Perspectives

Domestic equities started the quarter with solid positive returns as the market embraced the soft-landing scenario, inflation was coming down, and the Fed was thought to be at the end of its upward rate cycle. Yet, as the quarter progressed the market faded as the economy’s strength and stubborn inflationary readings, especially driven by higher oil prices, pushed up long-term interest rates, while the Fed’s policy statement clearly shifted toward the higher-for-longer scenario. Interest rates climbed to levels not seen in well over a decade.

The S&P 500 Index lost -3.3% for the quarter, however, it still maintained a respectable gain of 13.1% for the year to date. Energy was the only sector to advance meaningfully in the quarter, gaining 12.2%. While the mega-cap names posted mixed performance in the quarter, those in the Communication Services sector provided a bit of a cushion to large cap stocks. A rather eclectic mix of sectors including Utilities, Real Estate, Consumer Staples, and Information Technology lagged during the quarter, with mid-high single digit percentage losses. The Russell 2000 Index of small cap stocks trailed large caps with a decline of -5.1%. Small caps have now given up most of the year’s gains to register a modest 2.5% return for the year-to-date period. As with large caps, Energy was the only sector to post a substantial quarterly gain, rising 18.6%. The Health Care sector declined by -15.1% for the quarter on broad sector weakness. Utilities and Information Technology also lagged among small caps.

Growth and value styles registered near-identical losses in the quarter among large caps, while value stocks were comfortably ahead of growth among small caps. Year to date, growth remains well ahead of value.

Resilience was the word for this quarter, and perhaps will continue to be for at least the near term. Despite aggressive Fed efforts to slow the economy, things remain, well, resilient. GDP continues to show decent growth, while estimates have been steadily revised upward. Corporate earnings also remain strong. Capital spending has been bolstered by funds from the Inflation Reduction Act. Consumer confidence, while slowing, also remains favorable. Housing prices remain surprisingly strong, despite the rise in mortgage rates. The labor market is perhaps the biggest surprise, as the unemployment rate remains below 4%, initial jobless claims remain low, and wages continue to increase.

And yet, the market remains pressured. It should be no surprise that the Fed’s narrative has changed to one of higher-for-longer rates, as inflation, while slowing, remains uncomfortably above the Fed’s 2% target level. This environment has proven ripe for higher interest rates, making returns on fixed income investments a legitimate alternative to equities. We are far from the TINA (“there is no alternative”) environment of prior years.

How this interplay between a stronger economy and higher interest rates plays out is difficult to predict. Perhaps economic resilience is sustained, and we are in for higher rates for the foreseeable future.

This may not be the worst environment for stocks as earnings would likely be strong, and could offset pressure on stock multiples that higher rates might cause. Or perhaps higher rates will pressure companies and consumers, with their typical lags, starting us down the path to recession that the Fed wants and our current inverted yield curve has successfully predicted in many recessions past.

As implied above, we are once more taking up our earnings expectations, projecting 2023 S&P 500 earnings of $215. When combined with the quarter’s decline in equities, the market P/E has fallen to 20 times earnings, for an earnings yield of 5.0%. Still, with the rise in 10-year Treasury yields to 4.6%, the ratio of equity to fixed income yields has dropped to under 1.1 times. This ratio is low by historical standards, showing the improved relative attractiveness of bonds relative to stocks. Nonetheless, there remain sizable pockets of value in the stock market, as large cap P/E ratios are skewed higher by the handful of mega-cap names that sell at much higher valuation levels.

Our investment focus remains unchanged regardless of how this economic cycle plays out. We continue to seek out companies with quality attributes such as strong management teams, leading market positions and strong financial characteristics that tend to do best in a competitive world when the outlook is anything but clear.