Market Commentary | Q1 2023 Halftime Report


Sam Chaplin:

Hi everybody. My name’s Sam Chaplin. Today is February 16th, 2023. We’re coming to you with our halftime report for the first quarter here. You might have noticed in the past, we usually release our commentaries towards beginning of the quarter but we’re now writing commentaries at the beginning of the quarter and then these halftime reports halfway through to keep you updated on what’s happening in the markets. As always, I am joined by our Chief Investment Officer and Founder James Bradley.

James Bradley:

As always, I’m happy to be with you, Sam.

Sam Chaplin:

Great. So I’m going to try to keep it short and concise for you here as we can. But there’s a lot going on in the markets so we will do our best to keep it moving.

Our agenda here, we’re going to look at the economy, we’re going to look at what’s going on in the markets and we’re going to look at our general outlook that we’re having from our PFA investment committee research.

First off, the biggest thing to notice, and as I’m sure most of you have noticed now, is this balancing act going on for the Federal Reserve, trying to balance economic growth and price stability. We had a lot of inflation since beginning of 2022 really as we’ll take a look at. And the Federal Reserve is trying to balance between keeping prices stable, hiking interest rates enough so that it quells enough demand that demand slows down and isn’t causing as much inflation. But the problem is if you hike interest rates too much now you’re going to slow the economy to the point of recession. So they’re just trying to balance that act of high enough interest rates to quell inflation without being so high that growth gets slammed.

So on the next slide here, we can take a look at GDP growth. We did have those two negative quarters in the middle of 2022, which had a lot of people talking about a technical recession, which is technically the term. We’ll take a look at some of the other recession indicators and see how those are looking. But we did return to positive GDP growth in the last two quarters, ’22 and about 3% gains there, which is pretty typical for trendline GDP growth. Hard to tell on this chart because there’s two massive swings during COVID really blow up the scale in this chart and we can’t tell what’s going on anymore. But pretty average growth in the last couple quarters.

So before we jump into what’s happening in this inflation cycle, we wanted to give you a rundown of what a typical inflation playbook looks like, what typically happens, and we can then compare and contrast how this cycle is the same or different from previous inflation cycles. So this is pretty simplified, but on a long enough timeline of inflation, this is what generally happens. So we’re seeing inflation in the economy. There’s too much demand for not enough supply that’s causing prices to rise. The Federal Reserve has a tool to try to quell demand. They can’t do anything about the supply side, but they can try to quell demand by raising interest rates. You can think of how much mortgage rates have gone up, credit card rates, personal loans, any of that stuff. And as those interest rates come up, businesses and consumers spend less money and that helps balance the supply and demand imbalance.

Next what typically happens is companies start downsizing their workforce. Those companies are now faced with higher cost of borrowing. They’re also seeing a slowing economy because of those higher interest rates so their revenues are likely to go down in the future. So they start hunkering down for a recession. One of the ways they do that is by going from a really expansionary workforce to one that’s more scaled down for the economy that they’re expecting to be in.

After that consumer spending declines typically. Some people are being laid off, which slows consumer spending. Some people are seeing other people being laid off and they start to worry about their job security and they cut back on their spending. So first companies usually slow their spending and demand and then the consumers after that. Eventually the Fed has hiked interest rates so much that people are starting to have growth concerns. Now are those interest rates so high that it’s going to put us into recession? And as the economic growth starts to slow, they turn around and cut those interest rates. Historically, they typically do cause recession from those interest rates and have to cut them to correct for those interest rates slowing the economy so much.

So that’s what typically happens in inflation playbook. We’ve seen some of this and some of it has not been playing out as expected. So I’m going to kick it over to Jim first talk about inflation and interest rates.

James Bradley:

So relative to that playbook, where exactly are we?

And looking at this slide, if you look at the bottom, you’re seeing how interest rates came way down during the beginning of the pandemic and they’ve crept back up from a Fed funds rate standpoint to offset some of the inflation. And up top you see what that’s done. So the increasing interest rates clearly over the recent period have resulted in a decline in that inflation line which is good but you can also see pretty plainly that that decline has flattened more recently. And I’m sure the Fed is looking at that.

