United States
Economic data strengthens in the face of persistent inflation and high interest rates
Domestic equity markets trimmed their year-to-date gains in February, with the Russell 3000® ending the month down 2.4%. A continued narrative of elevated inflation, robust job gains and unexpected consumer spending strength bolstered investor concerns that the Federal Reserve (Fed) may have to ramp up the magnitude and duration of interest rate hikes.
Continued economic strength, in our view, has been supported by a resilient labor market. The January payroll report showed 517,000 net new jobs, which far outstripped expectations of 189,000. Additionally, jobless claims remain below expectations, which signals companies are retaining employees. Finally, despite slowing wage growth, the unemployment rate fell to 3.4%, the lowest level since 1969.
The downside to continued economic strength is the persistence of inflation. The February Consumer Price Index fell less than consensus expected, to 6.4% year over year versus the 6.2% estimate, while the Fed’s preferred inflation indicator, the Core Personal Consumption Expenditure Deflator, accelerated to 5.4% from the prior month’s 5.0%. These negative surprises added to heightened market volatility for the month, as investors were forced to reevaluate their expectations about the path of monetary policy.
Strong economic data and recent Fed comments have increased market expectations for a higher terminal rate (Figure 1). Elevated inflation is likely to be met by further monetary tightening. We continue to believe the primary drivers of the market’s path forward are the Fed’s forward guidance and the path of interest rates, especially as they approach restrictive territory.
Figure 1. Market-Implied Fed Funds Terminal Rate
Terminal rate will drive earnings growth trajectory
As of 2/28/2023. Source: Bloomberg, L.P.
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Fourth quarter earnings season for the S&P 500® is on pace to deliver a blended earnings growth rate of -4.9%, the first quarter of negative growth in two years. More concerning, in our view, is the low upside surprise of just 1.0%, which is not only well below the 15-year average of 4.5% but is also the lowest growth rate outside of a recession. We believe the anticipated 2023 economic slowdown is not yet fully reflected in consensus earnings estimates. Furthermore, we view the current consensus estimate of 1.8% as overly optimistic and expect margins to continue to moderate throughout 2023 as companies seek to right-size and manage expenses.
Despite the pullback, earnings multiples compressed only marginally in February, with the S&P 500 forward price-to-earnings (P/E) ratio declining half a multiple point to 17.5 times (x). While most equity valuations are near their 20-year averages, we caution that valuations are likely to fall, as we expect the lagged effects of tighter monetary policy to dampen sales and earnings growth over the course of 2023. Historically, there has been a correlation between rising interest rates and declining equity valuations. Thus, we expect limited earnings multiple expansion should the Fed continue to raise rates.
Fixed income markets lagged equities in February, primarily due to the reversal of declining interest rates. The 10-year U.S. Treasury (UST) yield climbed more than 50 basis points in the month, reaching its highest level since November 2022. With the swift rise in yields, volatility also increased, as measured by the ICE BofA MOVE Index, which also returned to levels not seen since November.
Given much of the rise in interest rates took place within short-term fixed income, several closely watched yield curves remained deeply inverted, including the curve measuring the spread between the 3-month and 10-year UST and the 2- and 10-year UST. While no single yield curve has perfect predictive power, the inversion of nearly all curves signals slowing growth ahead as aggressive monetary tightening weighs on the economy.
Developed International Markets
Hawkish central banks and stubborn inflation dampen market optimism
The MSCI World ex-USA Index fell 2.3% in February as macroeconomic headwinds returned to global markets. The U.S. dollar, which had been a tailwind for international equity returns in recent months, turned into a headwind, with the U.S. Dollar Index staging its largest monthly gain since September.
While a mild winter has helped Europe avoid a recession thus far, headwinds, such as elevated inflation, structurally high energy costs and tightening financial conditions, remain. Like the United States, developed markets are experiencing pockets of reaccelerating inflation, with core inflation in both Europe and Japan reaching new multi-decade highs. In our view, these inflation challenges suggest central bank tightening in Europe is far from over.
In contrast, the Bank of Japan (BOJ) has remained committed to its existing ultra-loose monetary policies. Incoming BOJ governor Kazuo Ueda has reassured investors that its policy remains appropriate until Japan’s 2% inflation target is consistently achieved. Given the BOJ’s balance sheet is 129% of Japan’s GDP (compared to 33% for the Fed’s balance sheet), an abrupt change to its monetary policy could create significant headwinds for global markets, thus we continue to monitor central bank developments closely.
