Key Points

• Growth Slowing: U.S. economic growth cooled in the first quarter amid stubbornly high inflation and rising interest rates. Real Gross Domestic Product (GDP), a measure of the value of all the goods and services produced in the U.S., expanded at a lackluster +1.1% annual rate in the first quarter.
• Earnings Update: Earnings for S&P 500 companies are expected to decline -3.7% year-over-year in the first quarter, which would mark the second consecutive drop in year-over-year earnings growth. Two consecutive quarters of annual declines are typically defined as an earnings recession, and Q1-2023 would translate into the first earnings recession since the pandemic. Fortunately, earnings beat rates are above average and the margin of surprises is the highest since Q3-2021.
• Debt Deadline Advanced: Treasury Secretary Janet Yellen warned that the U.S. could default on its debt obligations as soon as June 1 if Congress doesn’t act on the debt ceiling. That is a much shorter timeline than July which the Congressional Budget Office had previously projected. The calendar for Congress and President Biden is tight in May, leaving little time for a deal to get worked out. Still, a default is unlikely and a last-minute deal or at least a temporary suspension of the debt ceiling is expected.
• Returns Typically Rise After Hikes End: The Federal Reserve has conducted its most aggressive rate hiking cycle in decades over the last year, raising rates by a full 5%. That has created much tighter financial conditions and introduced stress in the markets, particularly among regional banks. Nevertheless, historically markets have been positive in the 12 months following the end of a rate hiking cycle.

Market Summary

Asset Class Total Returns

Source: Bloomberg, as of April 30, 2023. Performance figures are index total returns: US Bonds (Barclays US Aggregate Bond TR), US High Yield (Barclays US HY 2% Issuer-Capped TR), International Bonds (Barclays Global Aggregate ex USD TR), Large Caps (S&P 500 TR), Small Caps (Russell 2000 TR), Developed Markets (MSCI EAFE NR USD), Emerging Markets (MSCI EM NR USD), Real Estate (FTSE NAREIT All Equity REITS TR).

Capital markets have been remarkably resilient in the face of higher interest rates in 2023, with April delivering another positive month, and all major asset classes sitting on positive gains for the year to date through April. Better than expected first quarter earnings have helped investors overcome some of the banking sector jitters that developed in March. The failure of Silicon Valley Bank and Signature Bank on March 10 and March 13 respectively spurred a spike of volatility in March, but market volatility settled to surprisingly subdued levels during April, including a prolonged stretch of muted daily activity for the major equity indices. But it seemed only a matter of time before bank anxieties popped up again, which they did in the final trading sessions of the month. This time it was First Republic Bank that was shaky, and shares lost about three quarters of their value in the final week of the month before the bank was eventually taken over by J.P. Morgan on May 1. Nevertheless, the regional bank troubles didn’t keep the headline indices down. The S&P 500 Index finished April with a +1.6% gain, putting it up +9.2% for 2023 (total return including dividends). Eight of the eleven S&P 500 sectors were positive for the month, led by defensive sectors like Communication Services (+3.8%) and Consumer Staples (+3.6%). Small cap equities weren’t as fortunate as the Russell 2000 Index fell -1.8%, its third consecutive monthly drop. Tighter financial conditions are particularly challenging for smaller companies, plus the Russell 2000 Index has more exposure to the Financials sector, and more than twice the weight in banks, than the S&P 500. Developed Non-US equities were the strongest major asset class in April, with the MSCI EAFE Index advancing by +2.8%. But the MSCI Emerging Markets Index fell -1.1%, making April the third month of the year they have trailed developed markets. China, which makes up more than 40% of the MSCI Emerging Markets Index, reported decent economic growth in the month but concerns around geopolitical tensions helped push Chinese stocks down -5% in April.

Lower rate expectations and the proposition of an end to the rate hiking cycle helped bond markets also advance. Bond yields, which move in the opposite direction of prices, were relatively calm following a big plunge in March. The 2-year US Treasury yield slipped just -2 basis points (bps) to 4.01% and the benchmark 10-year US Treasury yield declined -5 bps to 3.42%. As a result, the Bloomberg US Aggregate Bond Index was positive for the third month this year, returning +0.6% in April, and bringing its year to date return up to +3.6%. Non-US bonds also eked out a gain with the Bloomberg Global Aggregate Bond ex US Index up +0.3% in April.

