Equity markets continued to rally in the first quarter, as inflationary numbers showed the first signs of easing off the peak inflation experienced during the summer and as the stock market positioned for the fed to begin easing rates by the end of the year; despite the fed giving no indication of rate cuts in 2023. The S&P 500 recovered around 7.5% during the first quarter of the year. The Technology-heavy NASDAQ led the market recovery up 17%, while the DOW Jones Industrial Average was relatively flat, up only .93% during the first quarter. The Russell 2000 Small Cap Index was up a modest 2.73% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the first quarter up 8.47% in US dollar terms and up 7.49% in local currency. The MSCI Emerging Markets Share Price Index closed 1Q2023 up 3.6% in US dollar terms.
2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. The first quarter of 2023 saw these same sectors, hit hardest in 2022, post the strongest recovery. S&P 500 sector results through 3/31/23: Technology 21.8%, Communication Services 20.5%, Consumer Discretionary 16.05%, S&P 500 7.48%, Materials 4.29%, Industrials 3.71%, Real Estate 1.88%, Consumer Staples .83%, Health Care -4.31%, Utilities -3.24%, Energy -4.03% and Financials -5.56%. Subtracting out the tech stock bounce, equity markets made little ground during the first quarter, as returns were concentrated in 2022’s laggards, while value and defensive stocks sold off.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 17.8X, slightly more expensive than the ten-year average P/E of about 17.3X. Currently, the market is estimating 1.5% earnings growth and 2% revenue growth in 2023, but analysts have already trimmed 2023 earnings forecasts down by 3.8% in the last three months alone. The average historical S&P 500 trough earnings multiple off of peak earnings has been 14.5X. This implies further downside for the S&P 500 if earnings have further negative adjustments; with higher interest rates, elevated inflation, and reduced economic growth potentially hitting corporate earnings in the future. Calendar year 2023 earnings guidance from managements will be a primary focus in the weeks ahead in order to provide some clarity on rising rates and inflation’s impact to corporate earnings. Currently, first quarter annual earnings growth is estimated to be down 6.6% from the prior year while the current consensus calendar year 2023 S&P 500 earnings number hinge on earnings growth returning to 9% growth by the fourth quarter. We are concerned that future earnings growth might have further to adjust with Wall Street analysts possibly still too optimistic.
During their March 2023 meeting, the Federal Reserve initiating another 25 basis point fed funds rate hike despite some new threats from instability in the banking sector. The March meeting marked the eighth interest rate hike, as the fed funds rate now sits at 4.75%-5.00%, the highest since 2007. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 5.9% in 2021, 2.1% in 2022 and is estimated by the fed to be .4% in 2023. Inflationary pressures are beginning to slow discretionary spending and eroding corporate profit margins. As measured by the Consumer Price Index, annual inflation rose 6% in February, down from the 40-year high of 9.1% in June; indicating that we have seen a peak in inflation. All in, the Fed is willing to slow economic growth by increasing borrowing costs as it fights historic levels of inflation. Current forecasts are predicting a Fed Funds Rate around 5.1% by the end of 2023, equal to fourth quarter projections. Additionally, current consensus is starting to price in something greater than a soft landing for the economy. Bloomberg’s one year out recession probability forecast is now 100%, up from 60% at the end of the third quarter.
The 10-year treasury staged a rally during the first quarter of 2023; starting the year at 3.88% and ending the first quarter at 3.47%. Current intermediate treasury rates are now back to levels last seen in 2010. Longest duration bonds outperformed shorter duration issues as yields fell across all maturities. Long treasuries returned 6.17% in the first quarter, while intermediate treasuries earned 2.27%. In a risk-on trade, higher credit quality underperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index returned 2.78% in the first quarter, while Baa rated bonds earned 3.57% during the same period.
The Bloomberg Dollar Spot Index weakened 1.31% in the first quarter of 2023, as international currency markets are expecting a pause in fed policy towards the middle of 2023. Light crude oil futures fell 5.9% thus far in 2023 over energy demand concern. WTI oil futures fell to $75.67 at the end of March from $80.45 at the end of the year. 30-year mortgage rates rose from 6.66% at year-end 2022 to 6.81% at the end of March, while 30-year treasuries fell 32 basis points from 3.97% at year-end 2022 to 3.65% at the end of the first quarter.
