Equity markets started the year on firm footing amid optimism around economic growth, signs of declining inflation, and the approach of a peak in Fed policy initiatives. Such optimism was short lived, however, as inflation readings came in hot entering February compelling the Fed to raise rates aggressively; 2022 earnings reports underwhelmed and fears of recession rose. As the regional banking crisis emerged amid a deposit run and some high-profile bank closures, it appeared we were in for a difficult March — only to have interest rates fall dramatically and markets anticipate that the banking crisis may have done the Fed’s work for them, potentially shortening the severity and duration of the Fed’s tightening cycle. A more resilient consumer and a strong labor market also helped put some wind at the market’s back. By quarter end, nearly all equity indexes had registered positive mid-single digit gains.
Domestic large cap stocks, as measured by the S&P 500, bolstered by the strength of mega-cap Information Technology, Communication Services, and Consumer Discretionary stocks, posted a gain of 7.5% for the quarter. Financial stocks were weighed down by the banking crisis, while Energy stocks also lagged amid a drop in oil and natural gas prices. The more defensive sectors of Health Care, Utilities, and Consumer Staples also lagged. Small cap stocks posted similar monthly trends to their large cap counterparts, although their decline in March, driven in particular by the collapse of regional banking stocks, was quite pronounced. What had been a sizable performance advantage over large caps turned into quite a rout, with the Russell 2000 gaining a more modest 2.7% for the quarter.
In contrast to last year’s trends, the strong sectors mentioned above all possess a notable growth bias, while the laggards tend toward defensive and cyclical-value characteristics, propelling Growth stocks to a sizable performance advantage over Value in the quarter. The performance of style factors showed a slight quality bias, led by larger cap, lower beta, and higher ROE stocks.
The Fed remains determined to bring down inflation toward its 2% target, and their aggressive tightening actions, with their typical lags, seem to be slowing the economy and pushing inflation down. Weak ISM Manufacturing survey results and the bond market’s inverted yield curve suggest the slowdown is occurring. Yet the economy’s resilience, as seen in the strength of the labor market, consumer spending and household balance sheets, makes it less clear if steps taken to date are enough to accomplish the Fed’s goal. Enter the regional banking crisis. While it had an immediate impact on smaller-cap bank stocks, the broader negative impact on the economy has yet to be felt. More stringent regulatory requirements and the outflow of deposits from regional banks, an important factor in corporate lending and economic growth, can’t help but slow the economy, as funding availability will diminish, lending standards will tighten, and borrowing costs will rise. Such an impact may help the Fed accomplish its goal of slowing economic growth and taming inflation, albeit while increasing the likelihood of recession. Still, the slowing economy should bring us closer to the end of this tightening cycle and position us for the next phase of growth. Exactly when this happens, how severe the recession will be, and when markets will anticipate the next up cycle, is dependent on many factors making it difficult to predict with any precision.
At the very least, it is prudent to reduce 2023 S&P earnings estimates, reflecting a difficult finish to 2022 earnings reports as well as the greater likelihood of recession later this year. assuming earnings of $200 in 2023, the market sells at about 20 1/4 times earnings, representing an earnings yield of 4.9%. With the 10-year US Treasury yield falling to 3.5%, the ratio of stock-to-bond earnings rose during the quarter to 1.4 times, leaving stocks still a bit expensive versus long-term averages. Nonetheless, there is still relative value in the market as smaller caps and non-US equities sell toward the lower end of relative valuation ranges versus domestic large caps.
Our continued focus on investing in quality companies is all the more relevant in these times of market and economic turbulence, as well-managed companies have a tendency to take advantage of the situation at hand, whether good or bad, for their long-term advantage.