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What a (Debt) Relief

After a May dominated by escalating concerns of a potential default on government debt, investors were relieved when a debt ceiling deal was reached to end the month. While the negotiations grabbed much of the headlines, market moves continued to be driven by questions about the trajectory of the economy, inflation and Fed policies. Equity markets were mixed for the month with the large cap US technology stocks again posting strong returns while more economically sensitive segments and non-US markets saw declines. Interest rates rose steadily during the month in response to the default worries, but fell sharply to end the month once the outline of the deal became clear. On the economic front, June’s employment report showed a still strong labor market, but the unemployment rate increased and corporate earnings continued to soften.

Equity Returns: May and Year-to-Date 2023

Stocks posted mixed returns in April. The NASDAQ returned to the top spot for the month, rising 5.93% and pushing its year-to-date return up to 24.06%.³ Enthusiasm for rapidly advancing AI applications pushed related stocks up sharply and greatly narrowed the breadth of the market leadership. The broader S&P 500 index was up just 0.43% in May and the Dow fell 3.17%.⁴ In the US, the economically sensitive small cap sector, especially its value half, posted negative returns for the month.⁵ Outside of the US, developed and emerging market equities fell over 2% with returns especially weak across Europe.⁶

Among sectors, gains were concentrated in technology and communications stocks. All other sectors posted negative returns, with performance especially weak in Energy (-10.61% for May), Materials (-7.11%) and the defensive Utilities and Staples sectors (-6.36% and -6.21%, respectively).⁷ So far this year, the Tech sector has accounted for 83% of the S&P 500’s gain, with the top eight performing stocks (in info tech and communications services) accounting for all of the gains.⁸ The spread between the dominant tech and communications mega cap companies and the broader market, as well as the hype around AI technology, reminds some of the dot com experience of the late 1990s which ultimately delivered a few winners but produced disappointment for the segment as a whole.⁹ Still, another factor boosting the relative performance of these companies so far this year is the tendency for investors to favor higher “quality” companies (those demonstrating steady and more resilient profitability) when economic conditions and corporate earnings weaken.

Fixed Income Returns: May and Year-to-Date 20233

‍With rising rates across maturities for most of the month and another 25 basis point increase in policy rates by the Fed on May 3rd, fixed income returns were weak across the board.¹⁰ The year-to-date performance of the major segments remains solid and a marked change from 2022, however. Markets seem to be pricing in no increase in rates by the Fed in June and indeed expecting rate cuts by the end of the year despite Fed Chairman Powel noting that the Fed did not expect to lower rates this year.¹¹

Now back to the economy 

So far in 2023, investors seem to have priced in a soft landing for the US economy. Given the 5 percentage point increase in interest rates by the Fed since early last year and the reduction in their securities holdings, most economic models would forecast a recession in the current year. The Fed’s own forecasts point to a mild recession starting later this year.¹² Many measures of economic activity remain strong, however, most notably the still tight labor markets. 339,000 jobs were added to non farm payrolls in June, well above economist estimates.¹³ The unemployment rate edged up 0.3% to 3.7% on a decline in jobs and a steady labor force (these numbers are from a different household - rather than establishment - survey).¹⁴ Many observers consider employment measures to be lagging rather than leading indicators of economic activity. The Conference Board’s Leading Economic Indicator index (LEI) does not contain either the payroll employment figures or the unemployment rate.¹⁵ The LEI for April (released on May 18th) was down for the thirteenth consecutive month and continues to signal contraction of economic activity starting in Q2 leading to a mild recession by mid-2023.¹⁶

Other measures also show the economy continued to grow through the first quarter. The second estimate of Q1 2023 GDP growth released on May 25th showed a 1.3% increase in economic activity, down from 2.6% in Q4 2022, but clearly not in recession.¹⁷ The GDP growth was bolstered by still rising consumer spending. April retail and food service sales were up 0.4% in April from March and 1.6% above levels from a year earlier.¹⁸ With consumption driving about 70% of US GDP, the behavior of consumers will determine the path of the economic cycle. And, since consumption is closely linked to employment and wages, the trajectory of those indicators will be key.

