Following a turbulent March, a calmer April was quite welcoming.
After a small run up to start the month, the S&P 500 traded sideways for two weeks prior to a small drawdown the final week of April. However, a month-end rally on the back of positive earnings from mega cap tech resulted in a positive month for the broad index. The S&P 500 gained 1.4%, the DOW advanced 2.1%, while the NASDAQ rose .5%. Bonds declined 1.3% as yields rose.
Small caps (IWM) eked out a .1% gain for the month. MOAT advanced 1.7% and Europe/IEV rallied 3.4%. Big banks (XLF) rallied 4.3%, but the more troubled regional bank sector (KRE) slumped 1% (after a 28% slump in March – not much of a rebound there).
WHAT’S DRIVING THE MARKET
After the Silicon Valley Bank collapse and ongoing concerns about the health of small and mid-size banks, the drum beat of recession grew louder throughout the month. The market appears to be on hold until additional economic data is released which will shed light on the state of the economy as well as the ever-important Fed rate meeting on May 3rd.
Earnings held up reasonably well, as more than 79% of companies that have reported earnings beat expectations. However, the bar was quite low coming into 1Q earnings season given the macro backdrop.
Positive earnings surprises from the likes of Microsoft and Meta helped spur some buying interest at the end of the month, helping boost the broad index to close the month with small gains.
Economic data continues to point to ongoing weakness. GPD for 1Q23 came in at 1.1%, weaker than the 2% expectation and lower than 4Q22’s 2.6% print, clearly indicating a slowdown in economic output.
An interesting observation given the YTD advance in the S&P500 and NASDAQ in the face of ongoing weakening economic data is the fact that only 35% of S&P 500 constituents have seen gains greater than the index itself. This points to narrow leadership, as evident by the fact that AI-related stocks (MSFT, GOOG, META, NVDA, CRM) have driven 50% of the S&P 500 gains this year, and the largest 15 companies have generated 90% of the S&P 500 returns for the year. This leaves hundreds of companies that are flat to down YTD.
PORTFOLIO ADJSTMENTS
Since our sizable reallocation mid-March and our integration of the updated modeling process, we maintained the positions that we entered in March.
On April 12th, we entered a 5% position in COWZ, a new fund added to our refreshed lineup. COWS is an active ETF that selects U.S. companies with the highest free cash flow. Free cash flow in the current environment should prove to be somewhat defensive since lending activity should theoretically slow down given the challenges in the banking sector. Those companies with high free cash flow do not need to access traditional lending facilities, thus providing some degree of insulation from a tightening credit environment. However, the sector that has encountered the highest free cash flow growth of late is energy. Given the narrow sector allocation of COWS, we have limited the potential exposure of this position so as to not take undue sector risk, although Energy is a nice diversifier and can be less correlated to the broader market.
On 4/19 we incrementally added to MOAT, and on 4/26 we increased our position in QQQ.
As of the end of April we were still underweight in equity exposure and have maintained a 10% position in a high yielding money market fund to collect a competitive yield and stabilize a portion of the portfolio.
Even with a somewhat defensive/underweight posture, TWG portfolios performed in line with their benchmark before fees for the month of April.
LOOKING AHEAD
As of the day of this writing, the Fed has chosen to increase the Fed funds rate by another .25%. This was widely expected and priced in the market. However, with the ongoing challenges that higher rates are causing to reginal banks, there is ample reason to be cautious. Over the weekend before the start of May, First Republic bank had failed, and the government swiftly arranged for a sale of the bank’s assets to JP Morgan before the market opened on Monday. This likely helped stem any contagion risk, yet still rattled the markets. So, another bank collapsed, partly due to the pace of rate increases over the past year, but also partly due to an overall negative tone on the safety of customer deposits. With the banking system under duress, economic conditions will likely get tighter. Tighter lending standards and lower credit issuance should have a similar impact as additional rate increases of the Fed funds rate, thereby accelerating the slowing of the economy.
How much the combination of higher rates and a reduction in lending activity will slow down the economy will not be known for months, given the long and variable lag of both factors. Banks will not immediately halt lending but will likely put their pencils down and evaluate the risks and sharpen their underwriting standards.
While these events certainly can increase the probability of a recession, the continued strength in the labor market will likely delay any technical recession, which is defined as two consecutive quarters of negative GDP. Monthly job openings have decreased over the past few months, and first-time unemployment claims have risen slightly. Still, the unemployment rate remains decades lows, implying that layoffs, so far, have not spiked to levels that would be indicative of an imminent recession.
However, a continued tight labor market and low unemployment supports consumption, which in turn will challenge a meaningful decline in inflation. So long as consumers continue to buy goods at prices that companies are charging, it is tough to see inflation coming down quickly. Stickier inflation will likely force the Fed to keep rates elevated for longer, which will continue to negatively impact growth. We may very well experience a gradual slowdown in growth over an extended period. This long-duration scenario will probably lead to an eventual recession, spurred by an increase in unemployment. Higher unemployment will reduce consumption, in which case earnings will likely decline, stock prices should be re-rated, inflation will crater, and the Fed will cut rates. At that time, the stage may be set for a trough in earnings and spark the next economic expansion.
Uncertainties remain ample, which will likely limit additional market advances, particularly as the S&P nudges up against the 4,200 level. This area has served as resistance in February 2023, as well as May and August 2022. A decisive move above 4,200 would be necessary for the market to overcome this hurdle. However, a floor of 3,600 should provide support should the market roll over. A relatively narrow trading range going back almost a full year.
The upcoming debt ceiling deadline will likely keep uncertainty elevated and may result in increased near-term volatility with a slight bias to the downside.
Whether the Fed will pause is also being factored into investor positioning. It appears that the Fed is warming up to pause and allowing the long and variable lag effect of rate increases to permeate through the economy. A pause will also enable the Fed to witness any impact from expected tightening in lending practices. In our view, a pause is necessary and welcome, but does not provide ample clarity to engender confidence that a robust recovery is imminently underway, which somewhat contradicts the current stock market level. But again, given the narrow leadership, we understand why index levels are where they are. It is just not telling the whole story, but instead masking some of the broad weakness.
A final thought is surrounding TARA – There Are Reasonable Alternatives to stocks. With money market and T-bill yields pushing 5%, we suspect investors may opt for the guaranteed safety of 5% instead of taking a risk to achieve a 6-7% return in equities. The equity risk premium is falling, which will likely limit additional stock buying. Thus, in our view, upside is extremely limited at this juncture, and risk is asymmetrical to the downside.
In summary, the economy is doing “OK” – not strong, but not super weak either. There is still a lot to be sorted out. Given the lag effect of rate hikes, we will probably see the trend of slowing economic data continuing. How much economic activity ultimately slows down will probably be driven by how long inflation remains elevated above the Fed’s 2% target, with a longer duration suggesting a higher probability of a recession.
We’ll have to be patient to see how this next leg in the journey plays out.
