Market Recap – Q1 2023
Despite the stress in the banking system, global equity markets held up remarkably well in March and posted solid returns for the quarter. The S&P 500 index was up 3.7% in March and gained 7.5% in the first quarter. Developed international stocks (MSCI EAFE Index) did a bit better, rising 8.5% for the quarter (and returned 2.5% in March). Emerging markets stocks (MSCI EM Index) gained 4% for the quarter and rose 3% in March.
Underneath the calm market surface there was wide dispersion in returns across sectors, market caps and styles. Large-cap growth stocks (Russell 1000 Growth Index) gained 14.4% in the quarter, while the large-cap value stocks returned 1% (Russell 1000 Value Index). The Nasdaq Composite Index surged 17%, while the Russell 2000 Small Cap Value Index dropped 0.7%.
Fixed-income markets had a strong quarter as longer-term bond yields fell, generating price gains. Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) returned 3%, as the 10-year Treasury yield fell to 3.5% from 3.9% at year-end. Riskier high-yield bonds outperformed core bonds, gaining 3.7%. Municipal bonds gained 2.3% (Morningstar National Muni Bond Category). Cash and cash equivalents, such as money market mutual funds, short-term CDs and U.S. Treasuries, continued to be attractive low risk options for investors, with rates recently between 4%-5% for maturities of 12 months or less.
Investment Outlook and Portfolio Positioning
With above-normal inflation and the Fed sharply tightening, the short-term outlook for economic growth was already poor coming into the year. Add to that the negative impact from tighter credit conditions due to recent stress in the banking system (i.e., Silicon Valley Bank, Signature Bank, First Republic, etc.), and the growth outlook has gotten worse. A U.S. recession this year is not a certainty, but weighing the available evidence, we believe it is still a very real possibility.
In an economic recession, it is almost certain that corporate earnings will decline. S&P 500 index earnings typically decline around 15% to 20% (peak-to-trough) during economic recessions as both sales growth and profit margins compress. In a mild recession, the earnings decline might be closer to 10% to 15%. Yet the current consensus earnings expectations for 2023 do not reflect nearly that magnitude of decline; nor do current stock market valuations. Continuing strong employment and wage data in the early part of Q2 may have a fair amount to do with this. With consumer spending still strong and representing roughly 70% of U.S. economic output, the unemployment rate may have to rise materially for behavior to change and the economy to experience more than a mild recession. Of course, one-off events (debt ceiling negotiations) or a prolonged banking sector crisis would throw all normal economic forecasts out the window.
We believe 2023 will present us with some excellent long-term investment opportunities. Unfortunately, most pundits expect we’ll have to go through at least a mild recessionary period with some degree of drop in global equity prices. While a recessionary bear market is the most frequently quoted base case, we do not rule out the possibility the U.S. economy avoids recession this year, or that the recession is mild, and stocks do not drop as sharply.
A lot still depends on the Fed and how much further they tighten (raise rates). If the Fed pauses their hiking campaign sooner than later, equities may positively respond (at least over the short-term), as lower interest rates imply higher P/E multiples. But there are numerous other key variables for the economy and financial markets that are beyond the Fed’s or any policymaker’s control.
As always, we thank you for your trust and welcome questions you may have.