Wealth Insights | Weekly Market Analysis | Economy | Equities
Weekly Market Analysis: 2023's Higher Hurdles
Posted on3 Things to Know
Skeptical on the Fed's projections
The Fed expects the US to weather its strategy to beat back inflation without material damage to the economy. CIO doesn’t think the Fed’s economic projections are any more accurate today than they were in 2021. When the Fed does cut rates – an event we expect toward the end of this year – it will be doing so to prevent further damage to job creation and fixed income markets.
Fed's actions not fully discounted
CIO believes 2022’s 19% loss in global equities and 16% loss in global bonds significantly revalued and boosted future return opportunities when measured over a year or more. However, CIO is skeptical that the scope of the Fed’s actions to slow the economy have been fully discounted in equities markets. The cost of capital for investment grade US borrowers doubled from 3% to 6% last year. Of course, equities didn’t fall 19% in 2022 amid rising profits without these fears in mind.
The higher cost of capital
Liquidity constraints in the fixed income markets are having meaningful knock-on effects on domestic equity return requirements for those investors willing and able to take long-term risks.
Summary
In this period replete with New Year’s resolutions, markets tend to focus on what can change for the better. CIO believes 2022’s 19% loss in global equities and 16% loss in global bonds significantly revalued and boosted future return opportunities when measured over a year or more. Early positive market performance in a given year does not correlate with full year returns, however. The cost of debt and equity capital is rising, not falling. CIO’s EPS estimates are around -12% relative to market consensus. With December’s positive job growth supporting markets, there is likely to be a reckoning. Equity markets have not bottomed before a recession has occurred. The track record of the yield curve (90% of recessions correctly predicted since 1960) is certainly better than the track record of economists.
Portfolio considerations
The combined impact of sharply higher rates, reduced lending by the Fed in credit markets, and a future economic slowdown suggest CIO should seek to focus on earning high-quality income from our investments, rather than pivot to high risk/return opportunities too soon.
Source: FactSet as of Jan. 4, 2023. Indices are unmanaged. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real Results will vary.
Skeptical on the Fed’s projections
It would be ideal if we could begin 2023 by saying “let’s invest now for the coming economic recovery.” But that isn’t what the Fed wants to see markets plan for. The Fed expects the US to weather its strategy to kill inflation without material damage to its economy. CIO doesn’t think the Fed’s economic projections are any more accurate today than they were in 2021 or in 2018. When the Fed does cut rates – an event CIO expects toward the end of 2023 – it will be doing so to prevent further damage to job creation and fixed income markets. This “boom and bust” pattern in the economy appears more closely aligned with the extremes of monetary policy easing and tightening over the past few years. This seems to be the pattern we are in now, especially if there is a rate reversal in our near future. This underscores our question: Are we really at the stock market bottom when the economy has further to weaken? Does the market properly value lower earnings and higher short-term rates than the yield curve anticipates?
Fed’s actions aren’t fully discounted
CIO believes 2022’s 19% loss in global equities and 16% loss in global bonds significantly revalued and boosted future return opportunities when measured over a year or more. However, CIO is skeptical that the scope of the Fed’s actions to slow the economy have been fully discounted in equities markets. The cost of capital for investment grade US borrowers doubled from 3% to 6% last year. Equities didn’t fall 19% in 2022 amid rising profits without these fears in mind. The combined impact of sharply higher rates, reduced lending by the Fed in credit markets and a future economic slowdown suggest there is a wide range of possible outcomes ahead of us. The most recent December employment data suggests resilience in labor with 223,000 new jobs added. Meanwhile, CIO’s EPS estimates for 2023 are around 12% below the consensus of industry analysts, suggesting there is a downward skew to future market action. The combined impact of sharply higher rates, reduced lending by the Fed in credit markets, and a future economic slowdown suggest CIO should seek to focus on earning high-quality income from our investments, rather than pivot to high risk/return opportunities too soon.
The higher cost of capital
Liquidity constraints in the fixed income markets are having meaningful knock-on effects on domestic equity return requirements for those investors willing and able to take longer-term risks. CIO expects over-leveraged businesses that require significant new capital, or that operate dated business models, may face real financing challenges. Financings via “collateralized loan obligations” that buy and own as much as two-thirds of the leveraged loan market may not be able to absorb as many new loans as they did last year. Private credit lenders, which generally have much more flexibility, are also reportedly becoming increasingly picky by reducing their loan amounts versus borrower asset values, avoiding certain sectors altogether and charging much higher yields when they do lend. All this data suggests that the rate investors demand for taking risk is rising, not falling, presenting a headwind for markets in the US.
Portfolio considerations
The earliest data for returns in 2023 suggest the outperformance of quality income that characterized 2022 is continuing this year. China shares have led performance early in 2023 after a hard landing in 2022. This is due to Covid policy changes that, while risky, indicate the extent to which policy makers want to see the world’s second-largest economy reopen. China’s much looser monetary policy will also accelerate growth as the year progresses. Ironically, CIO believes US markets will follow China higher in time given the mirrored – if time-lagged – similarities in the policies both are likely to follow. Europe, meanwhile, is providing an upside surprise in 2023. Investor outflows in 2022, lower valuations and a clearer onset of recession last year put Europe’s markets in a better place for recovery this year.
