Sign On
by Chris Haverland, CFA, Global Equity Strategist; Austin Pickle, CFA, Investment Strategy Analyst; Larry Pfeffer, CFA, Equity Sector Analyst
Key takeaways
- A common narrative on Wall Street so far this year is that equity prices are breaking out into a new and sustainable rally, but we foresee a continued oscillation in the ranges we’ve seen since last April.
- The economy continues to slow, and in our view, the Federal Reserve (Fed) is set to disappoint markets by holding interest rates at high levels for an extended period.
What it may mean for investors
- We believe market volatility is likely in the coming months, and as a result, we still favor a patient and disciplined approach that emphasizes quality. The opportunity to position for an eventual early-cycle rebound should arrive later this year, but now is not yet that time.
Several drivers have sparked investor optimism around the equity markets’ strong start to 2023. These include smaller rate hikes by the Fed, moderating inflation, improved macroeconomic (macro) conditions in Europe, China’s unexpectedly sudden economic reopening, and a depreciating U.S. dollar.
While we respect the recent upward momentum, the all-clear signal for equities is not likely here yet, in our view. The S&P 500 Index has been oscillating roughly between 3700 and 4300 for nearly a year. Such an extended period without a breakout higher or lower is unusual in a world where earnings either tend to grow or contract. We expect this range to continue in the coming weeks but see the stage being set for a breakout later this year and an equity market recovery into 2024.
Chart 1: S&P 500 Index has been range-bound for nearly a year
The chart shows the S&P 500 Index from January 1, 2021 - February 8, 2023 as a solid line. Horizontal dashed lines at 4,300 and 3,700 indicate the general trading range that the S&P 500 Index has been in since the S&P 500 Index first closed below 4300 during its descent into bear market territory on February 23, 2022. Sources: Bloomberg and Wells Fargo Investment Institute. Daily data: January 1, 2021 – February 8, 2023. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
This broad trading range for the S&P 500 coincides with a persistent disconnect between the market’s view and the Fed’s view regarding the path of interest rates. The Fed has communicated that the peak in rates is near, but, for a year now, equity markets consistently have extrapolated this message to mean that rate cuts are soon coming. Inflation past its peak only encourages this view among investors.
But a slower rate of interest rate increases — or even a pause — is not the same as rate cuts. Inflation in the U.S. (and globally) is coming down as we predicted, hoped, and wanted, but is unlikely to fall in a straight line. Upside surprises in inflation have been the rule in past disinflation periods. We expect that more near-term equity market volatility is likely as markets adjust expectations to the Fed’s message of higher-for-longer interest rates.
Likewise, the cumulative effects since last year of higher interest rates and inflation above wage growth are eroding earnings for the S&P 500 Index as a whole. We see the economy slumping toward a recession that is short and moderate by historical standards. Analyst expectations for full-year 2023 S&P 500 Index earnings have started to come down, but still seem too optimistic compared with our $205 target for S&P 500 Index earnings per share (EPS).
2023 sector leadership shift unlikely to persist
Still, the optimism reflected in the composite S&P 500 Index has shown up as a broad-based advance across sectors for the first time since late 2021. Unfortunately, the market leaders to-date have been mostly low-quality and long-duration sectors (see chart 2). All were among last year’s underperformers, and all are vulnerable to the higher-for-longer interest rates and a slowing economy. We do not view the recent breadth and leadership as sustainable — yet — and prefer not to chase equity rallies at this time.
Chart 2: Last year’s underperforming sectors have been this year’s leaders
The bar chart shows the total returns for the S&P 500 Index and its sectors for full-year 2022 and year-to-date returns as of February 8, 2023. The chart illustrates that those sectors that were the worst performers in 2022—Communication Services, Consumer Discretionary, Information Technology, and Real Estate—have been the top performing sectors in 2023. Sources: Bloomberg and Wells Fargo Investment Institute. Year-to-date return data measured from December 31, 2022 – February 8, 2023. Returns measured using the total returns of the S&P 500 Index and related S&P 500 sectors. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
If we check under the hood of the recent rally, notable dynamics emerge. We highlight two.
Not all that rallies is attractive: The fact that some of the worst-performing sectors, sub-industries, and individual stocks of 2022 have become the best performers so far in 2023 is not necessarily evidence of sustainable outperformance. For instance, the automobiles sub-industry (we rate autos as neutral) within the Consumer Discretionary sector (unfavorable) declined 62% in 2022, making it the worst-performing sub-industry in the sector. In January 2023, however, this sub-industry advanced 35% and was the best performer in the sector. The improvement is due largely to multiple expansion rather than by positive earnings revisions. The recent outperformance seems to owe more to mean reversion than to improving fundamentals.
Patience and selectivity are the watchwords: Several highly cyclical areas of the market have found their footing in recent weeks, as the rate of decline in earnings expectations has begun to moderate. For example, the correction in earnings expectations for companies tied to fast-moving and durable consumer goods began in earnest in May 2022, following significant profit warnings from two big-box retailers. Investors in these companies have had some time to discount weaker underlying conditions. However, we believe examples like this one are the exception, not the rule, for the majority of cyclically oriented sectors and sub-industries, where we sense that declining earnings have not been fully priced.
For now, we still view pullbacks in our favored areas as potential opportunities for adding exposure, but we prefer more selectivity in areas where sector allocation guidance and sub-industry recommendations are neutral or unfavorable. We do expect a better opportunity, later in the year, to broadly favor sectors that should outperform as economic and earnings performance turn sustainably positive.
Summary
We do expect an economic recovery to begin by the end of the year, and we expect equity markets to anticipate that well in advance. To that point, our year-end S&P 500 Index price target remains 4,300 - 4,500. But we believe that the time has not yet arrived for broad-based buying for the next economic recovery. Patience is key, for now. We expect that investors will need to stay nimble around the inflection from policy uncertainty and negative fundamentals to a more positive economic and earnings environment.
We currently favor U.S. Large-Cap and Mid-Cap over Small-Cap equities and Developed and Emerging Markets. We remain favorable on the Energy, Health Care, and Information Technology sectors, while we remain unfavorable on Consumer Discretionary and Real Estate.