On the other hand, the signs of slowing are seen in tighter credit conditions, weak consumer expectations, and declining new manufacturing orders and hours worked.¹⁹ Declining orders and hours worked in manufacturing go hand in hand and would signal a coming weakening in corporate earnings. So far, however, earnings have held up, with Q1 results for the S&P 500 up 4.8% over Q4 2022, although estimates for Q2 earnings expect a 1.1% decline from the Q4 levels.²⁰ For equity markets, which ultimately discount future earnings, these patterns will matter greatly. While a mild recession and weaker corporate earnings may ultimately unfold, so far this year investors have signaled a different opinion. 

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FOR IMMEDIATE RELEASE

SAN FRANCISCO and NEW YORK –  05.30.2023

Alternativ Wealth (alternativ-wealth.com) – a next-generation wealth management company with over $500 million in assets under management – has announced the addition of Tim Hamilton, CFP^®, CIMA^® as Managing Director, Senior Wealth Advisor, and a member of the Investment Committee. 

Founded in 2012, Alternativ Wealth purpose built its team, expertise, and resources to serve successful founders, executives, business owners, and professionals who have busy schedules and complex financial lives. 

“Our unique combination of technology and talent across wealth and investment management, is what enables us to hire world-class wealth management professionals like Tim” said Alternativ Wealth CEO Christian Haigh. “We’re tremendously excited to have Tim join Alternativ Wealth as Managing director and look forward to the massive impact he’ll make on our growing firm.”

Tim Hamilton brings more than fifteen years of wealth management experience to Alternativ Wealth, including operations, trading, financial planning, investment management and client management roles.

“Over my fifteen years in the industry, I have gained a deep understanding of what clients are seeking in a wealth advisory relationship and how to best empower my clients for future success” said Tim Hamilton. “I decided to join Alternativ Wealth because of the amazing team and their client-centric approach to wealth management.”

Wait and see

After a strong first quarter, equity markets cooled in April as investors sought to balance concerns about a weakening economy with expectations that the Fed was nearing the end of its tightening cycle. Amidst the uncertainty, stocks managed to eke out modest gains for the month in most segments. These gains came with notably lower equity market volatility, with the VIX index ending the month at 15.78, the lowest month-end level since December 2019.¹ Interest rates were also little changed over the month, with Treasury yields down 4 basis points for the 10-year and 2 basis points for the 2-year.² The relative calm in stock and bond markets may reflect investor caution on betting too strongly in either direction on the path of interest rates and economic conditions.

Equity Returns: April and Year-to-Date 2023

Stocks posted mixed, but solid returns overall in April, led by a 2.57% gain for the Dow, which had lagged substantially in Q1.⁵ The broader S&P 500 index was up 1.56% while the NASDAQ rose just 0.11% after gaining over 17% in the first quarter.^6 7 In the US, the economically sensitive small cap sector continued to lag in April as concerns about the slowing economy increased.⁸ Outside of the US, developed market equities gained 1.7% with stronger gains in Europe and weaker results in Asia and Emerging Markets.⁹

Defensive sectors (consumer staples, healthcare, utilities) led the market in April after a weak first quarter.¹⁰ Cyclical sectors (industrials, consumer discretionary and materials) posted slightly negative returns for the month. Technology stocks cooled in April, but are still up over 20% for the year. The communications services sector posted the highest return for both the month and year-to-date, bolstered by strong Q1 earnings results from Alphabet and Meta, the sector's two largest constituents. The financial sector rallied off of its lows as investors warmed to the idea that the worst of the troubles were behind the regional bank sector.

Fixed Income Returns: April and Year-to-Date 2023

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Fixed income markets continued to post positive returns across all segments with longer duration assets faring best.¹¹ Interest rates were little changed in April, rising steadily in the first half of April and then falling equally in the latter half of the month.¹² Markets seem to be pricing in another 25 basis point interest rate increase at the Fed’s May 2–3 meeting, but also expecting that will be the last one for this tightening cycle.¹³

Signs of a slowing economy? 

