Commentary - Q1 2023
In the first quarter of 2023, the stock market, as represented by the S&P 500 Index, generated a positive return of 7.5%. The market’s rise in the quarter followed a rise of similar magnitude in the fourth quarter of 2022. These two quarters of favorable returns were not large enough to return the Index to levels attained in early 2022. The Index remains approximately 16% below its peak of 4,797 reached at the close on January 3, 2022.
Large growth stocks and large value stocks rose during the quarter. The S&P 500 Growth Index produced a return of 9.6% and the Value Index generated a return of 5.2%. Over the one-year period completed at the end of the most recent quarter, the Value Index produced an annualized return of -0.2% while the Growth Index returned -15.3%. The one-year returns were produced as the Fed was raising the Fed Funds rate as part of its effort to lower the rate of inflation. Higher rates had an adverse effect on the performance of large growth stocks as the discount rate for capitalizing future cash flows rose along with interest rates. The Fed’s actions clouded the outlook for economic growth as well, and increased the uncertainty attached to earnings forecasts. Higher discounts rates and an uncertain outlook for future earnings reduced the willingness of investors to hold high PE stocks.
The favorable relative performance of growth stocks in the first quarter may have reflected changed expectations for higher interest rates. Growth stocks tend to be long “duration.” Recent estimates of inflation showed a diminished rate of increase in prices. In June of 2022, the CPI was rising at a rate close to 9.0% on a year-over-year basis. By March of 2023 the rate of increase had fallen to about 6.0%. This trend reduced the pressure for the Fed to continue to raise the Fed Funds rates aggressively. The most recent increase was 25 basis points while earlier increases were 50 basis points. To reduce inflation the Fed increased the Funds rate from nearly 0% in February of 2022 to 5.0% by the end of March 2023. While further increases might occur, it is not likely the increments will be as large or as frequent as they were in the recent past.
Another factor shaping the Fed’s actions may be concerns about the impact higher rates are having on the solvency of banks. The failure of Silicon Valley Bank was, in part, a consequence of the Fed’s strategy of raising rates. Several actions led to SVB’s insolvency, but an inverted yield curve surely contributed to the result. The yield curve has been inverted for some time as the Fed raised short-term rates and longer rates did not rise as fast. At the end of the first quarter, the rate on the one-year Treasury obligation stood at about 4.7% and the yield on the ten-year obligation was approximately 3.6%. A differential of this magnitude has not existed for almost 40 years. Bank liabilities tend to be closer to the short end of the yield curve and their assets further out on the curve, therefore as the Fed’s action produced an inversion, bank assets were generating returns below the cost of liabilities, all other things being equal.
The Fed did pause its efforts to reduce liquidity shortly after the SVB failure. Bank deposits were drawn down by nearly $900 billion after the SVB failure as large depositors sought safe havens. The Fed responded by adding to its balance sheet and increasing liquidity. The need to increase liquidity ran counter to the Fed’s effort to reduce inflation.
The unfortunate consequences of high inflation are significant. On occasion a money illusion masks the harmful effects of rising prices. For example, during the period from January of 2021 through March of 2023 the nominal rate of return for the S&P 500 Index was +2.9%. The return adjusted for inflation was -3.7%. Over the last 100 years the return in excess of inflation was +7.2%. In the recent period, the return on the Index, after adjustment for inflation, was 10.9% below the long-term average. It may appear the market has been flat or has trended upward slightly since January of 2021, but the reality is quite different. Owning stocks has led to a decline in real wealth, a bear market in asset values. The -10.9% value understates the damage to asset values because it does not reflect any reduction in returns resulting from tax burdens.
There is some evidence investors remain optimistic about the ultimate success of the effort to reduce inflation and anticipate an increase in profits and a sustainable long-term growth in economic activity. At the end of the first quarter, the S&P 500 was selling at a multiple of about 21.9 times trailing twelve-month earnings. This valuation is somewhat above the long-term median of roughly 20.4 times trailing twelve-month earnings. For most of 2023, corporate profit increases on a year-over-year basis will not be robust. The most recent reading showed overall profits increased at less than a 2% rate in the fourth quarter of 2022. It is likely corporate profits will decline in the first half or 2023 and resume positive increases in the second half of the year.
The path to lower inflation and acceptable levels of economic growth will not be smooth. As the Fed continues to try and reduce inflation, the Federal budget deficit is likely to remain over $1 trillion per year for the foreseeable future if the estimates rendered by the Congressional Budget Office are accurate. If the Fed stays the course for lowering inflation, the Treasury will need to find other sources of funds. The Administration has offered an increase in tax rates as a means of covering the deficit. Increases in tax rates will not produce an environment favorable to rising economic growth or increases in corporate profits.
The stock market generated returns below that of the rate of inflation during the late 1960’s and the 1970’s. During the presidencies of Lyndon Johnson, Richard Nixon, Gerald Ford, and Jimmy Carter, the rate of inflation was above the rate of return produced by the stock market. The economic policies of these Presidents produced an environment characterized by rising inflation and diminishing real economic growth. In the period from January of 1968 through January of 1982, the market produced a return of -1.7% per year when returns were adjusted for inflation. During the period from January of 1982 through January of 2021, the stock market produced an average annual return of 9.1% above the rate of inflation. The extended period of positive excess returns began with a change in economic policies. The Fed lowered the rate of inflation and stabilized prices, and the Reagan Administration lowered tax rates. The combination of sound monetary policy and lowered tax rates helped begin a decades long bull market for both stocks and bonds. The path to a favorable economic environment and market returns above the rate of inflation is well marked.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.