By Portfolio Manager, Paul Broughton
Everyone knows that equities are vastly more volatile than bonds. Equities are also seen as forward looking, as investors try to anticipate company performance. Is the rally in equities to start the year a little ahead of itself? With the economic outlook still highly uncertain, we expect ongoing higher volatility in share prices.
The S&P 500 and Nasdaq have rallied by about 17.4% each since the lows of October 12th of last year. But investor expectations were overwhelmed by the most recent jobs report, which came in nearly 3x stronger than anticipated (517k jobs compared to the 189k consensus forecast). The 2yr Treasury Note, a good proxy for the direction of the Fed Funds rate, moved from 4.10% before the jobs report release to 4.81% on Friday. The most recent readings on consumer and producer prices and retail sales were higher than expected and unemployment claims drifted lower, contrary to expectations. The takeaway from these very important readings in February is that unemployment remains remarkably low and consumers continue to spend. So, the Fed pivot thesis has been devastated and we now see potentially three more 25 bps rate hikes before the Fed is able to pause. This, in turn, caused investors to question the aforementioned recent rally, sending equity prices lower and bond yields higher.
Some of the optimistic price performance that we saw through early February can be attributed to the belief that a hard-landing outcome to the economy will be averted. Unemployment set a 53-year low of 3.4% and consumer confidence remains fairly healthy. Consequently, there’s been much discussion of a soft-landing or even a no-landing scenario. Investors became more aggressive, which is reflected in the relative performance year-to-date between the Dow Jones Industrial Average (DJIA), which is down 0.69%, compared to the S&P 500 and the Nasdaq, which are up 3.65% and 9% respectively. This divergence between the DJIA and the broader market shows more money being allocated to riskier stocks relative to the Dow’s blue chips. Last year we saw the Dow outperform the S&P 500 by 11.2% (-6.86% vs. -18.13).
As mentioned above, the consumer, in general, remains very healthy and this shows with the top performing sector year-to-date: consumer discretionary, up 11.3%. Leisure and entertainment related stocks have rallied by 10.7%. Auto stocks Tesla and GM are up 59.8% and 16.5% respectively. These numbers are not exactly indicative of a pending recession.
Even so, it is the highly inverted yield curve that keeps investors nervous that a recession could be possible in the months or quarters ahead. The spread between the 2yr and 10yr Treasury rates reached -87.6 bps on Feb 14th and it’s currently at -86.6 bps. The last time the spread was this inverted was in the Fall of 1981 when Paul Volcker was driving up interest rates to historic levels in the process of crushing the inflation that had been building since 1965 (chart below). In addition, a variety of high-quality companies are providing cautious views of the business outlook, including Walmart, The Home Depot, and Union Pacific.
We’re likely to see more volatility in equity markets as investor sentiment oscillates between fears of inflation and recession. Investors get modestly optimistic pushing equity prices higher on the hopes that inflation is cooling enough for the Fed to signal that they’re comfortable with pausing, and fearful of recession when the Fed pushes up interest rates further. This volatility is actually quite normal and Robert Shiller won a Noble Prize in Economics for showing that stock market volatility greatly exceeds fluctuations in the economy, even though stock valuations depend on the economy’s performance. Investors need to be aware that 2023’s outlook for equities is likely to remain challenging with more of the recent fits and starts that we’ve already witnessed in the first couple months of the year.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.