As has been the case for much of this year, April’s economic data painted a mixed picture. Inflation continued to ease but remained at a high level. The Fed’s preferred inflation gauge, the Core Personal Consumption Expenditure price index, was up 0.3% in April from March, but was still up 4.6% from a year earlier, well above the Fed’s 2% target.¹⁴ While pandemic influenced supply chain issues have certainly eased, continued tight labor markets and solid economic activity have kept inflation from falling faster. As a result, expectations that the Fed will actually cut rates in the second half of this year seem optimistic. Indeed, in his statement following the Fed meeting on March 22nd, Chairman Powell indicated, “The process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy.”¹⁵

The uncertainty of that path has much to do with the pace of economic activity. Growth is certainly slowing, but not yet contracting in most parts of the economy. Preliminary first quarter real GDP growth came in at 1.1%, down from 2.6% in Q4, with strong gains in consumer spending offsetting declines in corporate investment and inventory.¹⁶ Consumer spending drives the US economy and employment conditions underlie how strong consumer demand will be. Jobs increased by 236,000 in March and the unemployment rate remained at just 3.6%, signs that the labor market remains tight.¹⁷ Consumer spending is also influenced by changes in perceptions of wealth which can in turn be influenced by changes in home values, most households' largest asset. Home prices have been coming down since the middle of last year, with the most recent S&P/Case-Shiller National home price index off 5% since June 2022.¹⁸ On the corporate front, Q1 earnings released so far show a similar pattern – a slowing in earnings growth, but not yet a contraction.

It may be that we are just beginning to see the kind of slowing in the economy that will lead the Fed to end its current rate increase cycle in May. The glass half full scenario is that the rate increases so far will lead to a soft landing in the economy rather than a recession. This scenario seems to be what the markets have priced in. The glass half empty case is that continued strong growth keeps inflation high, forcing the Fed to keep rates “higher for longer”, a scenario that would certainly lead to downward pressure on most risky assets.

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A Hot Start

Despite several high profile bank failures in March and worries about tightening credit availability, stock and bond markets closed out the first quarter on a high note. Investors remained confident that easing inflation combined with the challenges in the banking sector will lead the Fed to be less aggressive with rate hikes for the rest of the year. At its March 22nd meeting, the Fed increased the target Fed Funds rate to 5% from 4.75%, matching the 25 basis point increase in February, but also reaffirmed its commitment to reducing inflation to 2%.¹ The debate now is whether the rate hikes implemented so far during this tightening cycle are enough to achieve that goal. February’s core inflation rate did ease slightly (the core Personal Consumption Expenditure index was up 0.3% from January after rising 0.6% the prior month) but still remains well above the Fed’s 2% target.²

Equity Returns: March 2023 and Q1 2023

Stocks posted solid returns for the quarter, led by a 17.05% rise for the NASDAQ composite index. The broader S&P 500 index was up 7.50% while the Dow, last year’s market leader, continued to lag, rising just 0.93% for the quarter.⁶ Small Cap stocks faltered in March, reflecting concerns about a weakening economy and higher exposure to the challenged regional banking sector.⁷ These index trends were reflected in industry returns. The technology and communications services sectors both rose over 20% for the quarter while defensive sectors (staples, utilities, healthcare) and energy stocks posted negative returns.⁸ The financial sector fell sharply in March after the troubles at Silicon Valley Bank emerged. Smaller banks were especially hard hit with the S&P Regional Bank index down almost 30% for the month.⁹ International markets also rose for the quarter with many European indices up double digits in dollar terms.¹⁰ 

S&P 500 Economic Sector Returns: March 2023 and Q1 2023

Fixed income markets rallied in March across all segments except preferred stocks as interest rates fell across maturities. The 2-year treasury yield fell almost 1% during the month and the 20-year yield declined 36 basis points.¹¹ Despite their weakness in March, preferred stocks posted the highest returns for the quarter among fixed income categories, up just over 4%.¹² Corporate bonds, both in the US and Internationally, also fared well, rising over 3%.¹³ While the strong returns for both stocks and bonds this quarter shows a continuation of the positive correlation that presented a challenge to standard asset allocation in 2022, there is some evidence that could be poised to change. In a recent research report, AQR found that, “historically, equity and bond markets have exhibited opposite-sign sensitivities to growth news and same-sign sensitivities to inflation news.”¹⁴ If that historical pattern holds, the current increase in recession concerns and the reduction in inflation worries could be accompanied by a return to negative correlation between equities and bonds.

Fixed Income Returns: March 2023 and Q1 2023

Overshooting? 

