Following two months of headline-heavy market turbulence, the second quarter began on a quieter note. Inflation data—while still sticky—showed additional signs of moderating. The demand side of the labor market also displayed some cooling, with job openings reaching 9.6 million, or down nearly 2.5 million from their March 2022 peak. Continuing jobless claims have been on the rise and are at levels similar to December 2021. While these readings are viewed favorably by the Federal Reserve, inflation still has a long way to fall before reaching the Fed’s target of 2%. At the most recent FOMC meeting, policymakers remained steadfast and raised interest rates an additional 25 basis points (bps) to 5.00%. However, the Fed signaled that a pause may be likely barring any macro surprises or renewed stress on the banking sector. When asked about bank conditions, Fed Chair Jerome Powell said that the strains in the sector “appear to be resulting in even tighter credit conditions for households and businesses.”

Two days following the Fed's announcement, non-farm payrolls for April came in much higher than consensus, sending the unemployment rate back down to 3.4%, suggesting that the labor market is still tight. Though prior two months were substantially revised downwards (combined -149k), wages, as measured by average hourly earnings, were also up 0.5% month-over-month, hotter than 0.3% consensus. Following the Fed, the European Central Bank (ECB) also raised rates 25bps to 3.25%, with ECB President Christine Lagarde explicitly stating that the bank would not pause given the inflation backdrop in Europe.

While headlines surrounding the regional banking crisis were quieter in April, regulators seized First Republic Bank at the beginning of May and arranged its sale to JPMorgan. First Republic represents the second largest banking failure in U.S. history, and other regional banks experienced price volatility on the news. The developments are a reminder that the Fed continues to walk a fine line between fighting inflation and maintaining financial stability.

Another potential cloud hanging over the market is the contentious U.S. debt ceiling negotiations and the possibility, however remote, of a U.S. default. Investors may recall the brinkmanship that took place back in 2011, when the credit rating of U.S. government debt was downgraded, and the resulting fallout that led the S&P 500 Index to lose nearly a fifth of its value, before its eventual recovery.

Looking to Earnings for Clues

Earnings season kicked off in mid-April with investors trying to gauge if weaker expectations were actually materializing. At the end of the month, more than half of S&P 500 companies had reported better-than expected results. The Consumer Discretionary sector led positive upside surprises with a year-over-year earnings growth of 48%. Other highlights as of month-end include the following:

• S&P 500 blended earnings declined -3.7% compared to an expected -6.7% at the end of the first quarter.
• The Technology sector has seen an overall earnings decline, with a stark divergence between large software firms (most positive) and more cyclical industries like semiconductors (most negative).
• Some Consumer companies are showing strength, although that may be fairly narrow as overall YoY earnings growth drops from 48% to 11% if you exclude Amazon. While only half of Consumer companies reported results by the end of April, investors are eagerly awaiting further insight into consumers from big-box retail companies later in May
• Financials saw better-than-expected earnings, led by positive surprises by JPMorgan, Citi and Bank of America.

While perceived earnings strength is positive for economic outlook, it is also a backward-looking indicator. The regional banking crisis occurred toward the end of the first quarter, which likely led to a slowdown in corporate activity that could pose headwinds to earnings for the remainder of the year. In addition, while estimates for 1Q earnings have climbed, they started from a relatively “low bar” and now remain essentially unchanged for the rest of 2023, reflecting a degree of pessimism on the part of analysts. Companies have also not been overly bullish on their yearly outlooks, with 46% issuing negative earnings guidance thus far. All told, we continue to expect further declines in earnings throughout the year, reinforcing our underweight view on equities.

S&P 500 Earnings Revisions for 2023 by Calendar Quarter

Source: FactSet, as of May 1, 2023.

It is important to note that although a slowdown is occurring, the U.S. consumer continues to appear resilient in the face of a potential recession. According to Bank of America and other banks including Citi, consumer checking balances are over 50% higher than pre-pandemic levels and the average credit card utilization rate by households remains below 2019 levels, providing some breathing room for consumers. However, tighter lending standards in the aftermath of the regional banking crisis could create additional concerns. On the last business day of the month, March personal income and personal spending came in, and were both generally in line with consensus, with no strong indication that demand is substantially increasing. The Employment Cost Index (ECI), a gauge of changes in employee compensation costs, remained strong for the first quarter, signaling that wage growth continues to be healthy and that the labor market needs to slow further. The better-than-expected earnings thus far, combined with the strength of the economy shown in first-quarter GDP and wage growth, reinforced the Fed’s action on Wednesday and may call into question the two or three anticipated rate cuts the market is pricing in by year end. However, the central bank may remain hawkish in the face of recent consumer and economic strength, which aligns with our view that rates could stay higher for longer and potentially be a catalyst for a re-pricing of risk assets.

April Results: Value Over Growth, International Over Domestic

Equities were mixed for the month, with a bias towards value, although growth has outperformed year-to-date. The S&P 500 Index bounced around during April, ultimately ending in positive territory after late rally. Non-U.S. developed markets outperformed the U.S. for the third month this year while more cyclical segments of the equity universe such as emerging markets posted negative returns, as did U.S. small caps. We continue to maintain an underweight view on equities given elevated valuations and the potential for further earnings declines. That said, the internal rotation in the market has affected valuation metrics unevenly, reminding investors to look for potential opportunities to add risk exposure over the course of the year.

Fixed income markets were also mixed, but skewed positive, with emerging market corporate debt and domestic high yield corporate bonds generating the best performance; munis were generally negative for the month. We continue to favor credit over equity given attractive yields and a benign default environment, with a preference for shorter-duration exposure and cash, as both offer returns and optionality. Given this backdrop, we recently upgraded high yield and emerging markets debt as there may be relative value opportunities to add risk to portfolios. In the event of rate volatility, we would look to capture higher yields at longer maturities as opportunities present themselves. As it stands, investors are being well compensated by the higher-rate environment in holding both cash and shorter-duration bonds at a fraction of the risk associated with equities.

Within private markets, we favor private debt following the emergence of banking system stresses, as tighter financial conditions are beginning to generate opportunities for providers of liquidity. While we maintain an overweight view on commodities for portfolio diversification, where applicable, recession risks could hurt short-term demand.

Overall, investors are being “paid to be patient” in shorter-duration assets, reinforcing our continued belief that there is little opportunity cost to remaining cautious and defensively positioned for the time being. A higher-for-longer terminal fed funds rate, sticky (but easing) inflation, a hot (but cooling) labor market, extended equity valuations and weaker earnings will likely challenge markets throughout the year. We continue to favor a focus on diversified, high-quality, shorter-duration assets while retaining the flexibility to add risk as potential opportunities present themselves.

Index Returns

Source: Bloomberg, total returns as of April 28, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg ExEnergy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.