First Quarter Outlook: Economic Resilience Begins to Crack

• The economy has begun to show signs of stress in its “tug of war” with a hawkish Federal Reserve.
• A banking crisis precipitated by Silicon Valley Bank put stocks in the red until the U.S. government backstopped depositors far beyond the $250,000 FDIC limit.
• Does this mean the government will backstop other sectors edging toward crisis, e.g., commercial real estate? Even if that were in the cards, it might be too little, too late.
• Despite signs of economic stress, there still seems to be significant optimism in the markets; growth stocks and high-beta stocks have continued to trounce value stocks.
• We believe it’s prudent to keep in mind that “fundamentals drive markets,” and to have a plan for when those fundamentals turn negative.

The “tug of war” between a hawkish Federal Reserve and the resilient private economy continued through the first quarter. As we said in our 2023 forecast in early January:

“Despite the stress of higher rates, the private economy continues to be resilient. Wall Street’s expectation is that we’ll see a demand-driven recession and easing demand would help the Fed’s fight against inflation. But that has yet to happen. The economy is being driven by a relentlessly strong consumer in a tight job market, where there are nearly two openings for every applicant.”

Despite a positive first quarter the markets were marked by volatility. Many observers asserted the Fed would continue raising rates until something broke, and in mid-March, something did: a crisis among mid-sized banks, precipitated by the failure of Silicon Valley Bank, nearly erased equity market gains. Banks regained their footing after a rescue courtesy of the U.S. Treasury. The tug of war continues to be exemplified by a mix of good and bad news:

• The Consumer Price Index (CPI) dropped to 4.98% year over year in March but was bested by a positive surprise from its cousin, the Producer Price Index (PPI), which dropped to 2.7% y/y.
• The Federal Open Market Committee (FOMC) raised the Fed funds rate to a range of 4.75 – 5.00% in March, the fastest one year increase on record starting from its range of 0.00 – 0.25% in February 2022.
• S&P 500 fourth quarter 2022 earnings contracted by 3.2%.
• The second and third largest bank failures in U.S. history happened in March with Silicon Valley Bank and Signature Bank. First Republic Bank was on the brink but was saved by a public–private partnership.
• Some of the most respected and well capitalized companies in commercial real estate ― including Blackstone, Brookfield and Columbia Property Trust ― defaulted on loans for office towers in San Francisco, Los Angeles and New York.

It is the office tower sector in the commercial real estate space that elicits the most concern. Very simply, the “remote” workers that used to fill these office towers are unlikely to come back to the levels seen before the pandemic. But there is a quadruple whammy impacting office towers:

• Office tower properties are generating less income to service debt.
• Office tower property values are plunging.
• Rising loan to value ratios are curbing owners’ ability to refinance.
• Sky high relative refinancing rates are making projects unprofitable.

This is bad for banks, since even if they are not direct lenders to the properties, they are direct lenders to the owners of the properties. Meanwhile, bond yields are exciting and a relatively safe place to park for now. But what if the Fed engages in another round of quantitative easing (QE4) via the U.S. Treasury?

Do investors in 2023 expect the Fed to bail them out of their risky positions, as it did in 2020? There is reason to think so. By guaranteeing bank deposits far beyond the $250,000 FDIC limit, in order to rescue the banking system from the SVB crisis, the U.S. government again injected liquidity into the system and effectively engaged in QE4. While this may have been necessary to sustain a basic building block of the financial system, it might be a step too far to assume the government will bail out commercial real estate. Even if that were a possibility, such a potential rescue is probably too late now: sky high refinancing rates and quantitative tightening likely have already damaged CRE.

My point is that there are a lot of things in the open to worry about, never mind the usual black swans that may be lurking underneath the surface. Below, we turn to the insights garnered from the Global Perspectives fundamentals: earnings, manufacturing and consumer spending.

Corporate earnings’ uncertain path

The most recently reported quarterly earnings growth for the S&P 500 Index, for the fourth quarter of 2022, was negative for the first time in two years. Earnings were –3.2%, that is, 4Q22 compared to the level of 4Q21; due to substantial contraction in the technology, consumer discretionary and financial sectors; offset somewhat by high growth in energy and industrials. Topline revenue grew 5.8%, led by energy and industrials.

Weaker manufacturing points to slower growth

The U.S. Institute for Supply Management (ISM) Manufacturing Index — a key measure of activity across the United States — dropped 1.4 points to 46.3 in March. Action Economics, LLC, reports this is the lowest level since May 2020, and the index has been in contractionary territory since November. The sub-components of the ISM Index also were weak, including employment, new orders and supplier deliveries.

Consumer spending remains supportive

Consumer spending remains alive and well, underscoring resilience in the economy. The advance estimate for February 2023 U.S. retail sales was $697.9 billion, down 0.4% from January but up 5.4% from February 2022. Maybe even more important are the jobs data. U.S. nonfarm payrolls increased by 236,000 in March, beating forecasts, after rising 326,000 in February and 472,000 in January. The March unemployment rate dipped to 3.5% from 3.6% in February and a 54-year low of 3.4% in January. Average hourly earnings were up 0.3% in March from 0.2% previously, leaving the annual rate at 4.2%, the weakest since June 2021 and significantly slower than 4.6% in February. Average weekly hours slipped from 34.5 to 34.4.

The financial markets were positive but volatile in March. The sudden failure of several U.S. regional banks, followed by the collapse and sale of Credit Suisse, forced a timeout on concerns with inflation and interest rates. Stocks pulled back as liquidity problems at Silicon Valley Bank briefly shook the banking sector, but the troubles appeared to be idiosyncratic rather than systemic. Markets regrouped after the government intervened to protect depositors. The U.S. Federal Reserve, seeking to avoid further “accidents” tied to higher rates, took a restrained step and increased the Fed funds rate by just 25 basis points at its March policy meeting.

The Fed’s restrained policy move helped lower market rates. The ten-year U.S. Treasury yield fell from nearly 4.0% in early March to less than 3.5% by month-end. Falling rates helped both stocks and bonds. For the quarter, information technology led the way with outsized returns bolstered by the consumer discretionary sector as the S&P 500 Index posted a gain of 7.5% in 1Q23, outpacing smaller caps, with the mid cap S&P 400 Index up 3.8% and the small cap S&P 600 Index up 2.6%. Easing rates also gave growth stocks an advantage over value stocks ― across the capitalization spectrum, growth styles saw gains whereas value styles posted losses.

The MSCI EAFE Index was the best performing equity asset class with a return of 8.5% and the MSCI Emerging Markets Index held up reasonably well with a return of 4.0%. The CBOE Volatility Index closed at 18.7%, a drop of 13.7%, and the S&P GCSI commodity Index was down 4.9%, hurt by the S&P GCSI energy sector, which was down 8.6% for the quarter.

Our Voya Global Perspectives “north star” corporate earnings has signaled that it is time to move to a defensive positioning in the portfolio to protect against a projected bear market. The intuition is that companies are expected to grow earnings each quarter compared to the same quarter a year ago. It is relatively rare, and dangerous for stock market valuations, when this is not achieved.

We believe it’s prudent to keep in mind our investment philosophy that “fundamentals drive markets,” and to have a plan for when those fundamentals turn negative. Depending on the government to bail out your risky positions is no plan at all, it’s a hope that may or may not be realized. The prospect theory of behavioral finance points out that investors hate losses twice as much as they like gains; Voya Global Perspective seeks to protect twice as much with diversification, and at times like now, a defensive positioning.