Underpinning the strong market returns in the first quarter seems to be a belief that the Fed is close to the end of its tightening cycle and that, if economic conditions weaken, interest rate cuts could be on the table this year. While that path for interest rates may indeed play out, we have not yet seen the kind of economic weakness that typically follows the substantial monetary tightening during the past year (rise in interest rates, removal of quantitative easing measures and the drop in the money supply).  By many measures, economic activity has remained remarkably strong (income and consumption increasing, employment and wage growth strong), but the impact from the past year of Fed tightening may just now be starting to show itself.^15 16 In fact, the Fed itself is projecting just a 0.4% growth in GDP for 2023, implying negative growth for the rest of the year.¹⁷

How much of an economic slowdown is priced into current asset prices is always challenging to know. Still, it is hard to see further multiple expansion if the economy and corporate earnings are poised to weaken. Investors will learn more as the mix of inflation and economic data and Fed policy plays out, but it seems warranted to remain relatively defensively positioned headed into the second quarter. 

Are we there yet?

After a strong January, equity and fixed income markets fell broadly in February. Investor optimism on easing inflation leading to a less hawkish Fed was challenged by still high price increases, tight labor markets and solid consumer spending. While many economic signals show deceleration, investors are rightly focussed on whether the pace of that deceleration is enough to put the Fed into a more neutral monetary policy stance. The Fed did indeed ratchet down the level of rate increases, raising the Fed Funds target rate 25 basis points at its February meeting, but also signaled that “a couple more rate hikes” are coming to get the rate to just above 5% in order to tame inflation that remains above the Fed’s target.^1 2 Longer term rates rose as well, with the 10-Year Treasury yield up 40 basis points over the month.³ A potentially higher path for interest rates than expected is what spooked the equity and bond markets in February.

Equity Returns: February 2023 and 2023 Year-to-Date

Equity markets fell during the month, with the S&P 500 index down 2.44% and the Dow off 3.94%.⁶ The NASDAQ continued to lead broader indices, falling just over 1% for the month.⁷ Only the technology sector managed to post positive returns for the month (up just 0.29%) while last year’s leaders, energy and utilities, fell sharply.⁸ International markets fared worse than the US, with emerging markets especially weak, off 6.67% for the month. ⁹

Fixed income markets also declined, with all but the shortest term treasuries posting negative returns for the month. Corporate bonds, both in the US and Internationally, fell over 3% for the month, almost wiping out their gains from January. Preferred stocks, which posted double digit gains in January, fell modestly in February, but remain up almost 10% for the year.¹¹

Easing inflation, but is it enough? 

Inflation measures are well off their highs from earlier this year, but the pace of decline has slowed in the past few months and prices in January increased from the prior month. The core CPI (less food and energy) rose 0.4% in January from December, but remains 5.6% above last year’s level. ¹² The Fed’s preferred inflation gauge, the Personal Consumption Expenditures price index, also rose in January from December and is now up 5.4% from a year earlier.¹³ As the table shows, both of these measures are well off the highs reached earlier this year, but investors are concerned that the pace of the year-over-year declines have slowed. Part of the issue the Fed is facing when trying to bring down inflation is higher prices (and wage gains) becoming entrenched in consumers’ and workers’ expectations. The February University of Michigan survey showed consumers expect 4.1% inflation over the coming year, down from last April’s peak of 5.4%, but disappointingly up from January’s 3.9% level.¹⁴ It is this gap between 4% inflation expectations and the Fed’s stated 2% target that has investors worried that the Fed will have to keep rates higher for longer.

Current and Expected Inflation

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Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Bank of Cleveland, University of Michigan^{15 16 17 18}

The tighter monetary policy has so far not resulted in an official recession. Consumer spending has remained strong, up 3% in January from December and 6.4% from January 2022.¹⁹ Labor markets also remain tight. With 97% of S&P 500 companies reporting, Q4 2022 corporate earnings are showing some weakness and expected to be down 1.7% from Q3 and guidance for the current quarter are trending lower.²⁰ Other indicators of economic activity are suggesting a broader slowdown. The index of leading economic indicators fell further in January and is indicating a likely recession in 2023.²¹ Another favorite recession indicator, the spread between 10 year and 3 month (or 2 year) treasuries is also indicating challenges. A negative spread (that is, higher short term rates than long term) is termed an inverted yield curve and has often been associated with a coming recession. The current spreads are close to -0.9% and have been negative since the middle of 2022.²² Still, Campbell Harvey, the economist whose research demonstrated the relationship, thinks that the tight labor market and strong consumer and corporate balance sheets could help the economy avoid recession this time, unless the Fed does not wrap up the current cycle of interest rate increases.²³

