Patience

July 7, 2023

By Ellen Hazen, CFA®, Chief Market Strategist

June Takeaways:

  • The debt ceiling was suspended on June 3, and is not scheduled to be revisited until 2025. A government shutdown could still be in the cards for this fall, but historically shutdowns have lasted from a few days to a few weeks, and do not typically materially disrupt markets
  • Jobs remain strong, with May nonfarm payrolls (reported in early June) of 339,000. This is the 30th consecutive month with over 200,000 jobs created. Unemployment remained fairly low at 3.7% in May, although this increased from 3.4% in April. Inflation as measured by the Consumer Price Index (CPI) declined from 4.9% in April to 4.0% in May, while the Personal Consumer Expenditure Index (PCE) declined from 4.7% in April to 4.6% in May
  • The Federal Reserve held its overnight rate steady at its June 14 meeting, while holding the door open for further increases. Currently, the markets are pricing in two more 2023 increases, with the rate peaking in November at 5.5%
  • Earnings estimates for 2023 declined slightly during the month. At the beginning of the year, Wall Street analysts expected S&P500 companies to grow earnings by 2%; now, they expect a 3% decline
  • The US equity market broadened a bit, but returns are still concentrated on a year-to-date basis. In June, the market-capitalization weighted S&P500 appreciated by 6.6%, while the equal-weighted S&P500 appreciated by 7.7%. Small-capitalization stocks appreciated by 8.2%. Year-to-date, the market-capitalization weighted S&P500 is up 16.9% while the equal-weighted is up 10 percentage points less, at 6.9%
  • Bonds declined modestly in the month, as interest rates increased by roughly 40 basis points across the curve. Credit quality remains high and spreads are fairly tight
  • The Federal Reserve Bank of Atlanta’s GDPNow indicator suggests that Q2 GDP will be 1.9, roughly flat with the 2.0% reported for Q1

What We Are Watching in July

  • Second-quarter earnings will start to be reported in the third week of July. We will be watching for evidence of (or lack of) pricing power, operating leverage, and revenue deceleration
  • CPI will be reported on July 12, and economists currently estimate a further decline in the headline number from 4.0% in May to 3.0% in June. PCE will be reported on July 28
  • New jobs will be reported on July 7; current expectations are for 225,000 jobs

It is a common saying on Wall Street that one should buy when others are fearful and sell when others are greedy. The markets, they say, alternate between fear and greed, with the astute investor taking advantage of others’ behavioral tics. As we look at 2023 both retrospectively back upon the first half, and prospectively forward to the second half, we see neither fear nor greed as the dominant expression in various asset classes. Rather, we counsel patience.

During the first half of 2023, the US equity market has displayed surprising strength. S&P500 returns have been in the mid-teens range. Given that long-term (multi-decade) nominal equity returns are usually in the high single-digit to low double-digit range, how did this happen?

There are at least three reasons. Sentiment, liquidity, and concentration.

At the beginning of 2023, sentiment was poor. Both individual investor and institutional investor sentiment was fairly bearish, and most economists were predicting a recession. Then, Q1 earnings were better than expected, with revenue growth beating expectations by 2.5% and earnings growth beating expectations by 6.5%. Investors’ sentiment quickly turned positive, providing fuel to the equity market.

When Silvergate Bank, Signature Bank, and Silicon Valley Bank failed in quick succession in March, regulators swiftly stepped in to remove any uncertainty. Depositors were paid in full and new liquidity programs like the Bank Term Funding Program ensured that other banks with lower-valued long-dated Treasury bonds could easily access liquidity. The specter of cascading bank runs rapidly faded, but the added liquidity stayed in the system.

The concentration in the market has been well discussed. Year to date through June, over half of the S&P500 returns have come from 5 stocks, which are up an average of 95%, while the other 495 stocks are up by an average of 7%. This concentration reflects the market’s current fascination with artificial intelligence. Companies like Microsoft, Apple, and Alphabet have seen their price-to-earnings multiples significantly expand even as their earnings estimate have remained fairly flat. Even a case like Nvidia (the producer of AI-enabling chips) where earnings estimates have significantly increased (from $6 to $10 for 2025), its price-to-earnings multiple has grown by a third, from 34x to 48x.

As we look toward the second half of the year, the starting point is different from what it was in December 2022. Sentiment is high amongst both institutional and individual investors. Ned Davis Research calculates that forward returns when sentiment is high have historically been modest, at best. (See chart below.)

Liquidity will start to seep out of markets, driven by tighter Federal Funds rates and the decline in the Fed’s balance sheet as maturing bonds are not replaced. In the shorter-term, excess Treasury issuance to refill its General Account (after having drawn it down during the debt ceiling standoff) will also drain liquidity.

At the same time, underlying economic measures look fairly strong, including the labor market and decelerating inflation. Neither economists’ GDP forecasts nor analysts’ earnings forecast are predicting a recession in the next year and a half, despite near-ceaseless chatter of one.

Thus, we continue to expect a “muddle-through” year: decent earnings, fading inflation, and strong jobs provide tailwinds, while high investor optimism and high valuations are headwinds. Stay buckled up, and stay patient.

Real Yields

Post-pandemic inflation has been high globally, not just in the US. As a result, central banks across the world have been raising interest rates. These higher rates have led us to examine whether an allocation to international fixed income is warranted.

When we compare each country’s central bank overnight rate against its inflation rate, we see that most developed markets still have negative real rates; inflation is higher than the central bank rate. Consequently, we believe most developed market central banks will need to continue to increase interest rates in order to provide meaningful brakes on their economies and tame inflation. The US and Canada are currently the only major developed markets with positive real interest rates.

When we examine emerging markets, we see a different story. Emerging market central banks generally started increasing interest rates well before the US. For example, the Brazilian central bank first raised interest rates in March of 2021, a full year before the Fed, and the Central Bank of Mexico started to raise rates that following June. Inflation in these countries peaked earlier than in the US, and has been declining; in response, both countries’ central banks have held rates steady for some time. This raises the possibility that they could cut rates before the Fed does. Longer-dated Brazilian yields have already started to decline, and markets are pricing in rate cuts. This backdrop is more supportive of the potential for capital gains in these markets’ debt than in non-US developed markets.

Of course, there are risks to this scenario. One risk is that inflation reaccelerates, driving rate increases once again. Another is that the local economy slows so much that the currency devalues. However, in our view, when evaluating non-US bonds, emerging market debt looks to be more interesting than developed market debt.

Disclosures

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