By Ellen Hazen, CFA®, Chief Market Strategist

April Takeaways:

• Earnings season began in full force, with just over half of S&P500 companies reporting. Takeaways thus far include continued cost pressure and negative operating leverage
• Earnings estimates for 2023 for domestic equities continued to slip and now reflect a 2.3% decline in 2023 versus 2022
• The very largest US stocks appreciated, while the average S&P500 stock declined slightly. International stocks outpaced US stocks, with the EAFE index +2.9% for the month, compared to +1.6% for the S&P500
• Bonds appreciated modestly, with both the Bloomberg US Aggregate Index and the Bloomberg Intermediate Government/Credit index increasing by 0.6%. Credit spreads narrowed modestly for investment-grade debt
• Inflation continued its steady decline from the peak in June of 2022; March Consumer Price Index (CPI) was 5.0%, down from 6.0% in February
• Jobs continued a string of positive surprises, with March new nonfarm payrolls of 236k (reported on April 7) slightly ahead of 230k expectations. Despite the positive surprise, this continues a clear decelerating trend, and is the lowest new jobs numbers since late 2020. The unemployment rate fell to 3.5% from 3.6%

What We Are Watching in May:

• Most of the rest of the S&P500 will report first quarter earnings; we expect continued declines in guidance for the remainder of the year
• New jobs will be reported on May 5; we expect continued solid numbers but, as noted above, new jobs may continue to decelerate
• The CPI will be reported on May 10, and the Personal Consumption Expenditure (PCE, and the Fed’s preferred measure) will be reported on May 26. These, too, are likely to continue to decline, although we believe that the PCE is unlikely to reach the Fed’s 2% target within the next several months
• The Fed is widely expected to raise rates by another 25 basis points on May 2-3; the market will be watching to see if the press conference verbiage suggests an inclination to pause further increases

A Narrow Market

Market dynamics in the month of April, while appearing to be healthy, were anything but. In the US, large-capitalization stocks (+1.6%) significantly outperformed mid-cap stocks (-0.8%) and small-cap stocks (-2.8%). While the S&P500 appreciated, providing a +1.6% total return, the median S&P500 stock declined by 3.0%. Only 39% of S&P500 stocks were up in the quarter, with 61% declining. Put differently, the equal-weighted S&P500 index increased by only 0.36%. On a year-to-date basis, the equal-weight S&P500 is lagging the market-cap weighted S&P500 by nearly 600 basis points, at 3.3%, vs 9.2% for the market-cap weighted.

Half of April’s 1.6% return came from just three companies: Microsoft (+6%), Apple (+3%), and Meta (+13%). On a year-to-date basis, a small handful of stocks have driven all index gains, with Meta, Amazon, Apple, Netflix, Alphabet, Microsoft, Nvidia, and Tesla accounting for just over 100% of performance.

Another way to look at this is that the ten largest stocks currently account for 29% of the S&P500 market capitalization; this is among the highest levels recorded over the last forty years; a more typical size is 20%. Even in the tech bubble in the 2000 era, the ten largest stocks accounted for closer to 26% of the market cap.

What this means for investing is that despite the market-cap weighted index being up for the year, all is not well. This lack of breadth is not healthy and suggests that the market may be at risk of correcting. Many of the smaller companies have gotten fairly inexpensive via underperformance (although many remain expensive), and better value can be found outside the large companies that have driven the index. Historically, narrow market leadership is a sign of a topping market and reinforces our expectation of volatility.

Update on Q1 2023 earnings

Just over half of S&P500 companies have reported earnings. Average sales growth has been 4%, while average earnings growth has been a 1.5% decline, demonstrating that the negative operating leverage we’ve observed over the past several quarters is continuing.

The best revenue growth was in Consumer Discretionary, led by experiences (hotels, restaurants, and cruises were generally strong) rather than goods (clothing and housing-related were generally weak). Weaker sectors for revenue growth include Materials, in which nearly all companies reported declining revenue, and Communications, with particular weakness in cable and telecom companies.

Earnings revisions were modestly negative among companies that have reported thus far. For Q2, upward revisions occurred for 80 companies in the S&P500, while downward revisions occurred for 46 companies. The same dynamic holds true for Q3 estimates and Q4 estimates, although by Q1 of 2024 the revisions are more balanced. Thus, analysts’ key takeaways from earnings reports were that the future looks a little less rosy than they had previously expected.

Here is a chart of consensus earnings growth over the next several quarters. Note the sharp acceleration starting after Q2 of 2023. We think this is unlikely, as the cumulative impact of a year and a half of Fed tightening will continue to slow the economy and is likely to slow corporate earnings growth.

As we look forward to the rest of 2023 and into 2024, two things are clear. First, the economy continues to slow, as evidenced by slowing inflation, slowing job growth, and slowing corporate earnings. Second, stresses in the economy are likely to increase as economic conditions tighten over the coming months. This may be exacerbated if brinksmanship increases over the debt ceiling. In this slowing environment, we expect continued volatility, and we own high-quality companies with strong cash flow and high returns on invested capital.

Back in the second quarter of 2021, we noticed a significant increase in inflation discussions when analyzing corporate earnings conference calls. This observation helped inform our view that inflation would last longer than anticipated. Today, inflation is still a hot topic, but it’s been joined by “headwinds” and “competition,” which today reinforces our view of slowing growth and the possibility that earnings estimates may be too high. We think it’s important to listen to what companies are telling us. Other trends we’ve noticed: “reshoring” has increased in popularity, while “chip shortages” are down by more than half from a year ago.

JPMorgan – Bookending the Banking Dislocation?

On Monday morning, JPMorgan agreed to acquire First Republic Bank. It’s been nearly two months since Signature Bank and Silicon Valley Bank failed as a result of losses on Treasury securities in conjunction with a run on deposits. First Republic was quickly identified by the market as possibly having the same problems; this week’s resolution was cheered by the markets. The banking system in aggregate does not appear to be systemically weak: capital ratios are solid, and we believe that banks will be able to absorb the inevitable credit weakness that will accompany an economic slowdown. Moreover, banks and regulators have been put on watch to manage their risks carefully. We expect that the banking dislocation chapter is closing.

From the Archives

It’s only been a few months, but investor interest in analyzing the possible consequences of breaching the debt ceiling has soared once again. Here is what we wrote in January 2023 (“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.

Today, we can see markets are most concerned about T-bills maturity specifically in the month of August, but both before and after then, yields are lower. This means the market is predicting any disruption to be short-term in nature, rather than a longer-term problem.

Our conclusions however remain the same: 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.

Disclosures