Growth for 2022 ended unexpectedly high, with inflation still too high and the investment community focuses on the Fed’s meeting next week.
U.S. equities were higher this week. The S&P 500 ended at the highest level since early December, increasing above its 200-day moving average. All sectors, except for healthcare and utilities, ended the week higher. Investors welcomed positive economic news that the economy might escape recession in 2023. Consumer discretionary stocks were strong, due to a big increase in Tesla shares over the week following a favorable outlook from CEO Elon Musk. The typically defensive consumer staples, health care, and utilities segments lagged. Recent comments from Fed governor Christopher Waller, a strong supporter for aggressive rate hikes, admitted that there area evidence of slowing demand and said that he would support a quarter-point rate increase at the Fed’s next meeting concluding February 1st. Friday’s inflation data came in line with expectations. The Fed’s preferred inflation gauge, the core personal consumption expenditures (PCE) index, excluding food and energy, rose 4.4% over the year, still above the Fed’s 2% long-term inflation target, but substantially below the 5.4% peak in February 2022 and the lowest in 14 months.
Treasuries ended the week weaker. The dollar index ended the week slightly stronger, while crude oil and gold prices declined. Asian stocks finished out the week with gains in light volume as mainland Chinese markets remained closed for the Lunar New Year holiday. The equity markets in Europe started the year with big gains, helped by warmer-than-expected winter weather which help the region avoid an energy crisis, China’s reopening, and expectations that central banks will refrain from aggressive tightening. The US economy demonstrated strong growth in the fourth quarter of 2022. The preliminary reading showed domestic product (GDP) rose by 2.9%. The increase was driven by a rebound in inventory accumulation, an increase in spending on nondefense and a larger fall in imports than exports. The rest of the report shows that growth slowed throughout the quarter as high interest rates weakened demand. As high interest rates negatively affect consumer demand, analysts expect economic growth to slow in 2023. Consumption growth slowed to 2.3% in Q4. Durable goods rebounded slightly, and residential and business equipment investment fell. Interest rate–sensitive parts of the economy remained under pressure, with residential investment declining again. We don’t expect the recent economic data to alter the Fed’s plans for further rate hikes. At next week’s Federal Open Market Committee meeting, analysts expect the Fed will hike rates by 25 basis points and keep rates higher for longer. The magnitude of the rate hikes going forward will remain “data dependent,” as the Fed has previously “broadcast” until it sees convincing evidence that inflation is meaningfully declining before stopping rate hikes.
The Q4 earnings season for the S&P 500 continues. Overall, 29% of the companies in the S&P 500 have reported actual results for Q4 2022 to date. Of these companies, 69% have reported EPS above estimates, but below the 5-year average of 77% and below the 10-year average of 73%. The number of S&P 500 companies reporting positive earnings surprises increased over the past week. If the index reports an actual decline in earnings for Q4 2022, it will mark the first year-over-year decline in earnings reported by the index since Q3 2020. On average, companies are reporting earnings that are 1.5% above estimates and if this number holds till the end of the reporting season, it will mark the second-lowest surprise percentage reported by the index since Q3 2012, trailing only Q1 2020 (1.1%). Margins for S&P 500 companies are forecast to average around 11.4% for the fourth quarter of 2022, according to FactSet. If that figure is maintained till all companies report it would mark the sixth quarter in a row of declining profit margins.
Negative earnings surprises reported by companies in the Financials and Industrials sectors were mostly offset by positive earnings surprises reported by companies in other sectors. Four of the 11 sectors of the S&P500 index are reporting year-over-year earnings growth, led by the Energy and Industrials. On the other hand, seven sectors are reporting a year-over-year decline in earnings, led by the Materials, Consumer Discretionary, Communication Services, and Financials. The forward 12-month P/E ratio of the S&P500 index is 17.8, which is below the 5-year average 18.5 but above the 10-year average 17.2. It is also above the forward P/E ratio of 16.7 recorded at the end of the fourth quarter December 31, 2022.
Equity and bond market volatility will remain elevated until there’s a meaningful and consistent decrease in inflation, and the duration of higher rates is more certain. We remain defensive in our positioning, and we’d look for opportunities to upgrade portfolios during market weakness. Within equities, we continue to favor U.S. Large Cap exposure, since China’s evolving COVID policies continue to weigh on manufacturing and growth despite reopening. We are more positive on Developed International equities, as the energy recession wasn’t as severe as anticipated. In the United States, we like equities that provide an attractive element such as quality, growth, and yield, albeit at higher valuations and as we expect earnings to deteriorate. For fixed income, we recommend a barbell positioning, with an overweight to short- and longer-dated bonds. We remain defensive in our credit positioning, with at benchmark duration, and higher in credit quality. We expect credit spreads to leak wider to account for recession risks.