And going to the next slide here, you can get a sense as to what’s going on behind that flattening. We see that goods disinflation, in other words, the stopping of those price increases of goods that you buy, whether it’s lumber or groceries or appliances or what have you, those have come back down to I’d say long-term normal levels as far as their price growth. And the Fed has made remark of that. But the blue line here, that’s the CPI services less energy services. And basically what they call the services number. And that’s clearly not coming down. That’s still on its way up. So the prices people are paying for goods is slowing. The prices that people pay for services is still problematic and we think you’re going to see the Fed be very stubborn in how they handle that when they’re looking at it.

If we look at the jobs numbers on this graph, that’s another thing that the Fed is keeping its eye on. They want to control inflation but not at the risk of big damage to the economy. They’d like to keep people employed if possible. Well, that doesn’t seem to be a problem. Unemployment has declined. It continues to decline. And we had a breakout jobs number a week or so ago that showed unemployment that really record lows. It’s right now at 3.4%, lowest we’ve seen in most of our lifetimes. And yet job openings remain pretty high. We still have a situation that we’ve been dealing with for well over a year now where the number of people looking for jobs is half as many as the jobs that are open out there. So the Fed probably is not going to be worried too much about continuing to raise those interest rates to fight inflation because they’re not putting us immediately into a jobs problem.

And when we look at the consumer, they’re doing their part in keeping the economy going right now. It’s very difficult to make the case for us being in a recession rate now when again, jobless numbers are so low, the consumer is still out there spending. One thing that’s notable is that a lot of that spending – and notable and maybe a little bit troubling – that a lot of that spending is going on credit. That could be a result of the higher prices that people are paying for the same goods and services that they purchased a couple years ago. And so while we see retail sales continue to climb, a lot of that’s going onto consumer credit. And that’s perhaps a little bit of an indication that a lot of the stimulus money that got put onto the economy has actually started to dry up.

Sam, I’m going to throw it over to you and why don’t we talk a little bit about the markets.

Sam Chaplin:

Yeah, so what are the markets supposed to do? We got this counterintuitive issue where inflation’s coming down but the economy still remains really hot between the consumer spending and employment. So it’s hard for the Fed to let off the interest rates while the economy remains hot. And really that volatility in interest rates expectations has been what’s driving a lot of the market performance recently. You can see here on top the 10-year Treasury rate going up pretty significantly since the beginning of 2022. And on the bottom, a really inverse relationship with the US Bond Index actually having its worst year since inception of that index last year, hitting a low of down 16.82%, rebounding a little bit over the last few months. A really poor year for the bond markets. But it’s breeding a lot of new opportunity where there’s some really attractive interest rates out there now for people who are willing to buy them and it’s making fixed income a more appropriate alternative for equities. Last year we were saying bonds were going to get hammered, so there was no alternative to equities. This year you can get an investment grade bond at 5%, which is a pretty good alternative to equities.

Moving over to the equity performance, US stock performance on here, we got the Dow Jones on top S&P 500 in the middle in the NASDAQ on the bottom. A couple things to point out here is one, not all indexes are created equal. Depending on which one of these indexes you’re following, there is wildly different returns in the stock market last year. The one on the top there, that Dow Jones tends to lean more towards value orientated companies which are less interest rate sensitive. Things like the healthcare sector and financials and industrials. Where down there on the bottom, the NASDAQ, it leans more towards interest rate sensitive companies like technology. S&P 500 there in the middle is the broadest gauge of all of these. So the best representation of how the whole market did down 13.22% at the moment after being down over 20% at the bottoms.

Looking at valuations, so that’s how things have gone. But as investors, we’re not concerned with what’s happening in the past. We’re concerned with how things look for the future. So when you’re looking at valuations here, it’s a lot of information on this chart, but what you really need to take a look at is that the forward PE multiple of the S&P 500 is currently a little bit over the 25-year average. We’re on much better footing at the start of ’23 than we were at the start of ’22 where you can see that valuations are way up there almost on par with the tech bubble back in 2000. And that has corrected a lot so that is good if you’re a long-term investor. It’s a significantly better entry point now than it was at the beginning of 2022.

That said, stocks are not cheap by any means. Like I said, still a little bit over the average valuations and there’s six different measures of valuations there and it’s showing we are slightly overvalued in 5 of them. And those are all within one standard deviation difference so it’s not a massive worry. But I think the takeaway is stocks still aren’t cheap.