Source: Bloomberg, as of April 30, 2023.
Price Returns for Equity, Total Returns for Bonds.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Quick Takes

GROWTH SLOWING

U.S. economic growth cooled in the first quarter amid stubbornly high inflation and rising interest rates. Real Gross Domestic Product (GDP), a measure of the value of all the goods and services produced in the U.S., expanded at a lackluster +1.1% annual rate in the first quarter according to the BEA’s first estimate of three. That was below the Wall Street consensus forecast of +2.0% growth and the prior month’s +2.6% pace. Declining business investment offset strong consumer spending and pointed to slowing growth. Spending on services such as travel, recreation, and health care grew at a modest +2.3% pace. Meanwhile, government spending rose +4.7%, following a +3.8% gain in the fourth quarter. In fact, it was the third consecutive quarterly increase in government spending, which added a full 0.81 percentage points to the Q1 top line growth. The biggest drag on GDP was from slower growth in inventories. The growth in inventories shrank by a whopping -$138 billion, the sharpest reversal in two years. The GDP Price Deflator increased to +4.0% from +3.9%. Overall, the report showed a continued deceleration in economic growth, but it was inventories—not a drop in personal consumption—that drove the slowdown.

The U.S. Economy Is Slowing
Real GDP, change from previous quarter (%)

Note: Seasonally adjusted at annual rates.
Sources: Commerce Department (actual); WSJ survey of economists (forecasts)

CORPORATE EARNINGS: GOOD NEWS/BAD NEWS

First, the bad news… an earnings recession is underway. Earnings for S&P 500 companies are expected to decline -3.7% year-over-year in the first quarter, according to data from FactSet, which would mark the second consecutive drop in year-over-year earnings growth. Two consecutive quarters of annual declines are typically defined as an earnings recession, and Q1-2023 would translate into the first earnings recession since the pandemic. Even more concerning would be if executives start issuing downbeat forecasts or if companies disappoint with larger-than-expected quarterly losses. According to Tajinder Dhillon of Refinitiv, “the prior earnings recession started in Q2-2020, lasting three quarters from start to finish. Today’s earnings recession may also last three quarters if analyst expectations turn out to be correct.” But here’s the good news… Dhillon points out that “Q1 estimates have declined significantly heading into earnings season which may set a lower bar for corporations to beat analyst expectations and surprise to the upside. The quality of a beat will matter, as investors look to hear from company management on numerous themes, including the macro-outlook, health of the consumer, impact of higher input costs on margins, employee hiring (or layoffs), and future capital expenditure plans.” And beating they are. At about halfway through the first-quarter earnings reporting season, 80% of S&P 500 companies are beating Wall Street’s earnings estimates, above the five-year average of 77%. Furthermore, as shown below, they are beating earnings projections by a margin not seen since Q3-2021. Currently, the average upside earnings surprise is +6.9% higher than the expectations. And those results are robust, only one sector isn’t beating the estimates and that’s Real Estate with a mere -0.9% downside surprise rate.

Much Stronger Earnings Surprises So Far in Q1-2023
Q1-2023 Earnings Surprises are well above Q4-2022 and the Pre-Covid Average

Source: RBC Wealth Management, national research correspondent, Refinitiv I/B/E/S, FactSet; data as of 4/27/23. Q1 2023 data is preliminary and likely to change as more companies report results.

