USMC - Taking Stock: Q2 2023 Equity Market Outlook

2023-03-24 03:00:00 ET

Summary

• We remain selective in taking risk as macro factors continue to drive sentiment.
• Despite the uncertainties, investors should not lose sight of equities’ enduring role in a well-balanced portfolio.
• We advocate a near-term focus on resilience via quality stocks, which historically have outperformed both the broad market and bonds in the one to three years after the Fed stops hiking rates.

By Tony DeSpirito

Key takeaways

Between stocks and a hard place. The first quarter packed a full gamut of investor emotion, as early cheer gave way to fears over stubbornly high inflation and fallout from Fed rate hikes. As Q2 begins, we see:

• Equities maintaining their long-term appeal.
• Returns increasingly driven by stock specifics.
• A need to emphasize quality and stability.

Equity market overview and outlook

An early-year stock rally fueled by hopes of a Fed pause proved short-lived. The first spoiler ? hotter-than-expected inflation data ? was followed by signs that rate hikes are having an economic impact as cracks emerged in the banking system.

The two counterforces make the Fed’s job more complicated as it becomes increasingly clear that taming inflation might not only incite recession but could also rock financial stability.

We remain selective in taking risk as macro factors continue to drive sentiment, but we do expect company specifics to grab the reins as the driver of returns once greater clarity emerges around inflation and the economy.

Despite the uncertainties, investors should not lose sight of equities’ enduring role in a well-balanced portfolio. We advocate a near-term focus on resilience via quality stocks, which historically have outperformed both the broad market and bonds in the one to three years after the Fed stops hiking rates, as shown below.

Quality readying to lead?

Average returns after Fed hiking cycle ends, 1984-2021

Source: BlackRock Fundamental Equities, with data from the Board of Governors of the Federal Reserve System and Bloomberg, calculated from Aug. 31, 1984-Dec. 31, 2021. Returns are calculated from the month when the Fed stops raising rates for peak rates periods in 1984, 1989, 1995, 2000, 2006 and 2018. All equities represented by the Russell 1000 Index and bonds by the Bloomberg U.S. Aggregate Index. “Quality” is defined as the top quintile of stocks ranked in the Russell 1000 Index using a proprietary research screen that assesses companies on 13 “quality” metrics. Past performance is not indicative of current or future results. Indexes are unmanaged. It is not possible to invest directly in an index .

Sticking with stocks

In a historically rare occurrence, both stocks and bonds delivered negative returns in 2022. The consensus view is that bonds now offer the best opportunity to invest at attractive prices since the global financial crisis (GFC). Yet stocks continue to play a critical role in a long-term investment plan and their “expensiveness” is partly a question of time horizon.

Perspective on price and performance

When it comes to price, starting point is critical to investment outcomes. That entry point is the most attractive it’s been in over a decade for bonds, setting up an appealing tactical opportunity for many investors.

Fund managers are seemingly seizing the moment, as Bank of America’s Global Fund Manager survey from February showed stock allocations are more than two standard deviations below their long-run average while bond allocations are higher than usual.

But the argument evolves as you extend the investing time horizon. A look at the equity risk premium (ERP) across nearly seven decades of data indicates current pricing is a fairly balanced proposition between the two assets ? with equities historically offering better long-term returns.

The ERP is a gauge of the relative risk-reward in stocks versus bonds, measuring stocks’ excess earnings yield over the “risk-free” rate. The ERP dropped recently after being abnormally elevated for 13 years as Treasury yields hovered near historic lows.

Yet the S&P 500’s current ERP of 1.71% is still above the 1.62% average since the index’s inception in 1957*, as shown below. This suggests that stock pricing relative to bonds is still slightly better than historical averages.

When it comes to performance, stocks have held the upper hand. Equities entail greater risk for their potential greater reward and are broadly expected to outperform bonds, which have lower volatility, over time. As the chart below shows, equities have even provided a more favorable performance outcome over shorter time frames, besting bonds 68% of the time over one-year holding periods.