For markets and investors, the focus will remain on the path of moderating inflation, the income and spending of consumers and the resulting corporate earnings delivery. Even more importantly, the attention will center on how the Fed reacts to developments in these areas. It’s clear that a more dovish Fed and a soft landing or mild recession is baked into equity prices. If either of those dimensions show signs of worsening then asset prices will have to fall further to adjust. 

A Nice Start

Assets across the risk spectrum rallied in January as investors saw signs that easing inflation would allow the Fed to reduce the magnitude and duration of future interest rate increases while avoiding tipping the economy into a recession. Equity markets surged over the month with the S&P 500 Index up 6.28%, a welcome reversal of December’s weak returns and last year’s 18% decline.¹ Fixed income market also delivered positive returns, rising over 2% in all segments except the very shortest-term bills and bonds. While the Fed continued to push up short-term rates, longer-dated interest rates fell, with the 10-Year Treasury yield down to 3.52% from 3.88% at the start of the year.²

In the equity markets, there was a reversal in some of the leaders and laggards compared with last year. The NASDAQ composite index posted a 10.76% gain in December while the Dow Industrial index rose 2.93%, a substantial shift from 2022 when the Dow outpaced the NASDAQ by over 25%.^3 4 Small Cap Value stocks on the other hand continued their market leadership, rising 11.96% for the month, almost 5% ahead of the growth half of the small cap market.⁵  International stocks also resumed the rally that began in October, with the S&P Global ex US Broad Market Index up 7.85% in December with many European country markets up double digits.⁶

Equity Returns: January 2023 and 2022

Reversals in fortunes were especially noticeable among S&P 500 equity sector returns in January. The defensive industries (utilities, healthcare and staples) that fell the least last year were the only sectors to post negative returns in January.⁹   Conversely, the economically sensitive sectors that had sold off most last year fared best in January, with Consumer Discretionary and Communications Services stocks up over 14% for the month.¹⁰ While lagging the broad market, energy stocks still rose almost 3% for the month as oil prices have hovered around $80/barrel year so far this year.¹¹

S&P 500 Economic Sector Returns: January 2023 and 2022

Inflation, recession and earnings 

Inflation gauges have started to fall recently, giving hope that the Fed will be less aggressive with interest rate increases going forward. The core CPI (less food and energy) fell 0.1% in December from the prior month, but remains 5.7% above last year’s level.¹³  The core Personal Consumption Expenditures price index, which the Fed pays a bit more attention to, rose in December from November and is now up 4.4% from a year earlier (down from 5.2% year-over-year in September 2022).¹⁴ Consumer inflation expectations have also fallen, with the University of Michigan survey showing consumers expecting 3.9% inflation over the next year, down from 5.4% last spring.¹⁵ The improved inflation picture has indeed led the Fed to smaller rate increases (50bp rise at the December meeting and 25bp on February 1), but comments from Chairman Powell and other Fed members indicate they are very concerned with ending the rate increases too soon.¹⁶

The good news is that the sharp rate increases have not tipped the economy into recession so far. Consumer spending has slowed but employment growth remains extremely strong despite a steady stream of layoff announcements.^{17 18}  Corporate earnings have also held up relatively well. Based on the 44% of the S&P companies that have reported results so far this year, Q4 2022 earnings are expected to be up 3.2% over Q3, but 8.8% below the record level achieved in Q4 2021.¹⁹

Taking these elements together, we have, as always, some mixed messages for investors to digest. Slowing economic growth to defeat high inflation is what the Fed wants. They have suggested that they aren’t satisfied that they have accomplished that goal yet. Four percent annual inflation is not that close to their 2% target. Still, investors seem to have priced in a less hawkish Fed and at worst a mild recession early this year and relatively solid corporate earnings growth. The strong returns in January reflect that investor optimism. The risks for markets in the near-term are that even with the Fed ratcheting down interest rate increases in line with expectations, the slowdown in the economy and earnings could easily be greater than expected and asset prices will then have to adjust.