But a big question too, is when you’re looking at long-term averages, we’re looking at the last 25 years and looking at how valuations compare. The question is the next 25 years going to look similar to this past 25 years? If the next 25 years we’re going to be in a higher inflation, higher interest rate environment, then comparing against the last 25 years isn’t very useful. So there’s a lot of questions going on of is this a complete regime change where things are going to be different from here on out or is this a blip and things we’ll go back to normal. So that is the stock market valuations.

Jim’s going to talk about some key risks in 2023.

I get to do the opportunities.

James Bradley:

Oh, go ahead. Yeah, no, we will look at the risks and opportunities as we’re looking forward. And I get the risks.

So basically there’s four major risk categories that we’re watching closely. Interest rate volatility certainly as the markets try to kind of suss out where the Fed is going, at what point they’re going to stop their increases, at what point they may even be forced to move in the other direction, that’s going to cause some ongoing volatility which will cause volatility in things like bond prices. And in the markets in general, we think. An energy price spike. Whether it be because of some just correction to where supply and demand is or whether it be because of an exogenous shock, the likes of which we’ve seen in Ukraine, are things that we want to watch too. We’ve been benefiting from a downturn in energy prices and that’s helped out quite a bit. Do we keep in that direction or does it bounce back up?

An inflation resurgence is always… This isn’t the first time around this for the Federal open market committee. What they’ve found in the past is they’ll look like they’ve stamped out the flames as far as inflation goes but then they’ll get another flare up. And they don’t want that flare up to happen and they’re willing to throw more shade on the market in order to keep that from happening by way of larger interest rates and by decreasing their balance sheet. And so we want to be careful, especially when we see what we saw on the services side about any kind of pick up in inflation.

And then just any manner of different geopolitical things that could either calm down and help the market a lot or that could get worse and hurt the market. Whether we’re talking about Russia, Ukraine. Whether we’re talking about China, Taiwan. Whether we’re talking about China-US relationships. All of these have probably some degree of impact on where we go economically and as a market coming up.

So those are the risks we’re looking at. Sam will tell you about where we think there’s some opportunities.

Sam Chaplin:

Yeah, thanks Jim. I think the geopolitics especially would be a big factor over the longer term. A lot of people seeing how fragile our supply chains were in the pandemic and that we might need to be more self-reliant. Rising tensions with some of these trading partners could lead to some deglobalization which actually could create inflationary pressures over the long term and higher interest rates. So it’d be interesting to see how that works out.

Areas of opportunity. It’s not all bad. Any crisis brings opportunity, right? We’re looking at US value stocks. They’ve been looking cheaply valued for quite some time now. They’re also less sensitive interest rates, which is helpful in this environment. So based on those two things, we think the value out performance that we’ve seen over the past year will continue as long as interest rates in inflation remains high.

Next would be international stocks, which also tend to be more value orientated and also have started out with much cheaper valuations. All momentum’s really been on the US side in these. A lot of these international countries, particularly in Europe, have suffered from slow growth, negative interest rates, poor trading outcomes. And we’ve seen a lot of that reverse where they’re now in positive interest rate territory. Growth is actually much better than was anticipated. And so this might actually be the catalyst to see some international market out performance, which again, we saw some at the tail end of last year and we think could have some legs to continue throughout this year.

And finally, investment grade bonds. As I mentioned, in the past decade or so, bonds haven’t been that interesting. Very low interest rates. Used to get maybe 1% or 2% on investment grade bond and now you can get 4% or 5%. And that makes it a strong alternative to equities for those seeking safety. We don’t think interest rates will go significantly higher from here. So we see this is a good opportunity to capture some of those higher yields and lock in some income for the coming years.

And with that, we will let you go.

So thanks for coming on with us. As always, you can tell everybody. If you have any questions or anything, feel free to drop them in the comments, we’ll try to get back to you. We also publish other content on LinkedIn and more content on YouTube, so give us a like and a follow and hopefully we’ll see you next quarter.

James Bradley:

We’ll see ya at the halfway point next quarter. Thanks a lot guys.

The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be construed as investment advice or a recommendation regarding the purchase or sale of any security. There’s no guarantee that the statements, opinions, or forecast provided herein will prove to be correct.