April Market Update
The final trading day of April added insult to injury on an already rough month for stocks. On the back of an abysmal earnings report from one of the world’s largest companies, Amazon, the S&P 500 fell 3.6% on Friday taking month-to-date losses to 8.7%. Long thought by many to be one of the most resilient consumer and technology-related companies, the news of its first quarterly earnings loss in seven years stunned investors. While we would not read too much into the loss itself, which was largely driven by the write-down of a non-core investment, weaker-than-expected growth and poor guidance for its core online consumer business weighed heavily on analysts’ outlooks. We note that other companies are similarly dealing with a cooldown in online business as consumers appear to become more comfortable making purchases in person rather than at home.
Across the rest of the S&P 500, earnings have been more sanguine. With more than half of the companies reporting their first-quarter earnings, year-over-year growth is expected to be more than 7%. Without Amazon, the growth rate exceeds 10%. Indeed, more than 80% of companies have beat expectations by an average of 3.4%. Amidst inflation concerns, profit margins have also remained resilient. While they have trended lower over the last several quarters, at 12.2%, they remain higher than any quarter from 2008 to 2020. So, what do growing earnings and falling stock prices lead to? Better valuations. With the S&P 500’s return flat over the last twelve months, forward P/E ratios have declined toward the long-term average.
While valuations are more attractive, risks to the equity markets remain. Thus far, consumption has proven resilient to rising prices allowing businesses to pass on higher costs with little impact on their margins. A tight labor market and wage increases have eased the pain from inflation on individuals’ checkbooks, and consumer-credit conditions remain healthy. As we move through the next few months, we’ll be looking for any changes in this data to inform our view. For now, however, we remain neutral on equities. We are prepared to reduce risk if our outlook deteriorates further or seize any opportunities if the bout of economic weakness causes the Fed to become less hawkish.
While equity investors are accustomed to volatility, losses in the bond markets cause more heartburn. As the Fed moves away from its zero-rate policy and has jawboned rate expectations higher, investors are wondering how high can rates can go? Fixed income has traditionally been a relatively safer place, serving as a ballast to portfolios during periods of volatility. So far this year, however, they have moved in the same direction as equities, with the Bloomberg Aggregate Bond Index falling nearly 10%.
This increase in correlation between stocks and bonds is understandable, but we do not believe it is a reason to give up on the asset class. As the Fed has moved rate expectations higher to cool inflation and pressured bond prices lower, it has also driven the discount rate on equities higher, compressing stock prices. However, the Fed’s moves provide it with dry powder to protect against future crises by providing space to reduce rates or restart QE.
While we came into the year with a negative view of fixed income, we believe that the market may be overestimating how much the Fed will raise rates. If Treasury rates continue to rise faster than the Fed signals, or the economy decelerates to the point that the Fed ends its tightening cycle earlier than expected, we may look to revert to a more neutral stance.
Frequently Asked Questions
1) If bonds have lost nearly 10% on the back of a single rate hike, should we expect much more significant losses as they keep going?
- Markets are discounting mechanisms. The bond market currently assumes that the Fed will raise its target rate from 0.25-0.50% range to 2.75-3.00% by December. Unless these assumptions move faster or higher, bond portfolios have already repriced for the tightening cycle.
2) The recently released GDP showed a decline of 1.4%. Are we in a recession?
- The decline in GDP was driven primarily by a reduction in inventory investment, lower exports, a drop in government spending, and an increase in imports. Much of this was related to accelerated inventory investment in Q4 2021, which pulled forward economic activity to the previous quarter. Importantly, consumer activity remained solid.
3) With inflation surging, should we have exposure to commodities and other inflation assets?
- We recommend that most client portfolios maintain an allocation to real assets. Our preferred approach is to invest in a diversified basket of real assets, such as real estate, infrastructure, commodities, and inflation-linked bonds, rather than trying to choose the next hot commodity.
4) Why is the US underperforming international stocks year-to-date with all the geopolitical concerns?
- US and International equity returns have flipped back and forth as relative winners throughout 2022. At the beginning of the year, better valuations in Europe were a boon to international stocks indices. Even during the initial phase of the Russian invasion in Ukraine, non-US stocks outperformed. However, as it became more apparent that the conflict would persist, investors became more nervous about the more direct impact the war may have on the European economy. As concerns about rising inflation spilled over to the US in April, domestic equities fell further. Remember, markets are anticipatory, and it is changes to current expectations that drive relative performance. The war’s disproportionate impact on Europe is likely already embedded into equity prices.
5) Should we move to cash?
- It might feel satisfying over the short run to move to cash as other assets continue to experience losses. However, we believe it is risky to be out of the market over the intermediate- and long-term. While our base expectation is that inflation continues to moderate, it is likely to remain higher than the yield on cash for some time to come. Thus, we expect cash to lose purchasing power. We believe that equities and fixed income remain more appealing asset classes over the intermediate- and long-term. Nevertheless, if cash yields move meaningfully higher than current expectations or our outlook on other asset classes deteriorates, we may increase cash positions.
6) What might cause you to change positioning in portfolios?
Importantly, we have made changes to many client portfolios, where appropriate, late last year in anticipation of volatility this year. Notably, we
- reduced fixed income in favor of alternatives;
- reduced our equity exposure back to strategic targets;
- increased our exposure to value stocks, which have more energy exposure; and
- increased our allocation to real assets.
The moves have been, on the whole, additive to relative results.
Additionally, we are considering changes to our international equity exposures that should, at the margin, reduce risk.
- We continue to monitor closely consumer and business spending for signs of weakness that might change our view on equities. Significant increases in delinquencies on credit or a pullback in spending could lead us to reduce our equity exposure more meaningfully. On the other hand, a continued deterioration in valuations that is not consistent with fundamentals could cause us to more aggressively add exposure.
- While short-term yields have improved over the last few months on Fed guidance, we do not believe that real (inflation-adjusted) yields are impelling enough to lure us away from equities and longer-term bonds yet. As we move through the summer, this view may change.
 Each clients’ objectives and circumstances are unique, and any trading reflects this. Considerations such as taxes, client preferences, and the appropriateness of an investment for a particular client account may lead to deviations from our target portfolios.