge than previously anticipated. In the meantime, real estate stress/distress has accelerated relative to our prior expectations. While most investors and funds are avoiding the most distressed real estate assets (e.g., office), stressed opportunities in other sectors are growing in popularity. These tend to be high-quality assets that need additional equity and/or debt capital because valuations are lower and bank financing has become substantially more scarce. In keeping with the theme above, we are focusing on high-quality assets with solid occupancy and rental rates that just need to adjust their capital structures for higher interest rates and lower advance rates from banks.