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Current Markets

Craig MacKinlay
Published on February 16, 2023

In January’s issue of Partner Talk, Fred Snitzer discussed some of the important take aways from the “painful year” that 2022 represented for most investors and emphasized the importance of looking forward.  As we approach the middle of the first quarter of 2023, it is now time to review the current investing environment and consider possible implications for future market performance.  That task is the goal of this issue of Partner Talk.

After 2022, the performance of financial markets year-to-date, in a relative sense, has been a pleasant surprise.  Through early February, evaluating equity performance using the Standard and Poor’s 500 Index, the market is up almost 9 percent.  For the same period, the bond market is up more than 4 percent based on the performance of the Bloomberg US Aggregate Bond Index.  However, many economists have suggested that drawing implications for the future from the current environment is difficult.  For example, Lawrence Summers, a Harvard professor and former treasury secretary described the current economy as a “confused picture” as far as markets are concerned.

Where are we at today?  There are many directions from which we can view the economy –  including economic growth and uncertainty, equity market valuation, and the role of interest rates.  We will touch on each of these.

As far as economic growth is concerned, a mixed picture emerges.  Forecasts of growth itself as measured by real GDP are modest but positive with consensus views projecting the economy to grow at about 1 percent in 2023.  There is wide variation in the forecasts.  Many economists believe that as the Federal Reserve acts to bring inflation under control, the economy will experience a major slow down and a recession will result – a so-called “hard landing.”  Others cite the recent strength of the U.S. job market and postulate that the Fed can bring inflation under control without a significant slowdown and engineer a “soft landing.”

This debate is one place where the “confused picture” arises.  Generally, to stabilize prices and control inflation, the Fed increases interest rates. There is currently an unusual gap between the Fed’s projection and the market consensus as to what Fed action will be necessary to get inflation down to the Fed’s stated objective of two percent.  The Federal Reserve Open Market Committee (FOMC) median projection is that the fed funds target rate will need to increase above five percent and will need to stay high throughout this year.  In contrast, the market consensus as reflected in the Fed funds future contract on the Chicago Mercantile Exchange (CME), is that inflation can be controlled with a rate less than five percent.  One explanation for this disagreement is that the Fed is taking an overly cautious stance now to compensate for what is viewed as doing a poor job controlling inflation over the past few years.

Market volatility is always a concern.  A reading of volatility expectations can be procured using the VIX volatility index published by the Chicago Board Options Exchange (CBOE).  This index is a forward-looking measure of stock market volatility.  Based on this index, market volatility has been moderate this year with an average measure less than 20 percent.  This reading is below the average VIX level over the past five years which is 21.5 percent.  However, one must attach a note of caution to concluding that future volatility will be low as unpredictable future events could lead to a jump in volatility.  Potential events could be unexpected developments related to the Ukraine crisis or a further increase in the current tension with China.  An unexpected increase would put downward pressure on market values.

As noted in January’s issue of Partner Talk, a positive consequence of the down market of 2022 is that the valuations of bonds and stocks are now roughly in line with historical norms.  Thus, relying on historical experience and taking a forward-looking perspective, one would expect markets to have reasonable performance this year.  However, as discussed above, uncertainty must be attached to such an expectation given many possible sources of downside risk.

With inflation currently moderating and current government bond yields near four percent, bonds represent a stable investment alternative.  A potential source of downward pressure on bond prices is the need for further intervention by the Fed to offset a reversal of the current inflation moderation.  Such action by the Fed will have a larger impact on the value of longer maturity nominal bonds since it is the present value of further out nominal flows that are impacted the most with rate increases.  This downward pressure on bond prices can be reduced by holding shorter maturities and by holding bonds that are inflation protected.  To offset these risks, PMA has reduced the duration (effective maturity) of its fixed income allocation and included an allocation to short term treasury inflation protected securities.

What about equity valuations?  The value of equities can be thought of as today’s value of future expected earnings.  Since the current consensus expectation is that earnings will grow by 3 percent on average in 2023, earnings forecasts are not sending a strong warning signal.  Related to earnings, a widely followed valuation measure is the price to earnings ratio.  In the investment community, an environment with high price to earnings ratios on average can be a warning of an overvalued market.  That is not a significant concern in the current market as the price to earnings ratio of the S&P 500 Index is approximately 20.  Using history as a guide, this number is close to the value that would be expected.  Another valuation measure, the dividend yield in the equity market, is also close to recent history at 1.7 percent.  These current values do represent a normalization relative to values observed during the recent pandemic.

It is necessary to continually monitor risks driven by the current economic conditions and make portfolio changes when justified.  At PMA, we have modestly increased our equity allocation to value stocks and altered our fixed income allocation to include inflation protected securities and to have a lower duration.  These changes reflect that in the marketplace, there are many things happening and many factors that need to be considered when analyzing valuation and the risk of stocks and bonds.

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