DEBT DEADLINE ADVANCED

On May 1, Treasury Secretary Janet Yellen made headlines by stating that the U.S. could default on its debt obligations as soon as June 1 if Congress doesn’t act on the debt ceiling. That is a much shorter timeline than July which the Congressional Budget Office had previously projected. Republicans and Democrats have been debating how to raise the debt ceiling for months but hadn’t made any meaningful progress toward reaching an agreement. House GOP lawmakers approved legislation last week that would raise the limit for about a year, while also capping spending, but the Democrats largely rejected the initial GOP plan, arguing the debt ceiling should be raised without conditions. However, following Yellen’s warning, President Biden on Monday did invite the top Republicans and Democrats of the House and Senate to meet on May 9th to discuss raising the borrowing limit. As seen in the chart below, the lack of progress on an agreement, along with the new constrained timeline, has sent the cost of insuring against a US Default, as measured by the price of the 1-year Credit Default Swap (CDS), to levels nearly three times the prior highs from the 2011 and 2013 debt-ceiling showdowns. To be sure, the new timeline is not friendly. On May 19th Biden leaves for Japan for a week-long trip. The House is only in session for only 12 days in May, and the Senate is in session for only 15 days. On May 26th (the Friday before Memorial Day weekend) Congress goes on recess for Memorial Day. Essentially that leaves the 9th to 26th to hammer out a deal but the realistic window is probably the 9th through 19th before Biden’s trip overseas. It should be pointed out that Yellen did qualify that the Treasury’s latest projection was still uncertain, and the Treasury Department could ultimately pay the nation’s bills for several weeks beyond early June. It is also important to note, that despite the brinksmanship and bluster by the politicians, the debt ceiling has been raised or suspended 52 times since 1978—32 times under Republican Presidents and 20 times under Democrat Presidents. So in all likelihood an agreement will be made or they will agree to kick the can down the road with a temporary suspension and do this all again in a few months.

Debt Ceiling Danger… been there, done that
The Rising Cost of Insuring US Debt Against Non-Payment

Source: Bloomberg, as of 5/1/2023.

RETURNS TYPICALLY RISE AFTER HIKES END

A year into its most aggressive rate hiking cycle in decades, the Federal Reserve has raised rates by a full 5%. That has created much tighter financial conditions, with housing, manufacturing, and capital markets all experiencing corrections over the year. A further tightening in lending standards due to banking system pressures has also developed adding to the restrictive economic conditions. The slowing GDP growth and tighter financial conditions are raising the odds of a U.S. recession. With that backdrop, monetary policy should pose less of a headwind for stocks going forward, particularly if the outlook worsens, which would likely push the Fed to ease monetary policy. The good news is that if history is any guide, equity markets tend to perform well in the 12 months following the end of a tightening cycle, as shown in the chart below. That’s not to say the economy and markets are out of the woods yet, but clearer skies may be on the way after a stormy 2022 and a choppy start to 2023.

Equities have historically performed well after tightening cycles
S&P 500 price returns in the 12 months following the past 6 hiking cycles

Source: FactSet, S&P 500, J.P. Morgan Asset Management..

Asset Class Performance

The Importance of Diversification. Diversification mitigates the risk of relying on any single investment and offers a host of long-term benefits, such as lowering portfolio volatility, improving risk-adjusted returns, and helping investments to compound more effectively.

Source: Bloomberg.
Asset‐class performance is presented by using market returns from an exchange‐traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees for and do not necessarily represent performance of specific mutual funds and/or exchange-traded funds recommended by The Retirement Planning Group. The performance of those funds may be substantially different than the performance of the broad asset classes and to proxy ETFs represented here. U.S. Bonds (iShares Core U.S. Aggregate Bond ETF); High‐Yield Bond (iShares iBoxx $ High Yield Corporate Bond ETF); Intl Bonds (SPDR® Bloomberg Barclays International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares U.S. Real Estate ETF). The return displayed as “Allocation” is a weighted average of the ETF proxies shown as represented by: 30% U.S. Bonds, 5% International Bonds, 5% High Yield Bonds, 10% Large Growth, 10% Large Value, 4% Mid Growth, 4% Mid Value, 2% Small Growth, 2% Small Value, 18% International Stock, 7% Emerging Markets, 3% Real Estate.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Chris Bouffard is CIO of The Retirement Planning Group (TRPG), a Registered Investment Adviser. He has oversight of investments for the advisory services offered through TRPG.

Disclaimer: Information provided is for educational purposes only and does not constitute investment, legal or tax advice. All examples are hypothetical and for illustrative purposes only. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Please contact TRPG for more complete information based on your personal circumstances and to obtain personal individual investment advice.