The first quarter of 2023 had a few notable causes for concern. There was the collapse of two sizable banks (Silicon Valley Bank and Credit Suisse), two more rate hikes by the US central bank, the ongoing Russian-Ukraine war, and elevated US-China tensions on the back of a suspected spy balloon and semiconductor export restrictions. Despite all of this, the S&P 500 and TSX indices rose 7% and 3.7%, respectively, to begin the year.
How could stocks perform well when there were many events to worry about? Consider a formula often used in the world of self-help: Happiness = Reality minus Expectations. This equation suggests that one will be more satisfied by the outcome of an event if one keeps expectations low beforehand, leaving ample room to be pleasantly surprised.
Investors can tweak this equation: Stock Market Returns = Reality minus Expectations. When expectations for future earnings, economic growth, etc. are too high, stock prices may have risen to such heights that if reality simply matches those elevated expectations, gains will be muted. Should there be even a slight undershooting of those expectations, share price declines would likely follow. By the end of 2022, however, we likely had the opposite. That is, expectations had declined enough that any positive economic developments could result in a market rally.
To illustrate this point, in our January commentary we pointed to a survey of economists that projected a 70% probability of a recession occurring. While we didn’t disagree with this assessment at the time, we also discussed potential sources of “upside surprises” that were not being considered. Since then, despite the troubles in the banking sector and two more rate hikes from the US central bank, those aforementioned economists have lowered the odds of a recession to 50% due to several positive surprise developments in recent months.
In China, the lifting of Covid restrictions has raised hopes that greater activity in the Middle Kingdom’s economy will provide a shot in the arm to the rest of the world. In Europe, natural gas prices collapsed thanks to an unseasonably warm winter, reducing the odds of a deep recession on the Continent. Globally, inflation has cooled, which could allow central banks to slow their pace of interest rate increases.
The cooling inflation has lowered long-term bond yields, which has probably provided the greatest boost to the markets via their impact on technology-related stocks. In 2022, richly-priced tech stocks saw their valuations compress, in large part due to rising interest rates. As the US 10-year bond yield has retreated from north of 4% in early March to 3.3% in recent weeks, growth stocks have seen a resurgence. This has more than offset weakness in the banking sector.
Source: Refinitiv
Sector Outlook
Looking forward, we continue to expect a moderate recession to commence at some point this year, with tighter lending standards at the banks and the recent uptick in oil prices increasing that probability. However, as we have mentioned in the past, a lot of the pain of a potential recession was felt in the stock market last year, so we expect any related downdraft in share prices to be manageable.
From a sector perspective, while we already discussed how declining interest rates have provided a lift to growth stocks, there are reasons to believe that strength may continue. The technology sector tends to outperform other parts of the market as the economy starts to slow and as central banks end their rate-hiking cycles. Moreover, after several years of profligate spending, many technology companies seem to have found religion when it comes to profitability and have begun to rein in their expenses – this may attract a broader investor base.
While we do own some of the higher-quality banks, we remain underweight the group in our portfolios. It is possible that the worst of the troubles in that sector is behind us, but we view rising funding costs and the potential for recession-induced loan losses as reasons to be cautious.
Because we believe many cyclical areas, such as semiconductors and consumer discretionary stocks, were overly punished last year, we have notable positions in these undervalued groups. We expect the potential downside will be manageable through any recession, but that the upside will be meaningful when growth reaccelerates.
As protection against a potentially deeper-than-anticipated economic downturn, we maintain a healthy exposure to more defensive sectors of the market, including consumer staples and health care.
Reality vs Expectations
Given our previously stated equation (Stock Market Returns = Reality minus Expectations) one should remain hopeful that we can avoid a recession, which would allow Reality to surpass the current Expectations. Regardless, our portfolios are built with a core of solid companies that have competitive advantages and stable balance sheets. These companies should be able to weather any potential near term economic contraction and thrive whenever conditions strengthen.
If you have any questions, please do not hesitate to Contact us!