It’s been a strong start to the year, but challenges remain—from inflation to bank stress aftershocks, to the debt ceiling. Are markets oblivious to the risks, or keenly aware of them?
Our Top Market Takeaways for April 28, 2023
Market update
What’s priced in?
Take the bad with the good. On one hand, this week showed growth is slowing, aftershocks from the banking crisis are continuing to reverberate, and the U.S. debt ceiling is lurking. Yet, Q1 earnings season is sending a strong signal that Corporate America is hanging on tight.
It’s the latter that’s sent markets grinding higher this week. A global portfolio of stocks and bonds is now up to the tune of ~6% so far this year.*
Markets are anticipation machines—virtually all price action can be explained by what investors expect to happen in the future. So does that mean markets are oblivious to the risks, or keenly aware of them?
For today’s note, we offer our take on what’s priced in:
1. A slowdown…without a recession
The U.S. economy grew 1.1% in the first quarter this year, slowing from Q4’s 2.6% pace and missing expectations. Consumption was still strong, but companies cut back on investment and drew down on their inventories. While that’s not good news, investors have had a long time to prepare. Much portfolio purging happened last year—remember 2022 marked the S&P 500’s worst year since the Global Financial Crisis and U.S. core bonds’ worst on record.
Markets also seem to be doing a pretty good job at sniffing out the problem areas. Heading into Friday, First Republic lost a staggering -57% this week as questions around its future percolated, while broader regional banks are down just -1.2%. The same can be said for ongoing worries around commercial real estate. REITs in the troubled office sector have sunk -18% this year, while the broader universe is +0.7% higher.
But while investors seem to have prepared for a slowdown ahead, the strong gains we’ve seen so far this year suggest that the potential for our base case of a recession isn’t fully appreciated either. As just a rough barometer, Google searches for “recession” have dramatically faded.
Investors seem less concerned about recession
The chart describes Google searches for recession indexing at 100 for March 2020 peak.
The line starts at 9 in December 2018.
Then it went up to a peak at 53 in August 2019.
Later it troughed at 7 in December 2019.
Then it spiked up to a new high at the indexed level of 100 in March 2020.
Later it dropped and troughed at 4 in December 2020.
Then it spiked again to 86 in June 2022.
Before quickly dropping to 27 in July 2022.
Then it went back up to 84 in the same month, July 2022.
It troughed to 17 in September 2022.
Had a new rise to 37 in October 2022.
Then it ended at a low point at 16 in April 2023.
2. The Federal Reserve getting its job done…not sticky prices
Inflation has slowed, but is still hot and well above the Fed’s 2% target—in large part due to a still resilient labor market. Yesterday brought word that 16,000 less people filed for unemployment insurance over the last week than the one before, even as companies have announced more job cuts (the likes of McDonald’s, Lyft, Walmart, Whole Foods and Deloitte all joined in this month).
Yet, markets are still betting on the Fed getting things back in balance, with expectations for future inflation (for instance, five-year breakeven rates) well anchored around the Fed’s mandate. Consumers also tend to agree. The latest survey from the University of Michigan showed that while consumers think prices will climb by 4.6% over the next year (up from 3.6% in March), they expect costs to rise at a lesser 2.9% pace over the next five years (holding steady from the prior month).
Market-based measures inflation expectations remain anchored
The chart describes 5-year inflation breakeven in percentages.
The line starts at 2.9 in December 2021.
Then it dropped to a low at 2.7 in January 2022.
Before rising to a high at 3.7 in March 2022.
It trended lower from there until it troughed at 2.1 in January 2023.
Then it peaked at 2.8 in March 2023.
The series ended lower at 2.3 in April 2023.
We tend to agree that the Fed will get its job done (with one more hike at next week’s meeting and cuts in the final months of the year), but getting inflation in check will likely come at a greater economic cost than the market expects. The average economist on the Street expects the unemployment rate to rise to 4.7% from today’s 3.5%. But as the impact of the rate hikes already seen continues to build, and the flow of credit is stymied as banks cut back on lending, we think more pronounced layoffs may be in the cards.
3. A short-lived downturn in corporate profits…but not meaningful pain
While it’s still early days, earnings for Q1 are so far, so good. Banks have been much better than expected, mega-cap tech has been blowing it out of the water, and consumer-linked names are showing they still have pricing power.
To be fair, things are definitely slowing down—right now, consensus expects S&P 500 earnings per share to fall -4% in Q1 over the prior year. But that’s already improved from expectations for more than -7% at the start of the quarter. And as just over half of the index has reported, some 80% of companies have bested expectations, above the five-year average of 77%.
What’s more, markets are expecting this to pretty much be the worst of it, with this or next quarter marking the trough in profits and a quick bounceback thereafter.
S&P 500 earnings are in the process of troughing
The chart describes the S&P 500 YoY% EPS growth (quarterly data) in a column chart format. It also writes out the consensus estimates for Q1 2023 at -4.0% and Q2 2023 at -5.3%.
The number starts at 6.1% in Q1 2014.
Then it went a bit higher to 10.8% in Q2 2014.
Later it dropped and troughed at -6.4% in Q1 2016.
Then it climbed to 26.9% in Q3 2018.
It dropped to the lowest point at -33.6% at Q2 2020.
Before going up to a high at 89.0% in Q2 2021.
Then the latest one ended at -2.8% in Q4 2022.
Then it switched to consensus for future quarters from here.
The first one came in at -4.0% in Q1 2023.
It went to trough at -5.3% in Q2 2023.
Before trending up at 14.2% in Q1 2024.