According to the Bureau of Labor Statistics, the March employment report showed 236k jobs gained during the month. The report was slightly below estimates for a gain of 239,000 jobs. This was the first monthly jobs gain number below expectations after the last year of overheated numbers. The March Jobs number reported unemployment at 3.5%, at the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in March was 62.6%, up from the pandemic trough of 60.2% in April of 2020. For March, hourly earnings rose 4.2%, below the recent wage inflation numbers averaging greater than 5% and indicating a slight cooling in wage inflation. The still hot jobs market, despite the Fed’s hiking policy, is keeping pressure on the Fed to raise rates higher. We see the fed raising rates 25 basis points in May and then holding rates steady. The recent jobs number showed the first signs of a labor market finally returning to reality.
Retail sales in February decreased .4% from the prior month, worse than estimates for a .3% decline as consumers pulled back spending on goods in response to inflationary pressures. Annualized retail sales were up 5.4% over the past year compared to the consumer price index’s measure of inflation up 6%. Gasoline station sales’ hit to discretionary spending finally abated as crude prices fell, with gas sales down 1.9% over the past year. Department store sales were up 2.5% from the prior year. E-commerce and mail-order houses ended the 12-month period with an 8.5% sales gain. Auto sales were down .8% from the prior year. Restaurant spending was up 15.3%, furniture store sales were up .1%, health care spending was up 8% and clothing and accessories were up 4.3%. Despite a return to spending on restaurants and services since the pandemic shutdowns concluded, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing.
Equity markets continued the rebound off October market lows during the first quarter. Stock market bulls bought the first signs of a peak in inflation expectations on the belief that the Fed’s tightening cycle will end next quarter and that the economy will not experience a significant earnings correction. With the technology sector accounting for 70% of the S&P 500 return in 2023, we view the lack of broad market participation as a sign of a market closer to a top than an ultimate bottom. In our opinion, equity market levels should reflect expectations on the future path of earnings and move away from the equity market’s current focus almost solely on levels of interest rates and fed action. While forward P/E multiples have come down following the bear market of 2022; a key question is have they come down enough to discount a confluence of economic challenges as the Fed moves the economy away from the easy money and stimulus spending of the past decade? One reason for our caution is the disconnect between Wall Steet analysts, who have yet to price in any appreciable decline in forward earnings estimates for 2023 or 2024, with Wall Street strategists who are not yet convinced that current projections for earnings growth in both 2023 and 2024 will hold. We prefer to wait on the real possibility for downward earnings revisions, beginning with this quarter’s earnings season, before getting more constructive on equity markets. However, equity markets have discounted a considerable amount of economic uncertainty during the current bear market and are well through most of this painful correction.
Within the fixed income markets, March of 2022 initiated a major shift in Fed policy as interest rate liftoff began in March of last year and is probably a couple months away from a pause in the feds interest rate tightening program. With core inflation currently running around 5.5%, we expect the fed funds rate to end 2023 around the fed’s telegraphed rate of 5.00% to 5.25%. Inflation is remaining sticky while economic growth concerns and banking liquidity issues are now beginning to take center stage. As inflation peaked in the summer of 2022, and following soft jobs opening numbers and slowing manufacturing indexes for February; interest rates have corrected off highs reached during the fourth quarter. Following these developments, the 2-year treasury started 2023 at 4.43% and has fallen to 3.76% today. The 10-year treasury has fallen from 3.88% at year end to 3.29% today while the 30 year treasury has fallen from 3.97% to 3.56%. Fixed Income market strategists now see the fed funds rate hitting 5.1% by year end 2023, while remaining above 3% well out to 2025. The Moody’s Seasoned Aaa Corporate Bond yield, currently at 4.41%, is at the highest levels seen in a decade, but has fallen from recent highs in November as inflation is showing signs of slowing and investors are starting to anticipate a rate environment that might be peaking. In our opinion, the fixed income markets still offer yields that provide an alternative to equity only investing that has not presented itself in the last decade’s low interest rate environment. They also offer defensive positioning to higher probabilities for a coming recession and the potential for lower corporate earnings in the near term.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.