The market rally this year has been impressive. Most asset classes have participated, and the laggards of last year have particularly outperformed. But last week it was a different ballgame as U.S. equities were lower, and the main indices S&P 500 and Nasdaq fell for the first time in three and six weeks, respectively. The S&P 500 and Nasdaq had their worst performance since mid-December. The S&P 500’s -1.1% retreat was the biggest weekly drop since mid-December. The NASDAQ posted a steeper decline of -2.4%; the Dow slipped about -0.1%. Value equities underperformed growth equities for the fourth time in the last five weeks. The dollar index ended the week higher, up by 0.6%. The US dollar tends to move in conjunction with investors' views on where U.S. rates are likely to go, and on how well the US economy is likely to perform relative to the rest of the world.
The yield curve inverted further—Bloomberg reported that two-year Treasury yields moved to their highest level over 10-year yields in four decades at one point on Thursday to 86 basis points —as fears persisted that the Fed would need to push the economy into recession in order to lower inflation. The yield on the benchmark 10-year U.S. Treasury note increased closing at 3.73%
U.S. central bank only raised rates by 25 basis points at its Feb. 1 meeting, making a downshift from a 50 basis points rate hike in December’s meeting and a 75 basis points rate increases earlier in 2022. The reason for slowing down was because inflation pressures in the U.S. have moderated and core inflation rates in other developed countries have also started easing. This is a positive development, and central banks are making progress in taming inflation. But as Chairman of the U.S. Federal Reserve Jerome Powell has indicated, there’s still more work to do in order to bring inflation back to its target range of around 2%. The Federal Reserve rate hikes are creating stricter lending conditions and weaker loan demand thus negatively impacting consumer purchasing power and slowing economic growth. Lending conditions have tightened particularly on mortgage, consumer, and commercial and industrial (C&I) loans. Furthermore, auto loan demand fell for a third straight quarter and credit card demand also fell. Banks will likely raise their lending standards for loans as they expect delinquencies to increase. According to analysts’ expectations economic growth will slow further in coming months.
We are approaching the end of the fourth-quarter earnings season with nearly 80% of the companies constituting the S&P 500 index having reported results. Earnings and sales results have come in better than expected but at the lowest earnings surprise rate in nearly a decade, excluding the COVID outbreak period. Of these companies, 69% have reported EPS that are 1.1% above estimates, which is below the 5-year average of 77%, and below the 10-year average of 73%. In terms of revenues, 63% of S&P 500 companies have reported revenues that are 1.4% above estimates, which is below the 5-year average of 69% but equal to the 10-year average of 63%. Technology and communication services companies have seen performance driven less by earnings or sales results and more by other factors. S&P 500 earnings for the quarter are expected to slow –2.3%, on a year-over-year basis, according to Bloomberg.
For 2023 analysts are estimating earnings growth of 2.5%. A decline in the first two quarters and growth in the latter two. The forward 12-month P/E ratio is 18.3, 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), as the price of the index has increased while the forward 12-month EPS estimate has decreased since December 31.
Equity and bond market will remain volatile until there’s a meaningful and consistent decrease in inflation as “data-dependent” Fed is now focusing on the cumulative effects of rate hikes. 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. We are more constructive on Developed International equities, as the energy recession wasn’t as severe as anticipated in Europe. In the United States, large cap equities provide a combination of quality and yield. We expect credit spreads to leak wider to account for recession risks.
According to reports “flows into mutual funds and related investment products showed outflows from global equities following four weeks of inflows, while bond funds continued to see steady inflows. Outflows from G10, including the US, drove most of the net selling this week. EM also saw net outflows, primarily from Mainland China. Flows into global fixed income funds remained positive, despite net outflows from government funds. Demand for short-duration bond funds turned more negative, while long-duration funds saw inflows.”
Coming next week there are important economic data to be released such as January’s Consumer Price Index on Tuesday, January’s retail sales on Wednesday and February’s NAHB Housing Market Index on Wednesday. Finally, earnings season continues next week with reports from The Coca-Cola Company, Airbnb, DoorDash, Marriott International, Cisco Systems, and Paramount Global, FirstEnergy Corp., SolarEdge Technologies, Palantir Technologies, and Avis Budget Group among others.