Then to stabilize near that level at 12.3% in Q4 2024.
We think that’s probably just a bit too optimistic. Tailwinds such as growing efforts to cut costs, stronger supply chains and a weaker U.S. dollar still need to be weighed against slower growth, higher prices and general business uncertainty. To us, that means earnings will still probably decline around -4% for the balance of 2023 versus the market’s bet to eke out +1% growth.
4. Growth over value, and international over United States…but there’s probably still some room to go
Much of the S&P 500’s rally this year is thanks to mega-cap tech. For instance, the largest 10 stocks in the S&P 500 (seven of which are tech or tech-enabled firms) make up just over 25% of the index, but account for 6.0% out of the index’s 8.3% year-to-date total return. The remaining 490 stocks have contributed a mere ~2.3%. Tech could continue its reign as growth becomes scarcer and investors see the highest-quality names as a safe havens—but over the medium term, we still see more value in small- and mid-cap stocks.
Though just a quarter of the S&P 500, mega cap tech has led returns
This chart shows the top 10 largest weights in the S&P 500 (namely AAPL, MSFT, AMZN, GOOGL, BRK, NVDA, GOOG, TESLA, XOM, UNH and JNJ), which make up 18% of the total index. These same companies have driven 5.1% of the year-to-date 6.2% return, with the remaining 82% of the index contributing 1.1%. Specifically, AAPL drove 1.6%, MSFT 1.3%, AMZN 0.6%, GOOGL +0.3%, BRK +0.1%, NVDA +1.0%, GOOG +0.3%, TSLA +0.3%, XOM +0.1%, UNH -0.1%, JNJ -0.1%, and other companies +1.1%.
International stocks have been the other bright spot this year. Europe is outperforming the United States by 5.5% in dollar terms. Is it all priced in? We don’t think so. For one, Europe is still trading at a ~28% discount to the United States—wider than its longer-term 20% average.
5. Debt ceiling drama…but not default
Angst over the looming debt ceiling has revved back up. Even as House Speaker McCarthy passed a bill this week that would suspend the limit for a year in exchange for spending cuts, it’s unlikely to gain much traction in the Senate. Negotiations are just getting going, and lower tax revenues this year also suggest the X-date (the potential default date) could come on the earlier side.
Markets are reflecting some of the risk, with record-wide dispersion in T-bill yields (as investors avoid ones maturing near the potential default date) and a historic pop higher in U.S. government credit default swaps (i.e., the cost to insure against a default in government debt). These oddities will probably continue as policymakers work out the kinks, but we and investors believe a compromise will eventually be found to avoid a worst-case scenario.
The risk of U.S. default has pushed T-bills in different directions
This chart describes 1-month and 3-month Treasury bill yields on two lines.
Diamond signs are used to represent the most recent data point (3.3% for 1-month Treasury bill yield and 5.1% for 3-month Treasury bill yield) in April 2023.
The unit is %.
For the 1-month Treasury bill yield line, it started at 0% in May 2015.
It trended up until it peaked at 2.4% in April 2019.
Then it slowly fell to 1.5% in January 2020.
Then it dropped to -0.02% in March 2020.
It stayed near 0% until it reached 0.01% in February 2022.
Then it went up all the way until it reached 4.6% in March 2023.
It then dropped to 3.3% in early April 2023 before ending the series at 3.98%.
For the 3-month Treasury bill yield line, it started at 0% in May 2015.
It trended up until it peaked at 2.4% in March 2019.
Then it slowly fell to 1.3% in February 2020.
Then it dropped all the way to -0.04% in March 2020.
It stayed near 0% until it reached 0.1% in January 2022.
Then it went up all the way until it reached 4.9% in March 2023.
Then it slightly dropped to 4.3% in the same month March 2023.
Lastly, it rose to a new high at 5.06% in April 2023.
All in all, the market seems priced for what we know now. It doesn’t fully reflect recession risks, but it doesn’t entirely account for a bull case of smooth sailing ahead, either.
As investors seek answers, it’s likely more volatility is ahead. Bonds can help smooth the ride and offer protection, especially as growth slows. This also means that U.S. stocks are probably in for a choppy ride, leading us to see more opportunities in select sectors (reasonably priced technology, industrials, healthcare), as well as in Europe and China. Taking a longer-term view with megatrends, such as the energy transition, supply chain reorientation and digital transformation, may also offer stability and growth in the face of the evolving cycle.
It’s natural to be skeptical, especially given the existing slate of unknowns. Your J.P. Morgan team is here to help.
*This refers to a portfolio proxied by 60% MSCI World Index and 40% Bloomberg Global Aggregate Bond Index.
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The Bloomberg Global Aggregate Index provides a broad-based measure of the global investment grade fixed-rate debt markets. The Global Aggregate Index contains three major components: the U.S. Aggregate (USD 300mn), the Pan-European Aggregate (EUR 300mn), and the Asian-Pacific Aggregate Index (JPY 35bn). In addition to securities from these three benchmarks (94.1% of the overall Global Aggregate market value as of December 31, 2009), the Global Aggregate Index includes Global Treasury, Eurodollar (USD 300mn), Euro-Yen (JPY 25bn), Canadian (USD 300mn equivalent), and Investment Grade 144A (USD 300mn) index-eligible securities not already in the three regional aggregate indices. The Global Aggregate Index family includes a wide range of standard and customized subindices by liquidity constraint, sector, quality, and maturity. A component of the Multiverse Index, the Global Aggregate Index was created in 1999, with index history backfilled to January 1, 1990. All indices are denominated in U.S. dollars.
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