The lagged effect of monetary policy tightening is our chief concern in Europe. European consumers and businesses have been cushioned by pandemic-era fiscal stimulus so far; however, European bank survey data shows weaker demand for future borrowing (Figure 2). In our view, this suggests monetary tightening will remain a market headwind. The European Central Bank is slated to begin quantitative tightening in March, which is expected to have a dampening effect on the European money supply, potentially creating a new headwind for global market liquidity. Given the potential for additional rate hikes, we expect to see subdued economic activity in 2023.
Figure 2. European Bank Lending Survey-Year-over-Year Anticipated Change in Borrower Demand (%)
Demand for borrowing shows weakness ahead
As of 2/28/2023. Source: Bloomberg, L.P.
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Estimated calendar year 2023 earnings growth in international developed markets continues to edge lower, recently reaching 1.8%. We believe current earnings estimates are optimistic given unresolved macro headwinds. Earnings multiples are susceptible to downward revisions, as estimates are likely to be revised lower to reflect slower revenue growth and margin compression.
Emerging Markets
Investors ignore fundamentals amid China’s reopening
Emerging market (EM) equities suffered their worst monthly decline since last September, ending February down 6.5%, led by a more than 10% decline in China. After China’s strong rally since the country’s reopening began in November, EM equities stalled in February. We believe China’s equity markets advanced aggressively on the surprise reopening, but recent worries about a more hawkish Fed paired with muted Manufacturing Purchasing Managers’ Index data in China have dampened investor enthusiasm.
As of this publication, more than 34% of EM companies have reported fourth quarter earnings results. The blended earnings growth rate of 3.8% is relatively strong, driven by an upside surprise of 9.2%. Earnings growth was led by several large index constituents that reported revenue and earnings beats and raised guidance for 2023. This comes in stark contrast to last quarter when EM equities missed earnings expectations, with a negative surprise rate of -6.0%. We believe the current consensus 2023 earnings estimate of -3.5% has yet to fully reflect China’s reopening. With a forward P/E multiple of 12.1x, we believe EM remains attractive relative to developed markets (Figure 3).
Figure 3. Developed vs. Emerging Market Next 12 Months P/E
Emerging market valuations approach most attractive levels in 10 years
As of 2/28/2023. Source: FactSet®. FactSet® is a registered trademark of FactSet Research Systems, Inc. and affiliates.
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TEXT VERSION OF CHARTS
Figure 1: Market-Implied Fed Funds Terminal Rate
Terminal rate will drive earnings growth trajectory (view image)
Date |
Market Pricing of Fed Funds Terminal Rate |
2/28/2023 |
5.59% |
1/31/2023 |
5.08% |
12/30/2022 |
5.14% |
11/30/2022 |
5.08% |
10/31/2022 |
5.15% |
9/30/2022 |
4.70% |
8/31/2022 |
4.11% |
7/29/2022 |
3.42% |
6/30/2022 |
3.65% |
As of 2/28/2023. Source: Bloomberg, L.P.
Figure 2: European Bank Lending Survey- Year-over-Year Anticipated Change in Borrower Demand (%)
Demand for borrowing shows weakness ahead (view image)
Date |
Business |
Consumer Credit |
Mortgages |
12/31/2022 |
-4.4 |
-16.9 |
-64.4 |
6/30/2022 |
12.1 |
0.6 |
-9.6 |
12/31/2021 |
23.2 |
11.8 |
-1.4 |
6/30/2021 |
21.2 |
12.6 |
5.7 |
12/31/2020 |
17.0 |
2.8 |
-4.6 |
6/30/2020 |
76.5 |
-29.8 |
-66.8 |
12/31/2019 |
1.0 |
13.6 |
19.7 |
6/30/2019 |
5.0 |
11.0 |
6.0 |
12/31/2018 |
10.6 |
15.2 |
18.2 |
As of 2/28/2023. Source: Bloomberg, L.P.
Figure 3: Developed vs. Emerging Market Next 12 Months P/E
Emerging market valuations approach most attractive levels in 10 years (view image)
Date |
MSCI World Ex USA / MSCI EM 1-Year Forward P/E Ratio |
Average |
2/28/2013 |
1.075866 |
1.218663 |
2/28/2014 |
1.191584 |
1.218663 |
2/27/2015 |
1.099141 |
1.218663 |
2/29/2016 |
1.13076 |
1.218663 |
2/28/2017 |
1.13277 |
1.218663 |
2/28/2018 |
1.153267 |
1.218663 |
2/28/2019 |
1.235819 |
1.218663 |
2/28/2020 |
1.251911 |
1.218663 |
2/26/2021 |
1.385439 |
1.218663 |
2/28/2022 |
1.413376 |
1.218663 |
2/28/2023 |
1.243173 |
1.218663 |
As of 2/28/2023. Source: FactSet®. FactSet® is a registered trademark of FactSet Research Systems, Inc. and affiliates.
