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SUMMARY
- Bond Market and Fed views diverged sharply in March.
- Many asset classes had positive performance in Q1; growth-oriented equities outperformed value.
- Our strategy is to tactically add fixed income if yields rise, and inflation-sensitive themes if earnings accelerate.
Quarterly Recap: Same Facts, But Two Very Different Conclusions Lead to a Standoff.
In the first quarter of 2023, the question of ‘how much longer will central banks need to fight inflation’ defined financial markets. However, certain market participants have gleaned starkly different answers from the same data. From the Federal Reserve’s perspective, inflation continues to be higher than their target levels and they have continued to communicate that rate cuts are not currently a viable option. However, it seems the bond market is focusing on the slowing year-over-year inflation; indicating to us that investors believe inflation will continue to drop, and central banks will soon be able to lower rates.
This disconnect between the bond market and the Fed’s policy widened during the unexpected collapse of Silicon Valley Bank. The market viewed this event as a sign of economic weakness and began expecting the Fed to cut rates in an effort to ease financial strain. However, the Federal Reserve quickly stepped in to shore up deposit issues but have reiterated that doing so is sufficient protection against a financial crisis. Jay Powell and company continue to see price instability as a bigger risk than market volatility and have maintained their message of ‘higher rates for longer’ accordingly.
While the Federal Reserve and the bond market were having their “old west” stare down, equity investors were trapped somewhere in the middle, although the preference for growth implies to us they have sided with bond investors. Earnings reported in Q1 were positive in most sectors year-over-year, but definitively slowed throughout 2022. Despite this slowing, equity markets ended with the best quarterly returns in 2 years, albeit through a steep decline in early March showing the elevated volatility embedded in the markets. In our view, equity markets are looking beyond slowing earnings growth and placing some faith in the bond markets’ forecast of lower long-term interest rates. This view is supported by growth-oriented themes outperforming value-oriented themes in the US, a first in over a year. We think this outperformance will be challenged in Q2 if the Federal Reserve does not provide the accommodation the bond market is now expecting.
Returns Recap: Positive Q1 Hides Despite the Diverging Outlooks.
The first two months of Q1 2023 continued the rally that we saw in Q4 2022. The drivers were the same as Q4 2022: inflation remained elevated but cooled, allowing growth-oriented stocks to outperform. However, in March, the collapse of Silicon Valley Bank upset the positive. Somewhat isolated from the issues, developed international markets remained in the lead. However, with a heavy weighting to the regional banking industry, US small cap equities dropped to the worst-performing equity segment. As discussed above, March ended up being a positive month for growth-oriented themes, allowing US large cap to produce a solid quarterly return.
On the fixed income side, returns were more muted than developed markets, but still positive. High yield saw some spread volatility during the aftermath of the regional banking crisis, but was able to rally at the end of March.
US Sectors: Growth Oriented Sectors Lead the Way
For the US sectors, expectations for lower rates seem clear. The top three performing sectors are all growth-oriented, while value-oriented sectors all performed below the broad S&P 500. Two value-oriented sectors in particular, Energy and Financials, had rough quarters for more idiosyncratic reasons. As previously discussed, financials struggled in the face of continued rate hikes and the resulting regional bank failures. For the energy sector, future demand expectations took a hit in the first quarter, with weak global economic data creating concern about their future demand for oil. Defensive sectors found themselves somewhere between the outperformers and underperformers. Overall, we still believe that intra-sector selection will be just as important as inter-sector allocation moving forward.
International: Commodity Producers and China Lag Developed Europe, Japan, and US
Similar to the themes we saw in US Sectors, commodity-producing countries, such as Canada and several of the constituents of Emerging Markets (see chart above), lagged the relatively more growth-oriented developed markets, which are net beneficiaries of declining energy prices due to their status as energy importers.
Looking at Developed Markets from a selection lens, we see that growth and quality themes were the driver of outperformance for developed indexes (see chart left). If our ‘most likely’ scenario (see below for description) of rising rates and moderating, but persistent inflation happens, our expectation is that this trend will reverse in the quarters ahead.
For emerging markets, China was a relative outperformer within emerging markets, due to its large technology sector. Interestingly, we believe it was also Chinese economic data and geopolitical relations that caused commodity markets to struggle this quarter, causing more broad emerging market struggles.
Moving forward, we believe the shift in narrative of either higher rates for longer than the Bond Market expects or a shift from rising rates to falling rates will become clearer in the second quarter. Thus, we think opportunities will emerge where the market over or under values segments based on shifting outlooks.
Outlook: Waiting to see who blinks first in the interest rate due
Overall, the first quarter performance of 2023 was positive, especially given the mid-quarter banking crisis and the continued geopolitical conflicts in Europe and China. We are concerned about the wide discrepancy we see between the Fed’s plans and the bond market’s pricing of future interest rates.
As discussed in our 2023 Outlook, we see three likely outcomes of this standoff:
- Economic Growth: Slowing, but Positive / Inflation: Moderating, but Persistent (BASE CASE / MOST LIKELY OUTCOME)
- In this scenario, the Fed will be proven correct and interest rates must go higher to combat inflation. If this plays out, we believe equity investors should expect volatility but directionless markets, an environment where we believe the P.A.T.T.Y theme (a focus on investments with strong yields and free cash flows to support them) would be the most effective strategy.
- Economic Growth: Resilient / Inflation: Under Control (BULL CASE)
- Specifically, a recession or significant slowdown quickly emerges, causing inflation pressures to dissipate quickly. In this scenario, the bond market wins the standoff, and the Fed would begin to forecast rate cuts and/or monetary stimulus. In this scenario, quality and growth-oriented US equities would be the strongest performers, in our view. Additionally, international stocks would benefit from strong currencies.
- Economic Growth: Recessionary / Inflation: Strong (BEAR CASE)
- The most challenging scenario is if we see high inflation and evidence of a recession, which would force the Fed to continue to raise rates even in the face of a recession. In that scenario, bonds and stocks would perform poorly as long interest rates rise and economic and earnings growth fall.
Due to the lack of a clear outcome, we remain neutral in our equity positioning. Also, we continue to believe that a prudent path forward is to opportunistically add fixed income at higher yields, and to make allocations into inflation-sensitive equity sectors in markets as earnings come through. While this strategy may not perfectly time the bottom of market, we believe it is prudent to wait for signs of earnings confirmation before increasing our allocation to stocks.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.