An equity edge across time horizons

Percent of time stocks have outperformed bonds, 1957-2022

Source: BlackRock Fundamental Equities, with data from the Robert Shiller database, as of Dec. 31, 2022. Stocks represented by the S&P 500 Index and bonds by the 10-year U.S. Treasury. The analysis looks at total return and calculates the percent of times stocks provided a greater cumulative return than bonds for each holding period. Past performance is not indicative of current or future results. Indexes are unmanaged. It is not possible to invest directly in an index.

A relative view of valuations

Equity risk premium for U.S. stocks, 1957-2023

Emphasizing resilience

With recession a looming concern, investors understandably gravitate to the lower-risk asset. But equities are a critical long-term growth engine and can be built into portfolios with a focus on resilience. We believe this is best achieved through active selection with an emphasis on “quality” characteristics.

What is quality?

“Quality” in investing can be a subjective term. We apply a comprehensive metric comprising 13 factors that offer a broad, quantitative measure of quality. Among them are profitability, earnings stability, free cash flow generation, use of leverage and capital allocation.

Our quality metric has tended to outperform in down markets, and 2022 was among its best years since 1977. We believe this outperformance could continue in 2023 given a historical late-cycle advantage for quality, attractive relative valuations and a history of outperformance in the years following the conclusion of Fed hiking cycles, as shown on page 1.

Actively keying in on quality

Building quality into an equity portfolio can be achieved in various ways, across both growth and value disciplines. Our Fundamental Equities portfolio management teams are adding quality through stock selection that emphasizes:

1. Earnings compounders

In the short run, macroeconomic influences can have an outsized impact on stock returns. This has been painfully evident in the past year amid high inflation and Fed rate hikes. Yet companies’ underlying fundamentals are responsible for the lion’s share of stock returns across time, as illustrated below.

We seek companies that can maintain their earnings growth throughout market cycles. Those that compound their earnings by reinvesting them into revenue growth, margin improvement or share count reduction are effectively compounding returns to shareholders. We look for solid balance sheets and positive free cash flow (essentially a buffer against any shortfalls) as additional key signposts

Fundamentals dictate long-term returns

S&P 500 Index sources of total return, 1988-2022

2. Dividend growers

Dividend-paying stocks have outperformed nondividend payers over the long term with less volatility, but companies that grow their dividends stand out most, as shown at the upper right. Statistically, a company’s record of and commitment to paying a dividend has instilled a measure of resilience.

We find their managements are loath to cut a dividend and send a negative signal to the market, so dividend growers tend to be well-run companies built to weather diverse markets. Stocks with a history of dividend growth also have tended to fare better in a rising-rate environment versus the highest-yielding stocks (essentially “bond proxies”) that tend to follow bond prices down as rates rise.

More return with less volatility

Return and risk by dividend category, 1978-2022

3. Stability sectors

Healthcare was a favored stability sector across our global Fundamental Equities platform last year and remains so today. Company earnings in the healthcare sector have historically proved to be recession resilient, and we would expect that precedent to hold in the next recession. This is important in a year in which stock performance is more likely to be driven by earnings , versus last year when returns were driven by multiple contraction.

Pricing for healthcare stocks is compelling, with valuations below the market average. Other defensive sectors such as consumer staples and utilities were bid up in price last year as investors sought stability and their valuations still sit at or above the broad market. Healthcare also boasts a long-term tailwind as aging populations and increasing health-related needs worldwide set the stage for attractive growth prospects across the sector.

Actively keying in on quality We see each of the above expressions of quality gaining in importance in 2023 as return outcomes rely less on broad market moves and more on individual selection.

Macro conditions are driving daily market moves, but individual stock fundamentals historically dictate long-term investor outcomes.

* ERP calculated with data from Robert Shiller, Standard & Poor’s and Refinitiv, March 1, 2023. The ERP is calculated using the S&P 500 earnings yield and subtracting the 10-Year Treasury Constant Maturity Rate.

This post originally appeared on the iShares Market Insights.

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