It was a tumultuous quarter for global equity markets, punctuated by elevated inflation, an increasingly high stakes war in Ukraine, and the sudden and shocking threat of a good, old fashioned banking crisis. And to think, we still have three quarters of the year left!
U.S. stocks, as measured by the S&P 500 Index, returned 4% in the quarter, including dividends. International stocks, as measured by MSCI’s All Country Worldwide Ex-U.S. Index, returned 3.5%, including dividends. Given the events that unfolded over the last three months, on top of last year’s turmoil, we were pleased to see positive returns for equities in the first quarter.
We believe U.S. stocks rose in the first quarter because 2023 S&P 500 Index earnings estimates only fell 3.5% from where they were at the end of 2022. While stocks typically follow changes in earnings estimates, sentiment at the beginning of 2023 was particularly negative and investors were widely expecting a much greater decline in 2023 estimates than what has turned out to be the case… thus far.
The risks to stocks are widely known. The Fed is purposefully trying to reduce economic growth in order to bring inflation down. Slowing growth raises the probability that companies will miss their sales targets. Disappointing sales, higher interest rates, wage and tax increases are all obstacles to profit margins, stoking fears of further downside risk to earnings estimates. An inverted yield curve, meaning longer-dated bond yields are below shorter-dated ones, often portends a recession. Lower sales and profits from companies may still be in store, but year-to-date figures are mixed overall. In fact, at one point in February, U.S. stocks were up 9% year-to-date, indicating investor excitement that the worst may be over. Then, the Fed brought investors back to reality by signaling they were nowhere near done raising short-term interest rates. We have seen this movie before.
As if the equity markets did not have enough to fret about, seemingly out of nowhere, late in the quarter came renewed fears of a systemic banking crisis. Silicon Valley Bank and Signature Bank both failed, and concerns started to spread to other banks as depositors rushed to get their money. As the dust is (hopefully) starting to settle with disaster averted, we have three conclusions about the situation.
The first is that bank failures happen on occasion and do not always mean the entire system is at risk. Some poor decisions were made at specific banks, compounded by a lack of risk oversight. The government as well as other large banks (e.g., JPMorgan) have worked to contain the fallout, and they are committed to restoring the public’s faith in deposit safety. We do not see a broader banking crisis unfolding at this point.
Second, at this juncture, we think bank stocks are unattractive investments. The pendulum of banking regulations tends to swing widely in both directions. Increasing regulations on the banking sector are highly likely in order to prevent these types of situations from recurring. Such rules will be headwinds to future earnings growth and could also cap valuation multiples. Dividend growth may be constrained as banks are forced to hold more capital on their balance sheets.
Third, to the extent that fallout from the recent banking chaos diminished economic activity in the U.S., the Fed may now be closer to reducing interest rates than it was before. Falling rates could take pressure off banks’ deposit rates and their securities portfolios, which have been the main risk impacting regional banks. On the other hand, with economic activity weakening, banks’ loan loss provisioning and delinquency rates on their commercial loans are rising. Never say never, but from where we sit today, Howland Capital’s Investment Committee is hard pressed to envision a compelling case for bank stocks moving forward.
In summary, as we exit the quarter and reflect on what feels like a few years compressed into three short months, we are encouraged that stock markets rose in the quarter, earnings estimates did not fall more, and that the U.S. economy has thus far remained resilient enough to withstand aggressive Fed actions aimed at bringing inflation down to a more manageable level.
Looking back at the outlook we provided at the end of 2022, the range of scenarios we see playing out for stocks through the rest of this year and into the next remains unchanged, with one important caveat. We believe the probability of our downside scenario has modestly increased.
The outlook for corporate earnings is unclear and the number of factors clouding our vision is increasing. The S&P 500 Index earnings per share for 2023 are expected to be $221 versus $216 in 2022 and $206 in 2021. Estimated earnings of $221 in 2023 puts the current S&P 500 Index valuation on a price-to-earnings basis at 18x, which is slightly ahead of the long-term 25-year average. If this 2023 estimate turns out to be true and earnings grow further in 2024, we think the market looks fairly priced. With this outcome, we are optimistic that stocks can rise from current levels.
Taking the larger view, while we are encouraged that markets have seen an upswing so far this year, we exit the first quarter of 2023 with even less clarity than when it began. Inflation remains persistently high, there are lingering fears about the earnings estimates are proving more resilient than expected. Risks have increased over the last few months and despite this, the Fed must continue to do what is necessary for the long term, even if it means greater pain in the short term. On the flipside, the job market remains strong, and earnings estimates are proving more resilient than expected. Risks have increased over the last few months and despite this, the Fed must continue to do what is necessary for the long term, even if it means greater pain in the short term.
We remain steadfast in our belief that healthier economic times will eventually come. The U.S. economy and corporations will likely emerge stronger and healthier from this period of adjustment, even if the Fed goes too far and the market falls in the near term. While the recovery thus far in 2023 is welcome and indicative of potentially better economic times ahead, we remain cautious and ready for more “bumps in the road”. That is why our long-term recommendation remains unchanged. Plan for and communicate cash needs to avoid selling stocks unnecessarily at depressed prices. Stay invested in accordance with your long-term goals, and please feel free to reach out to Howland Capital if there is anything we can be doing to help.