February 2023
US Economy: Recession?
Fears of economic turbulence have yet to be realized, as US GDP grew 2.9% in the 4th quarter, unemployment has remained historically low and consumer spending is resilient (though softening), pointing to the possibility of a mild recession or a downturn that rolls through various sectors of the economy. Real estate, a key driver of economic growth, continues to decelerate dramatically and could dim the more optimistic outlook.
US Stocks: The January effect.
US large-cap stocks were soundly positive but small-cap stocks (+9.7%), typically more sensitive to inflation and economic growth, were the front runners with investors optimistic about valuations and inflation appearing on a downward trajectory. With that said, while most sectors were higher, defensives, which were strong throughout 2022, underperformed with utilities, health care, and consumer staples all down for the month.
Foreign Stocks: Surge continues.
Over the last three months, both developed (+20.4%) and emerging markets (+22.2%) have outpaced the US, a testament to the importance of rebalancing to maintain diversified allocations through market turbulence. The tailwinds for foreign equities: an 11% drop in the US dollar since last Sept., cheaper relative valuations, and indexes with lower allocations to the tech and consumer discretionary sectors.
Fixed Income: Fed delivers slower pace.
Bond market investors started to price in the likelihood that the Fed would begin to slow its pace of interest rates increases, driving up both taxable and tax-exempt by 2% to 3% in Jan. The Fed did raise rates only 0.25% at its Feb. 1st meeting – after six straight hikes of at least 0.50% — but indicated more rate increases are likely.
Real Assets: Bracing for stress.
Despite a potentially rosier economic outlook that lifted public REITs, the private real estate market has been beset by redemption requests, and real estate overall is bracing for additional stress. Infrastructure has been a standout performer, led by pipelines (+6.5%), boosted by the rollout of federal infrastructure spending.
Alternatives: Leaders to laggards.
Alternatives held up relatively well during 2022, posted middling returns while other asset classes lost ground. But in January, middling performance put hedge funds and other alts at the rear relative to other asset classes. Hedge funds were generally flat, while the marks for private equity and private real estate finally started to reflect the downturn traditional assets suffered through during most of 2022.
Source of data: Bloomberg
Equities Total Return
| JAN | 3 MOS | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | 6.3% | 5.8% | (8.2%) |
| U.S. Small Cap | 9.7% | 5.0% | (3.4%) |
| U.S. Growth | 8.4% | 4.6% | (15.5%) |
| U.S. Value | 5.4% | 7.1% | (0.5%) |
| Int’l Developed | 8.1% | 20.4% | (2.8%) |
| Emerging Markets | 7.9% | 22.2% | (12.1%) |
Fixed Income Total Return
| JAN | 3 MOS | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | 3.1% | 6.4% | (8.4%) |
| TIPS | 1.8% | 2.6% | (8.4%) |
| U.S. High Yield | 3.9% | 5.1% | (5.1%) |
| Int’l Developed | 3.0% | 10.5% | (17.5%) |
| Emerging Markets | 3.3% | 9.7% | (6.1%) |
| Tax-Exempt | |||
| Intermediate Munis | 2.1% | 5.4% | (1.0%) |
| Munis Broad Mkt | 3.1% | 8.2% | (3.7%) |
Non-Traditional Assets Total Return
| JAN | 3 MOS | 1 YR | |
|---|---|---|---|
| Commodities | (0.5%) | (0.3%) | 6.2% |
| REITs | 9.3% | 12.5% | (10.9%) |
| Infrastructure | 5.0% | 11.0% | 5.9% |
| Hedge Funds | |||
| Absolute Return | 0.1% | (0.3%) | 1.8% |
| Overall HF Market | 1.7% | 1.8% | (1.4%) |
| Managed Futures | (0.7%) | (5.9%) | 16.8% |
Economic Indicators
| JAN-23 | OCT-22 | JAN-22 | |
|---|---|---|---|
| Equity Volatility | 19.4 | 25.9 | 24.8 |
| Implied Inflation | 2.2% | 2.5% | 2.5% |
| Gold Spot $/OZ | $1928 | $1634 | $1797 |
| Oil ($/BBL) | $84 | $95 | $91 |
| U.S. Dollar Index | 119.1 | 127.8 | 115.6 |
Our Take
Historically, January has marked a renewal for financial markets. Whether that is related to new investment after the clearing of financial ledgers at year-end, bonuses being put to work, the unwinding of tax trades, or several other explanations, the month has been positive with some regularity, even if the “January Effect” has been muted or non-existent in recent years.
Does a good start to the year bode well for the rest of 2023? Not necessarily, although market sentiment seems to have improved recently. Historical precedent indicates the Fed not being able to bring down inflation without seriously damaging the economy. But a month into 2023, dire predictions for the economy are yet to materialize.
US consumers are not as flush as they were when wallets were stuffed with stimulus cash. But consumers continue to spend, drawing on savings and credit card borrowing. The economy can continue to push forward as long as we don’t see meaningful deterioration in the labor market, where job openings are currently plentiful and the unemployment rate is down to 3.5%.
With that said, we are not out of the woods yet. Fed rate increases, which started in March 2022, typically take 12 months or longer to have full impact. Historically, the US economy tends to slip into recession around the time the Fed pauses interest rate increases, and the market lows have been hit. There is still plenty of opportunity for the Fed to continue pushing rates up, potentially past the economic breaking point, especially given the lag in impact.
What’s more, a corporate earnings recession may be materializing. Profit estimates for 2023 are coming down: no growth in corporate earnings is expected for 2023, and a nearly 5% drop for Q4 2022 (vs. Q4 2021) results. While we are still early in the reporting season, fewer companies are beating estimates (70% vs. the 77% norm) and 88% of the executive teams providing outlooks have been negative vs. a five-year average of 59%.
As we have pointed out in our January Commentary, the geopolitical landscape has likely changed, with global cooperation on the decline at best (and open conflict at worst), and this can be expected to affect economies and markets. As a result, investors should not expect the low volatility of the last few decades, driven in part by the “peace dividend” and globalization, but should instead be prepared to exploit the opportunities presented by higher volatility amid a change in market regime.
Looking Forward
Many asset classes now offer valuations and/or yields that are more attractive than we have seen in many years. Below are some of the areas of interest:
- International equities — lower valuations relative to US stocks, cheaper relative to their own history, and could be facing less pressure from a strong US dollar.
- US small-cap stocks — modestly more attractive than their larger counterparts, and we envision adding to this asset class on a marginal basis as part of rebalancing.
- Strategies around new opportunities — these have emerged due to the pandemic and the war in Ukraine, including energy sourcing, supply chain restructuring, and food production.
- Credit markets — the spike in interest rates has created stress in some segments, and therefore, opportunities. The “income” has been put back into “fixed income.”
- Private markets – new opportunities in the private markets as distressed investors seek to sell stakes in illiquid partnership interests at a discount.
