First Quarter 2023

Considering the long and variable lag of interestrate increases, we believe consensus forecasts may be overly optimistic and that stocks may remain rangebound for the near and medium term

Equities began 2023 with exuberance, as the worst-performing stocks from 2022 sparked a strong rally in the first two months of the quarter. Concerns regarding regional bank liquidity slowed stocks later in the quarter, and one of the largest bank failures in history led to significant treasury market volatility. The Technology, Communication Services and Consumer Discretionary sectors propelled the S&P 500 and Nasdaq 100 rallies, continuing the recovery that began last October. Seven of the eleven economic sectors produced positive returns, and large-cap growth stocks provided strong leadership: Apple +27%, Microsoft +21%, Nvidia Corp +90%, Tesla +68%, and Meta Platforms +76%. Developed-country stocks outperformed emerging-country stocks and were one of the quarter’s best performers. Bonds continued their recovery as longerterm yields fell sharply in anticipation of slower growth and lower inflation down the road, even as the Fed increased short-term rates. Overall, both stocks and bonds earned solid gains in the first quarter.

The Fed raised rates twice during the quarter for a total of nine increases since March of 2022. Inflation appears to have peaked last summer, with the Consumer Price Index (CPI) subsiding from a 9% annual rate to 5% currently. Progress has been made, but the process has been slow, and inflation remains far above the Fed’s stated 2% target. The manufacturing economy and housing sector have been contracting for over a year. Excessive savings have been reduced. Confidence among consumers, homebuilders, and small business is depressed. The aggressive rate-hiking cycle also exposed poorly managed banks and sparked fears of bank runs at regional banks. Bank turmoil is consistent with the idea that weak links are exposed by significantly higher interest rates.

The job market is still robust, especially within the service sector, with one of the lowest unemployment rates since the 1960’s at 3.5%. Consequently, the US consumer remains resilient in opposition to the Fed’s inflation fight. Evidence is rising though that wages are starting to moderate, with both Average Hourly Earnings (AHE) and Unit Labor Costs (ULC) showing a clear downward trend for about a year.

Expectations for Fed policy are varied and wide-ranging among both investors and economists. In the short term, most expect the year-end federal funds rate to range from 4.75 to 6%, but there is more variability in longer-term forecasts. The Fed’s 2025 forecast ranges from 2.5% to 5.5%, revealing quite a bit of uncertainty within the Federal Open Market Committee. Investors expect the Fed to increase rates by 0.25% in May before reversing course in July. Fed Chairman Powell insists otherwise, with a singular focus on driving inflation down towards 2%. In sum, we expect Treasury volatility to remain high and the Fed to remain data dependent, focusing on monthly continuing jobless claims and various service inflation indicators.

One year into the Fed’s rate-hiking cycle, tighter financial conditions have finally caught up with the economy and stocks. Profitability, while robust for S&P 500 companies, has been falling for a year after peaking in the first quarter of 2022. Overall pricing power is expected to fade, and earnings are expected to contract for the next two quarters before recovering later in the year. Considering the long and variable lag of interest-rate increases, we believe consensus forecasts may be overly optimistic and that stocks may remain rangebound for the near and medium term. Expectations for bond returns are more favorable as the end of the rate-hiking cycle begins to come into view. Investor patience and a focus on long-term objectives remains paramount as GDP growth slows and we evolve through the later stages of the business cycle.


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