Several big surprises this year, but inflation will govern the market’s next moves

Author:

Shep Perkins, CFA | Chief Investment Officer, Equities

The first six months of 2023 were full of surprises for investors, not the least of which was a Nasdaq surge of 32% — its best first half since 1983. The S&P 500 Index gained nearly 16% for the first half, powered by mega-cap stocks. Despite intense recession fears at the start of the year, we have seen resilience in the U.S. economy. Not all the news has been pleasant, but even headwinds like the banking crisis in the first quarter haven’t dampened investor enthusiasm for equities.

Notable developments in 2023 include:

• Despite a hawkish Federal Reserve and much higher short-term interest rates, the U.S. economy, and especially the labor market, has remained robust. More astonishing is the fact that the European economy has also been resilient. The universal view had been that both regions would be in a recession by now.
• A less-pleasant development relates to China. It has emerged from its extended pandemic lockdown, but China’s economic recovery has been weaker than anticipated. Investors were expecting a sharp acceleration for the second-largest economy in the world. However, China’s tepid recovery has helped mitigate inflationary pressures.
• Another big surprise is the sharp rally in stocks, especially mega-cap growth stocks. At the midpoint of 2023, the Nasdaq’s surge had far exceeded all predictions. The two biggest fears coming into the year — an economic contraction and sticky inflation — did not materialize, propelling stocks higher as anxiety ebbed.
   

Where do we go from here?

In some ways, not much has changed. The two concerns that were front and center in January are still prominent. Entering the year, investors feared a looming recession and sticky inflation. The same is true today. The Fed continues to talk up rate hikes to combat inflation, and forecasters are anxious about an economic nosedive. The key difference is that the equity market is now higher, making stocks more expensive.

The recession scenario

The key variables remain the economy and inflation, both important drivers of the 10-year bond yield, which helps drive the stock market P/E multiple. Counterintuitively, if the economy tips into a recession, it may be good for broad equity indexes. Inflation pressures could weaken, the Fed could turn dovish, and the 10-year bond yield might fall. Growth stocks, which are a dominant part of major indexes like the S&P 500, are more resilient in economic downturns and could continue to power higher. These positive outcomes are counter to fears and are underappreciated by many investors.

The economy-stays-strong scenario

If the economy remains strong, we’ll see a better environment for corporate earnings in general. A continued strong labor market would fuel consumer spending. Ironically, this may not be good for the overall market, as we’ve seen in recent weeks with 10-year bond yields rising above 4%. However, it would be better for active managers, as the mega caps wouldn’t be so dominant.

But importantly in this scenario, inflation is likely to continue easing. The housing component of inflation is almost guaranteed to decline in the next 12 months due to the technical way it’s calculated. Moreover, inflation in some other countries is now well below the U.S. level. For example, inflation in Spain and Greece is below 2%, and China is at 0%. There’s a decent chance that within a year, much of the concern will be around deflation rather than inflation, as is the case for China today.

Inflation remains key for second-half performance

Overall, we believe the new U.S. bull market has more room to run. Inflation is the most important indicator for equity performance in the next 6 to 12 months. If inflation pressures continue to ease and economies maintain their footing, the S&P 500 should hold on to — if not add to — its first-half gains. Inflation remains above the Fed’s 2% target, but what’s underappreciated is how much it has retreated. While many fear that inflation may remain sticky, there’s equal chance it won’t and that inflation will fall below 2%.

The equity market swoon in the first three quarters of 2022 has been followed by three consecutive quarters of positive returns. Ironically, investor cautiousness entering the year combined with anxiousness caused by the banking crisis could continue to provide fuel for stock market gains. Assets in safe havens like money markets, which have yet to rotate meaningfully back into equities, could help push the market higher from here. Most of the global economy is on solid ground, and corporate earnings growth is poised to accelerate following a likely bottoming this quarter.

The case for small caps

In terms of styles, small caps are worth watching. The group has lagged considerably over the past five years. Interestingly, small-cap stocks have outperformed the average S&P 500 stock this year, when excluding the “magnificent seven” mega-cap growth stocks.

Small caps have almost always delivered strong returns in the 6- and 12-month periods following a final Fed rate hike. Currently, there is a considerably wide valuation gap between small-cap value stocks and the S&P 500. Historically, this has led to small-cap value outperformance in the subsequent year. For small-cap growth stocks, there have been five down years since 2001 for the Russell 2000 Growth Index. In each case, performance has been positive in the following year, with an average return of 26%. We’re on pace to match that average this year, as 2022 marked the sixth annual decline since 2001 for small-cap growth stocks.