Article originally published on: https://advisorstream.com
A wide range of equity market outcomes lies ahead for the remainder of 2023, and flexibility will be paramount to navigate this volatility. The saying “when the facts change, I change my mind” has never been more important.
There are several critical questions surrounding the market outlook: What are the implications of the current stress in the U.S. banking system? Will the U.S. enter a recession? Will inflation reach the Federal Reserve’s target of 2%? What level of earnings will the S&P 500 achieve this year?
Investors need to consider present volatility against a long-term backdrop of opportunities and challenges. Global investors have recently focused on the banking system following the failure of three U.S. banks, including Silicon Valley Bank, the country’s 16th-largest bank by assets, and the regulator-driven sale of 167-year-old Credit Suisse, the world’s 45th largest bank by assets. Credit Suisse ’s acquisition by larger rival UBS in a deal worth $3.2 billion took significant stress out of the global banking system. Still, fears of further systemic issues have roiled markets, even as Fed and Swiss banking authorities responded swiftly to instill confidence. Assuming these bank failures remain contained, the key question for investors is, what measures will the Fed take next?
It’s been argued that the Fed’s aggressive monetary tightening has put stress on the banking system. While continued monetary-policy tightening was previously well-accepted, today that appears far less likely. In fact, the market has started to discount cuts before year end, and the “Fed pivot” narrative has returned. The Fed does not want to magnify stress in the banking system, but its goal of containing inflation has not yet been attained and cutting interest rates too quickly could reaccelerate inflation. I believe the Fed will remain vigilant on inflation and expectations of rate cuts are premature. But realistically the odds of the Fed cutting rates this year have risen.
The chance of a U.S. recession has been the primary unknown for investors. The topic hovers over markets and dampens optimism.
Once the U.S. yield curve inverts, as it did in October, a recession has typically followed within roughly 12 months, according to the World Economic Forum. The U.S. bond market has a near-perfect track record in predicting recessions, but could this time be different?
Equity-market sentiment has improved since the fall. Strength in key consumer indicators such as the unemployment rate, wage growth, and spending has given investors reason for hope that a recession may be avoided. While this may be possible, these same consumer factors stoke inflationary concerns for the Fed. That means the risk of a recession remains high.
Inflation is likely past its peak, but how fast will it fall and to what level? This is one of the most important variables to consider and one of the most difficult to forecast. The Fed was one of the last major institutions to realize inflation was a persistent problem that needed addressing. Its response was ultimately aggressive but late, requiring more drastic measures.
The Fed holds its inflation target of around 2%, which seems unrealistic. Inflation is likely to prove sticky as labor supply challenges lead to wage inflation and services demand remains persistent. In this context, markets will likely have to gain comfort with inflation closer to 3%, or even 4%, compared to the sub-2% we have enjoyed for years.
Another wild card is China’s reopening. The country’s significant easing of its controversial zero-Covid policy and its increased support for the property sector are positive for both the Chinese economy and the global economy, given China’s important role in global supply chains. While China’s reopening may help stave off a U.S. recession, it’s also possible that the return of Chinese demand could worsen the inflation problem in the long run. It’s hard to say exactly how it will shake out, but at a minimum China is likely to keep inflation above the Fed’s 2% target.
Earnings also remain a concern for investors, as stock prices typically follow earnings. Earnings expectations for the S&P 500 have fallen over the last few quarters. Last summer, the market forecast earnings of roughly $250 per share in 2023, and more recently, expectations have fallen closer to $225. This has been a significant headwind for the market to navigate.
Earnings could decline further and will likely continue to be a source of concern this year. For some industries, such as banks and consumer durables, inflation is becoming harder to pass on in pricing, which could lead to margin pressure. The health of the consumer remains a large factor, and while spending trends remain strong, a meaningful slowdown is a real possibility. The Fed’s aggressive tightening has yet to be fully metabolized and will likely further dampen earnings power. While there is earnings risk from current levels, the downside should be moderate. However, the lack of upside is a challenge for equity markets.
So, what to do? In simple terms, be more active—buy weakness, sell strength. This is not a one-decision market anymore. That strategy of buying every dip worked well in the era of easy money, but investors now need an active approach. Success will be determined by the ability to find companies with better fundamentals than the market appreciates, not by factor exposure.
Despite the uncertainty, astute investors may still find pockets of growth, especially in areas of the market with idiosyncratic opportunities. The health-care sector appears particularly appealing due to its durable spend and innovation in devices, services and biopharma. Energy could benefit from tighter supply and strong demand. Additionally, U.S. small-cap stock valuations are at a near-decade low relative to large caps, which is appealing.
In the near term, volatility is expected to reign as inflation, labor, and earnings pressures persist. However, investors must pay attention to the data, especially as the year progresses. Stick to company fundamentals and, again, remain active. If the Fed accomplishes its mission to tame inflation, prepare for the upside, and if not, buckle up for the bumpy ride ahead. Either way, the winds can change quickly.