This time last year, equity markets were reeling with losses not seen in years – the S&P 500 index hit an intraday low in mid-October, having lost roughly 26% of its value thus far in 2022. Investors feared an impending recession as the Fed had begun raising interest rates to combat high inflation. Deteriorating ties with China, which was still in COVID-lockdown mode, and the ongoing war in Ukraine contributed to the market’s dire mood too. Evaluating the then knowns, very few investors, if any, could paint an upbeat outlook for the market in 2023. Especially so, if you were then told that 2023 would witness the failure of three major banks, that mortgage rates would hit 8%, up from under 3% the year before, and that there was going to be another war!
Fast forward to today and headline market indices are up meaningfully, albeit featuring some twists and turns. Since hitting its low in October 2022, the S&P 500 provided a total return of 30% at its peak at the end of July 2023 and has returned almost 25% as of this writing; the S&P 500 Equal-Weight Index has delivered a total return of 13% since their 2022 lows. The strong market performance has defied a roughly 8% reduction in estimated 2023 earnings for the index, in effect raising valuation multiples.
Why so? Investors assigned a higher probability to rate cuts by the Fed in the second half of 2023 after the banking crisis hit in March. And expectations of an economic “soft landing” became widespread as economic data remained resilient, just as inflation readings started to decline. To add to it, large-cap Technology shares, which comprise a significant portion of the S&P 500 index, benefited from newfound enthusiasm around artificial intelligence (AI) and its prospects for technology earnings. Finally, new Fed facilities established in the wake of the banking crisis, and a simultaneous drawdown of the Treasury’s cash balances boosted systemic liquidity, likely supporting the market rally.
While markets have given back some of their gains, the still robust market performance might lead one to conclude that prior investor concerns had dissipated. Instead, many of the concerns from late 2022 are just as relevant today, if not worse. Geopolitically, while the war in Ukraine rages on, Hamas’ recent surprise attack on Israel has triggered a crisis that could spiral into something bigger, the odds of which are non-zero. Relations between China and the U.S. – the world’s largest trading partners – have worsened with the U.S. imposing new export bans on advanced chips and chip manufacturing equipment to China. Additionally, China’s economy has sputtered post reopening (from COVID) as negative wealth effects have come into play after the government’s crackdown on real estate. Importantly, consumer-related statistics in the U.S. are deteriorating as consumers have spent through excess savings and dialed up borrowings.
In our view, the Fed’s rate policy still bears the most attention. The current Fed Funds Rate range of 5.25%-5.50% is already higher than was anticipated by investors in late 2022 at less than 5%. Recent Fed commentary also suggests that rates may now remain higher-for-longer given continued strength in labor markets and in structural drivers of core inflation. While higher rates are already making their presence felt – banking crisis, higher interest expense/reduced earnings for companies – we wonder whether companies and governments are ready for rate increases after having seen them decline steadily for decades. Through the end of September, 516 U.S. corporations have filed for bankruptcies [i], notably exceeding the 321 and 263 bankruptcies seen in the same period in 2021 and 2022. On the government front, America’s net interest expense on its debt will exceed its defense budget over the next three years [ii]. And J.P. Morgan estimates that net-interest-payments-to-GDP is set to hit 3.2% by 2029, levels last seen in 1991 [iii].
Simplistically, equity markets have risen in the face of a growing set of risks, raising the potential for higher market volatility. One could certainly argue that the correction in late 2022 was overdone. But the appreciation in the market’s valuation multiple in 2023 in a rising rate environment is counter to historical experiences – valuation multiples typically contract when inflation is high and interest rates are moving higher.
An environment of risk and uncertainty also affords opportunities for patient investors. As we have shared in past missives, higher interest rates have already made increased allocations to fixed-income more attractive, especially on a risk-adjusted basis. And within the equity markets, opportunities are emerging in areas outside of the large-cap technology companies, which have handily outperformed the remainder of the market. As always, we remain focused on capital preservation during uncertain times and seek to utilize volatility to grow your wealth over time.