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Equity markets frustrate both bulls and bears
Despite some wavering in May, global equity markets have generally remained resilient year-to-date. Most major indexes have held on to gains made in the first quarter of 2023, when markets overcame volatility driven by bank failures in the U.S. and Europe. The U.S. Federal Reserve’s 25 basis points (bps) hike in early May, which raised the fed funds target rate to a range of 5.00%–5.25%, will likely prove to be the final increase of this cycle. But the lagged effects of the Fed’s historic tightening have only recently begun to emerge, creating market uncertainty. And with the U.S. debt ceiling negotiations coming down to the wire, we expect equity market volatility will only increase in the near term.
- Economic stability vs. banking instability. The “abnormal normalization” of economic activity in the post-Covid era persists. Inflation, though moderating, is still stubbornly elevated. Growth in the underlying economy continues to show some resilience, despite mixed data. Meanwhile, instability within the U.S. financial system — particularly among mid- to small-sized regional banks — has complicated the Fed’s inflation fight. As a result, the currently anticipated pause in rate hikes does not mean policymakers will pivot to rate cuts in 2023. In fact, we cannot entirely rule out the possibility of further rate increases later this year.
- Earnings outpace low expectations. The S&P 500 Index is headed for its first earnings recession since 2020. On the surface, the S&P 500’s most recent earnings season appeared benign. With almost all companies reporting as of 15 May, the decline in earnings (roughly -2.5%) was an improvement over estimates from earlier in the reporting season. A deeper dive, however, shows that indexlevel earnings growth was once again propped up by the outsized results of a single sector (in this case, consumer discretionary). Earnings expectations remain modestly positive for the full year, but in our view that will be accompanied by heightened volatility around earnings as economic activity slows, ultimately leading to a modest contraction in GDP.
- Portfolio impacts. We’re still confident that equity markets will continue to offer opportunities. Specifically, in this environment of fragile sentiment, we believe investors may be best served by allocating to companies that (1) have a history of growing their dividends, and (2) are tied to U.S. infrastructure. Dividend growers tend to be high-quality names offering strong free cash flows, defensible margins and income/portfolio protection in volatile times. Infrastructure companies, typically well insulated from higher debt costs and elevated inflation, may benefit from inelastic demand, which is key during periods of slowing or negative economic growth.
1 FTSE Russell
2 Data for 1926–2020 from Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbook, Roger G. Ibbotson and Rex Sinquefield.
All market and economic data from Bloomberg, FactSet and Morningstar.
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